In accordance with this guidance, the Company groups its assets and liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.
An instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a recurring basis in the financial statements:
Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2).
Cash flow hedges are recorded at fair value on a recurring basis. The fair value of the Company's cash flow hedges is determined by a third party vendor using the discounted cash flow method (Level 2).
The following tables present the balances of assets measured at fair value on a recurring basis as of SeptemberJune 30, 20212022 and December 31, 20202021 (in thousands). There were no liabilities measured at fair value at September 30, 2021 and December 31, 2020.
Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.
The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:
Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreements will not be collected. The measurement of loss associated with impaired loans can be based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the observable market price of the loan, or the fair value of the collateral less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company’s collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2) within the last twelve months. However, if the collateral is a house or building in the process of construction or if an appraisal of the property is more than one year old and not solely based on observable market comparables or management determines the fair value of the collateral is further impaired below the appraised value, then a Level 3 valuation is considered to measure the fair value. The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.
The following tables summarize the Company’s assets that were measured at fair value on a nonrecurring basis during the periods (dollars in thousands):
Accounting guidance requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The carrying values and estimated fair values of the Company’s financial instruments at SeptemberJune 30, 20212022 and December 31, 20202021 are as follows (in thousands):
The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.
Restricted stock units are an award of units that correspond in number and value to a specified number of shares of employer stock which the recipient receives according to a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with the employer for a particular length of time. Each restricted stock unit that vests entitles the recipient to receive one share of common stock on a specified issuance date.
A summary of the activity for the Company’s restricted stock units for the period indicated is presented in the following table:
Changes in each component of accumulated other comprehensive income (loss) were as follows (in thousands):
The following table presents information related to reclassifications from accumulated other comprehensive (loss) income (loss) for the three and ninesix months ended SeptemberJune 30, 20212022 and 20202021 (in thousands):
Service charges on deposit accounts consist of monthly service fees, overdraft and nonsufficient funds fees, and other deposit account related fees. The Company's performance obligation for monthly service fees is generally satisfied, and the related revenue recognized, over the period in which the service is provided. Payment for service charges on deposit accounts is primarily received immediately or in the following month through a direct charge to customers' accounts. Overdraft and nonsufficient funds fees and other deposit account related fees are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time.
ATM fees are primarily generated when a Company cardholder uses a non-Company ATM or a non-Company cardholder uses a Company ATM. ATM fees are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time. Check card fees are primarily comprised of interchange fee income. Interchange fees are earned whenever the Company's debit cards are processed through card payment networks, such as Visa. The Company's performance obligation for interchange fee income is largely satisfied, and related revenue recognized, when the services are rendered or upon completion. Payment is typically received immediately or in the following month. In compliance with Topic 606, debit card fee income is presented net of associated expense.
Wealth management fees are primarily comprised of fees earned from the management and administration of trusts and other customer assets. The Company's performance obligation is generally satisfied over time and the resulting fees are primarily recognized monthly, based upon the month-end market value of the assets under management and the applicable fee rate. Payment is generally received a few days after month-end through a direct charge to customers' accounts. Estate management fees are based upon the size of the estate. Revenue for estate management fees are recorded periodically, according to a fee schedule, and are based on the services that have been provided.
Fees for other customer services include fees for brokered loans, check ordering charges, merchant services income, safe deposit box rental fees, and other service charges. Check ordering charges are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time. Merchant services income mainly represent fees charged to merchants to process their debit and credit card transactions. The Company's performance obligation for merchant services income is largely satisfied, and related revenue recognized, when the services are rendered or upon completion. Payment is typically received immediately or in the following month. Safe deposit box rental fees are charged to the customer on an annual basis and recognized upon receipt of payment. The Company determined that since rentals and renewals occur fairly consistently over time, revenue is recognized on a basis consistent with the duration of the performance obligation.
The following table presents noninterest income, segregated by revenue streams in-scope and out-of-scope of Topic 606, for the three and ninesix months ended SeptemberJune 30, 20212022 and 20202021 (in thousands):
Notes to Consolidated Financial Statements (Unaudited)
Note 16.10. Derivative Financial Instruments
On April 21, 2020, the Company entered into two2 interest rate swap agreements related to its outstanding junior subordinated debt. One swap agreement was related to the Company’s junior subordinated debt with a redemption date of June 17, 2034, which became effective on March 17, 2020. The notional amount of the interest rate swap was $5.0 million and terminates on June 17, 2034. Under the terms of the agreement, the Company pays interest quarterly at a fixed rate of 0.79% and receives interest quarterly at a variable rate of three-month LIBOR. The variable rate resets on each interest payment date. The other swap agreement was related to the Company’s junior subordinated debt with a redemption date of October 1, 2036, which became effective on April 1, 2020. The notional amount of the interest rate swap was $4.0 million and terminates on October 1, 2036. Under the terms of the agreement, the Company pays interest quarterly at a fixed rate of 0.82% and receives interest quarterly at a variable rate of three-month LIBOR. The variable rate resets on each interest payment date. The Company expects the junior subordinated debt instruments to transition from a LIBOR-indexed floating rate of interest to a SOFR-indexed floating rate by June 30, 2023.
The Company entered into interest rate swaps to reduce interest rate risk and to manage interest expense. By entering into these agreements, the Company converted variable rate debt into fixed rate debt. Alternatively, the Company may enter into interest rate swap agreements to convert fixed rate debt into variable rate debt. Interest differentials paid or received under interest rate swap agreements are reflected as adjustments to interest expense. The Company designated the interest rate swaps as hedging instruments in qualifying cash flow hedges. Changes in fair value of these designated hedging instruments is reported as a component of other comprehensive (loss) income. Interest rate swaps designated as cash flow hedges are expected to be highly effective in offsetting the effect of changes in interest rates on the amount of variable rate interest payments, and the Company assesses the effectiveness of each hedging relationship quarterly. If the Company determines that a cash flow hedge is no longer highly effective, future changes in the fair value of the hedging instrument would be reported as earnings. As of SeptemberJune 30, 20212022, the Company has designated cash flow hedges to manage its exposure to variability in cash flows on certain variable rate borrowings for periods that end between June 2034 and October 2036. The notional amounts of the interest rate swaps were not exchanged and do not represent exposure to credit loss. In the event of default by a counterparty, the risk in these transactions is the cost of replacing the agreements at current market rates.
All interest rate swaps were entered into with counterparties that met the Company's credit standards and the agreements contain collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in these derivative contracts is not significant.
Unrealized gains or losses recorded in other comprehensive (loss) income related to cash flow hedges are reclassified into earnings in the same period(s) during which the hedged interest payments affect earnings. When a designated hedging instrument is terminated and the hedged interest payments remain probable of occurring, any remaining unrecognized gain or loss in other comprehensive (loss) income is reclassified into earnings in the period(s) during which the forecasted interest payments affect earnings. Amounts reclassified into earnings and interest receivable or payable under designated interest rate swaps are reported in interest expense. The Company does not expect any unrealized losses related to cash flow hedges to be reclassified into earnings in the next twelve months.
The following table summarizes key elements of the Company's derivative instruments at SeptemberJune 30, 20212022 (inand December 31, 2021 (in thousands):
| | | September 30, 2021 | | | June 30, 2022 | |
| | | Notional Amount | | | Assets | | | Liabilities | | | Collateral Pledged(1) | | | Notional Amount | | | Assets | | | Liabilities | | | Collateral Pledged(1) | |
Cash Flow Hedges | | | | | | | | | | | | | | | | | | | | |
Interest rate swap contracts | | $ | 9,000 | | | $ | 990 | | | $ | 0 | | | $ | 0 | | | $ | 9,000 | | | $ | 2,213 | | | $ | 0 | | | $ | 0 | |
| | | December 31, 2021 | |
| | | Notional Amount | | | Assets | | | Liabilities | | | Collateral Pledged(1) | |
Cash Flow Hedges | | | | | | | | | | | | | | | | |
Interest rate swap contracts | | $ | 9,000 | | | $ | 941 | | | $ | 0 | | | $ | 0 | |
| (1) | Collateral pledged may be comprised of cash or securities. |
Note 17. Acquisitions
Acquisition of the Bank of Fincastle
On July 1, 2021, the Company completed the acquisition of The Bank of Fincastle (“Fincastle”) for an aggregate purchase price of $33.8 million of cash and stock. The Company paid cash consideration of $6.8 million and issued 1,348,065 shares of its common stock to the shareholders of Fincastle. Upon completion of the transaction, Fincastle was merged with and into First Bank. At the time of closing of the acquisition, The Bank of Fincastle had six retail bank offices operating in the greater Roanoke region of Virginia. The former Fincastle branches continued to operate as The Bank of Fincastle, a division of First Bank, until the systems were converted on October 16, 2021. As of June 30, 2021, Fincastle reported total assets of $267.9 million, total loans of $194.5 million and total deposits of $236.3 million. For the three-month and nine-month periods ended September 30, 2021, the Company recorded merger related expenses of $1.3 million and $2.0 million, respectively, in connection with the acquisition of Fincastle. The Company estimates that it will incur aggregate costs related to the merger of $3.4 million, with the remaining $1.4 million of merger related expenses expected to be recorded throughout the fourth quarter of 2021 and first quarter of 2022.
Acquisition of SmartBank Loan Portfolio
On September 30, 2021, the Bank acquired $82.0 million of loans and certain fixed assets from SmartBank related to their Richmond area branch, located in Glen Allen, Virginia. First Bank paid cash consideration of $83.7 million for the loans and fixed assets. Additionally, an experienced team of bankers based out of the SmartBank location have transitioned to become employees of First Bank. First Bank did not assume any deposit liabilities from SmartBank in connection with the transaction, and SmartBank intends to close their branch operation on December 31, 2021. First bank has agreed to assume the facility lease at the branch and will continue to operate a loan production office from the location after the SmartBank branch is closed. First Bank’s assumption of the lease and acquisition of the remaining branch assets is expected to be completed in the fourth quarter of 2021, subject to customary closing conditions. The Company did not incur significant expenses related to the acquisition of loans and fixed assets in the third quarter of 2021.
The acquisitions were accounted for as business combinations under ASC 805,Business Combinations. Under acquisition accounting, assets acquired, and liabilities assumed are recorded at their acquisition date fair values, and any excess of the purchase price over the aggregate fair value of the net assets acquired is recognized as goodwill. Determining the fair value of assets and liabilities, particularly related to the loan portfolio, is inherently subjective and involves significant judgment regarding the methods and assumptions used to estimate fair value. During the measurement period, the acquirer shall adjust the amounts recognized at the acquisition date and may recognize additional assets or liabilities to reflect new information obtained from facts and circumstances that existed as of the acquisition date that, if known, would have affected the measurement of the amounts recognized as of that date. Measurement period adjustments are recognized in the reporting period in which they are determined. The measurement period may not exceed one year from the acquisition date.
The following table presents the total consideration paid by the Company in connection with the acquisition of Fincastle and the SmartBank loan portfolio, the fair values of the assets acquired and liabilities assumed, and the resulting goodwill. Amounts for the Bank of Fincastle acquisition are as of July 1, 2021. Amounts for SmartBank are as of September 30, 2021.
(Dollars in thousands) | | Bank of Fincastle | | | SmartBank | | | Total | |
Purchase price: | | | | | | | | | | | | |
Cash paid | | $ | 6,752 | | | $ | 83,745 | | | $ | 90,497 | |
Common stock issued | | | 27,069 | | | | 0 | | | | 27,069 | |
Total purchase price | | $ | 33,821 | | | $ | 83,745 | | | $ | 117,566 | |
| | | | | | | | | | | | | |
Identifiable assets acquired: | | | | | | | | | | | | |
Cash and due from banks | | $ | 46,158 | | | $ | 0 | | | $ | 46,158 | |
Federal funds sold | | | 120 | | | | 0 | | | | 120 | |
Securities, AFS, at fair value | | | 12,112 | | | | 0 | | | | 12,112 | |
Restricted securities | | | 183 | | | | 0 | | | | 183 | |
Loans, net of ALLL | | | 193,664 | | | | 81,636 | | | | 275,300 | |
Bank premises and equipment | | | 3,471 | | | | 172 | | | | 3,643 | |
Accrued interest receivable | | | 1,561 | | | | 143 | | | | 1,704 | |
OREO | | | 2,137 | | | | 0 | | | | 2,137 | |
BOLI | | | 5,852 | | | | 0 | | | | 5,852 | |
Other assets | | | 4,259 | | | | 0 | | | | 4,259 | |
Total identifiable assets acquired | | $ | 269,517 | | | $ | 81,951 | | | $ | 351,468 | |
| | | | | | | | | | | | | |
Identifiable liabilities assumed: | | | | | | | | | | | | |
Demand deposits & savings accounts | | $ | 184,535 | | | $ | 0 | | | $ | 184,535 | |
Time deposits | | | 52,246 | | | | 0 | | | | 52,246 | |
Accrued expenses and other liabilities | | | 1,132 | | | | 0 | | | | 1,132 | |
Total identifiable liabilities assumed | | $ | 237,913 | | | $ | 0 | | | $ | 237,913 | |
| | | | | | | | | | | | | |
Net identifiable assets acquired at fair value | | $ | 31,604 | | | $ | 81,951 | | | $ | 113,555 | |
| | | | | | | | | | | | | |
Goodwill resulting from acquisitions | | $ | 2,217 | | | $ | 1,794 | | | $ | 4,011 | |
The following table presents certain unaudited pro forma information as if the acquisition had taken place on January 1, 2020. These results combine the historical results of Fincastle and the Company for the period prior to the merger. While certain adjustments were made for estimated effects resulting from the application of the acquisition method, including certain fair value adjustments, this pro forma information is not indicative of what would have occurred had the acquisition actually taken place on January 1, 2020. Pro forma adjustments for the nine month periods��ended September 30, 2021 and September 30, 2020 include the net impact of accretion of loan discounts related to market interest rates, amortization of premiums on deposits, amortization of intangible assets and related income taxes. Additionally, the Company expects to achieve further operational cost savings and other efficiencies as a result of the acquisition which are not reflected in the unaudited pro forma amounts below.
| | | Unaudited Pro Forma | | | Unaudited Pro Forma | |
| | | Nine Months Ended | | | Nine Months Ended | |
(Dollars in thousands, except per share amounts) | | September 30, 2021 | | | September 30, 2020 | |
Total revenues (net interest income plus noninterest income) | | $ | 37,670 | | | $ | 36,077 | |
Net income | | $ | 7,849 | | | $ | 7,145 | |
Net income per share, basic | | $ | 1.26 | | | $ | 1.15 | |
Net income per share, diluted | | $ | 1.26 | | | $ | 1.15 | |
The revenue and earnings amounts specific to Fincastle since the acquisition date that are included in the consolidated results for 2021 are not readily determinable. The disclosures of these amounts are impracticable due to the merging of certain processes and systems at the acquisition date. Merger related expenses associated with the acquisition of Fincastle were $2.0 million through September 30, 2021. These costs included the integration of systems and operations and legal and consulting expenses, which have been expensed as incurred. Additional merger related expenses are expected to be incurred throughout the fourth quarter of 2021 and first quarter of 2022.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward-Looking Statements
First National Corporation (the Company) makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include, but are not limited to, statements regarding profitability, liquidity, adequacy of capital, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and the impact of the Company’s acquisitions of The Bank of Fincastle (Fincastle) and the SmartBank loan portfolio, including the expected levels of merger related expenses to be incurred by the Company, the expected benefits of the acquisition of Fincastle (Merger), and the potential impact of the acquisitions on the Company’s and First Bank’s (the Bank) liquidity and capital levels, as well as certain financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:
| • | the ability of the Company and the Bank to realize the anticipated benefits of the Merger, including the ability to successfully integrate Fincastle’s systems and processes into the Company’s systems and processes; |
| • | expected revenue synergies and cost savings from the Merger that may not be fully realized or realized within the expected time frame; |
| • | revenues following the Merger that may be lower than expected; |
| • | customer and employee relationships and business operations as a result of disruptions caused by the Merger; |
| | • | the effects of the COVID-19 pandemic, including its potential adverse effect on economic conditions and the Company's employees, customers, credit quality, and financial performance; |
| | • | general business conditions, as well as conditions within the financial markets; |
| | • | general economic conditions, including unemployment levels, inflation and slowdowns in economic growth; |
| | • | the Company’s branch and market expansions, technology initiatives and other strategic initiatives; |
| | • | the impact of competition from banks and non-banks, including financial technology companies (Fintech); |
| | • | the composition of the loan and deposit portfolio, including the types of accounts and customers, may change, which could impact the amount of net interest income and noninterest income in future periods, including revenue from service charges on deposits; |
| | • | limited availability of financing or inability to raise capital; |
| | • | reliance on third parties for key services; |
| | • | the Company’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses; |
| | • | the quality of the loan portfolio and the value of the collateral securing those loans; |
| | • | demand for loan products; |
| | • | deposit flows; |
| | • | the level of net charge-offs on loans and the adequacy of the allowance for loan losses; |
| | • | the concentration in loans secured by real estate may adversely affect earnings due to changes in the real estate markets; |
| | • | the value of securities held in the Company's investment portfolio; |
| | • | legislative or regulatory changes or actions, including the effects of changes in tax laws; |
| | • | accounting principles, policies and guidelines and elections made by the Company thereunder; |
| | • | cyber threats, attacks or events; |
| | • | the ability to maintain adequate liquidity by retaining deposit customers and secondary funding sources, especially if the Company’s reputation would become damaged; |
| | • | monetary and fiscal policies of the U.S. Government, including policies of the U.S. Department of the Treasury and the Federal Reserve Board, and the effect of those policies on interest rates and business in the Company's markets; |
| | • | changes in interest rates could have a negative impact on the Company’s net interest income and an unfavorable impact on the Company’s customers’ ability to repay loans; |
| • | geopolitical conditions, including acts or threats of terrorism, international hostilities, or actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the U.S. and abroad; and |
| | • | other factors identified in Item 1A. Risk Factors of the Company’s Form 10-K for the year ending December 31, 2020.2021. |
Because of these and other uncertainties, actual results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results. The following discussion and analysis of the financial condition at SeptemberJune 30, 20212022 and statements of income of the Company for the three and nineandsix months ended SeptemberJune 30, 20212022 and 20202021 should be read in conjunction with the consolidated financial statements and related notes included in Part I, Item 1, of this Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending December 31, 2020.2021. The statements of income for the three and nineandsix months ended SeptemberJune 30, 20212022 may not be indicative of the results to be achieved for the year.
Executive Overview
The Company
First National Corporation (the Company) is the bank holding company of:
| | • | First Bank (the Bank). The Bank owns: |
| | • | First Bank Financial Services, Inc. |
| | • | Bank of Fincastle Services, Inc. |
| • | ESF, LLC |
| | • | Shen-Valley Land Holdings, LLC |
| | • | First National (VA) Statutory Trust II (Trust II) |
| | • | First National (VA) Statutory Trust III (Trust III and, together with Trust II, the Trusts) |
First Bank Financial Services, Inc. invests in entities that provide title insurance and investment services. Bank of Fincastle Services, Inc. owns investments in an entity that provides mortgage services. Shen-Valley Land Holdings, LLC wasand ESF, LLC were formed to hold other real estate owned and future office sites. The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities and are not included in the Company’s consolidated financial statements in accordance with authoritative accounting guidance because management has determined that the Trusts qualify as variable interest entities.
Products, Services, Customers and Locations
The Bank offers loan, deposit, and wealth management products and services. Loan products and services include consumer loans, residential mortgages, home equity loans, and commercial loans. Deposit products and services include checking accounts, treasury management solutions, savings accounts, money market accounts, certificates of deposit, and individual retirement accounts. Wealth management services include estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, and estate settlement. Customers include small and medium-sized businesses, individuals, estates, local governmental entities, and non-profit organizations. The Bank’s office locations are well-positioned in attractive markets along the Interstate 81, Interstate 66, and Interstate 64 corridors in the Shenandoah Valley, the Roanoke Valley, central regions of Virginia, and the Richmond and Roanoke market areas.city of Richmond. Within these markets, there are diverse types of industry including medical and professional services, manufacturing, retail, warehousing, Federal and local government, hospitality, and higher education.
The Bank offers loan and depositBank’s products and services are delivered through 20 bank branch offices, a loan production office and customer service centers in two retirement villages. For the location and general character of each of these offices, see Item 2 of the Company's Form 10-K for the year ended December 31, 2021. Many of the Bank’s services are also delivered through the Bank’s mobile banking platform, its website, www.fbvirginia.com, its mobile banking platform,and a network of ATMs located throughout its market area, one loan production office, a customer service center in a retirement community, and 20 bank branch office locations located throughout the Shenandoah Valley, the central regions of Virginia, and the Richmond and Roanoke market areas. In addition to providing traditional banking services, the Bank operates a wealth management division under the name First Bank Wealth Management. area.
Revenue Sources and Expense Factors
The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 70% and 80% of the Company’s total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank’s interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on deposits, fee income from wealth management services, and ATM and check card fees.
Primary expense categories are salaries and employee benefits, which comprised 56%58% of noninterest expenses for the ninesix months ended SeptemberJune 30, 2021,2022, followed by occupancy and equipment expense, which comprised 12%13% of noninterest expenses. The provision for loan losses is also typically a primary expense of the Bank. The provision is determined by factors that include net charge-offs, asset quality, economic conditions, and loan growth. Changing economic conditions caused by inflation, recession, unemployment, or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs, and ultimately the required provision for loan losses.
COVID-19 Pandemic Update
Operations
During the third quarter of 2021, the Bank continued to follow its Pandemic Plan that strives to protect the health of its employees and customers, while continuing to deliver banking services. In response to vaccinations that continued to be provided to thousands of people in our market areas, and the decrease in the number of COVID-19 cases in our communities, the Bank entered phase two of its plan in late March 2021 after operating in phase one since early December 2020. After operating for almost four months primarily through branch drive throughs, ATMs, and mobile and internet banking platforms, lobbies re-opened in March for walk-in customers to conduct their banking business.
Paycheck Protection Program
The Bank actively participated as a lender in the U.S. Small Business Administration’s (SBA) Paycheck Protection Program (PPP) to support local small businesses and non-profit organizations by providing forgivable loans. Loan fees received from the SBA are accreted by the Bank into income evenly over the life of the loans, net of loan origination costs, through interest and fees on loans. PPP loans totaled $22.8 million at September 30, 2021, with $1.3 million scheduled to mature in the second and third quarters of 2022, and $21.5 million scheduled to mature in the first and second quarters of 2026. The Company believes the majority of these loans will ultimately be forgiven and repaid by the SBA in accordance with the terms of the program. It is the Company’s understanding that loans funded through the PPP program are fully guaranteed by the U.S. government. Should those circumstances change, the Company could be required to establish additional allowance for loan losses through additional provision for loan losses charged to earnings.
The Bank recognized $737 thousand and $247 thousand of accretion on deferred PPP income, net origination costs, through interest and fees on loans for three month periods ending September 30, 2021 and 2020, respectively, and recognized $1.8 million and $429 thousand for the nine months ended September 30, 2021 and 2020, respectively. The total amount of deferred PPP income, net of origination costs, not yet been recognized through interest and fees on loans totaled $652 thousand at September 30, 2021.
Asset Quality Impact
The economic impact of the pandemic had an unfavorable impact on the financial condition of certain Bank customers. The Bank entered into loan modification agreements in the fourth quarter of 2020, and during the first half of 2021, to provide relief to certain customers that were continuing to experience temporary business interruptions from the pandemic. The modifications were designed to help borrowers continue their business operations while minimizing potential loan charge-offs. The magnitude of the potential decline in the Bank’s loan quality will likely depend on the length and extent that the Bank’s customers experience business interruptions from the pandemic.
Loan Modifications
In response to the unknown impact of the pandemic on the economy and its customers, the Bank created and implemented a loan payment deferral program for individual and business customers beginning in the first quarter of 2020, which provided them the opportunity to defer monthly payments for 90 days. By June 30, 2020, loans participating in the program reached $182.6 million. The majority of these loans resumed regular payments during the second half of 2020 after their deferral periods ended. There were no loans remaining in the program at September 30, 2021. These loans were not considered troubled debt restructurings (TDRs) because they were modified in accordance with relief provisions of the CARES Act and interagency regulatory guidance.
During the fourth quarter of 2020, and during the first half of 2021, the Bank modified terms of certain loans for customers that continued to be negatively impacted by the pandemic by lowering borrower’s loan payments with interest only payments for periods ranging between 6 and 24 months. Modified loans totaled $13.3 million at September 30, 2021, with $13.2 million in the Bank’s commercial real estate loan portfolio and $83 thousand in the commercial and industrial loans portfolio. The loans were comprised of $11.6 million in the lodging sector and $1.7 million in the leisure sector. All modified loans were either performing under their modified terms or resumed regular loan payments as of September 30, 2021.
Capital
The Company issued $5.0 million of subordinated debt in June 2020 as a result of its risk management program and capital planning. The purpose of the issuance was primarily to further strengthen holding company liquidity and to remain a source of strength for the Bank in the event of a severe economic downturn. The Company may also use the proceeds of the issuance for general corporate purposes, including the potential repayment of the Company’s subordinated debt that was issued in 2015 and became callable on a quarterly basis beginning January 1, 2021. The subordinated debt issued in 2020 consists of a 5.50% fixed-to-floating rate subordinated note due 2030 issued to an institutional investor and was structured to qualify as Tier 2 capital under bank regulatory guidelines.
After being suspended for most of 2020, the Company’s stock repurchase plan ended on December 31, 2020. The Company has not authorized another stock repurchase plan due to certain factors, which include the continued uncertainty and potential impact of the pandemic on the economy and the Bank’s customers. The Company continued to pay cash dividends on common stock of $0.11 per share throughout 2020, and in February 2021, it declared a quarterly cash dividend of $0.12 per share, which was a 9% increase. Company declared another quarterly cash dividend of $0.12 per share in both May 2021 and September 2021.
Overview of Quarterly Financial Performance
The following items had the most significant impact on financial performance, when comparing the second quarter of 2022 to the same period in 2021.
| ● | The acquisition of The Bank of Fincastle (Fincastle) had a significant impact on balance sheet growth. On July 1, 2021, the acquisition date, Fincastle had total assets of $267.9 million, interest-bearing deposits in banks of $43.5 million, total securities of $12.0 million, loans, net of the allowance for loan losses, of $191.5 million, and total deposits of $236.3 million. |
| ● | The acquisition of the SmartBank loan portfolio from its Richmond-area branch impacted the composition of the Bank’s earning assets. On September 30, 2021, the acquisition date, the loan portfolio totaled $82.6 million. The Bank funded the acquisition of the loan portfolio with cash, which decreased interest-bearing deposits in banks in the third quarter of 2021. |
| ● | The provision for loan losses totaled $400 thousand for the second quarter of 2022, which was a $1.4 million increase compared to the recovery of loan losses of $1.0 million in the second quarter of 2021. |
| ● | Total loans increased $43.7 million, during the three-month period ending June 30, 2022. |
| ● | Accretion of PPP income, net of costs decreased to $35 thousand for the second quarter of 2022, compared to $509 thousand for the same period in the prior year. |
| ● | Accretion of purchased loan discounts, net of premium amortization, totaled $351 thousand for the second quarter of 2022, compared to no purchased loan accretion for the same period in the prior year |
Net income increased by $644$493 thousand, or 15%, to $2.4$3.8 million, or $0.38$0.61 per diluted share, for the three months ended SeptemberJune 30, 2021,2022, compared to $1.8$3.3 million, or $0.36$0.69 per diluted share, for the same period in 2020.2021. Return on average assets was 0.71%1.08% and return on average equity was 8.64%15.04% for the thirdsecond quarter of 2021,2022, compared to 0.74%1.31% and 8.52%15.33%, respectively, for the same period in 2020.2021.
The increase in net income resulted primarily from a $2.2$3.8 million, or 29%51%, increase in net interest income a $1.5 million decrease in provision for loan losses, and a $447$345 thousand, or 20%14%, increase in total noninterest income, compared to the same period of 2020. These favorable varianceswhich were partially offset by a $3.3$2.3 million, or 54%35%, increase in total noninterest expenses.expense and an increase in the provision for loan losses. The provision for loan losses totaled $400 thousand for the second quarter of 2022, compared to a recovery of loan losses of $1.0 million for the same period of 2021.
NetThe $3.8 million, or 51%, increase in net interest income increased $2.2 millionresulted from a $2.0 millionan increase in total interest income and a $176 thousand decreaseno change in total interest expense, compared to the same period of 2020. Although the net interest margin decreased by 35-basis points to 3.06%, netexpense. Net interest income increased as the impact of the lower net interest margin was offsetexpanded by a $383.8 million, or 43%, increase in32 basis points and average earning assets a $490 thousandincreased by 37%. The margin expansion resulted from an increase in accretion of deferred PPP loan income, net of origination costs,earning asset yields, a change in the earning asset composition, and $238 thousand of accretion of loan discounts, net of premium amortization, on acquired loans. Total interest expense decreased by $176 thousand, or 23%, primarily from a decrease in the cost of funds. Earning asset yields increased by 25 basis points from a higher interest expense on deposits asrate environment during the Bank loweredsecond quarter of 2022, while the cost of funds decreased by 7 basis points, primarily from lower interest rates paid on deposit accounts.deposits and subordinated debt. The Merger ofchange in the earning asset composition favorably impacted the net interest margin as average total securities increased and average interest-bearing deposits in banks decreased. The Bankgrowth in earning assets resulted from both the acquisition of Fincastle with and into First Bank on July 1, 2021 contributed to the increase in average earning assets. from deposit growth.
The provision for loan losses decreased $1.5 million, which resulted from no provisiontotaled $400 thousand for loan lossesthe second quarter of 2022 in contrast to the thirdsecond quarter of 2021 and provision forwhen the Bank recorded a $1.0 million recovery of loan losses of $1.5 million for the same period of 2020.losses. The allowance for loan losses totaled $5.4$6.2 million, or 0.66%0.70% of total loans at Septemberon June 30, 2021. There were no significant changes in the general or specific reserve components2022, 0.69% of the allowance during the quarter. Net charge-offs totaled $31 thousand for the period. Loans acquired from Fincastletotal loans on December 31, 2021, and SmartBank during the third quarter were recorded at fair market value, which resulted in valuation discounts0.89% of total loans on the loan portfolios. Due to the valuation discounts, there was no allowance for loan losses required on the acquired loans at SeptemberJune 30, 2021.
NoninterestThe $345 thousand, or 14%, year-over-year quarterly increase in noninterest income increased $447was primarily a result of a $251 thousand primarily from increasesincrease in service charges on deposits, followed by increases in ATM and check card fees, wealth management fees, and an increase in fees for other customer services. The merger with Fincastle contributed to increases in all noninterestincreased income categories, except for wealth management fees. The increases were partially offset by decreases in brokered mortgage fees and other operating income.
Noninterest expense increased $3.3$2.3 million, primarily from the addition of employees, customersor 35%, and branch offices through the merger of The Bank of Fincastle with and into First Bank on July 1, 2021, and from merger related expenses that totaled $1.3 million during the quarter. Several noninterest expense categories increased as a result of the merger. The $1.3 million of merger related expenses contributed to the increases in salaries and employee benefits, marketing, supplies, legal and professional fees, data processing, and other operating expense.
Based on management's analysis and the supporting allowance for loan loss calculation, a provision for loan losses was not required during the third quarter of 2021, compared to a provision for loan losses of $1.5 million during the same period of 2020. The decrease in the provision for loan losses was attributable to a decrease in the general reserve component of the allowance for loan losses that was offset by net charge-offs on loans. The provision for loan losses recorded in the third quarter of 2020 was primarily attributable to anthe increase in the specific reserve componentnumber of employees, branch offices and customers that resulted from the acquisition of Fincastle and the acquisition of the allowance forSmartBank loan losses.portfolio. Salaries and employee benefits increased by $1.4 million, followed by increases in occupancy, equipment, and other operating expense.
For a more detailed discussion of the Company's quarterly performance, see "Net Interest Income,” “Provision for Loan Losses,” "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.
Acquisition of The Bank of Fincastle
On July 1, 2021, the Company completed the acquisition of The Bank of Fincastle for an aggregate purchase price of $33.8 million of cash and stock. The Company paid cash consideration of $6.8 million and issued 1,348,065 shares of its common stock to the shareholders of Fincastle. Upon completion of the transaction, Fincastle was merged with and into First Bank. At the time of closing of the acquisition, The Bank of Fincastle had six retail bank branch offices operating in the greater Roanoke Valley region of Virginia. TheVirginia and reported total assets of $267.9 million, total loans of $194.5 million and total deposits of $236.3 million. After the merger, the former Fincastle branches continued to operate as The Bank of Fincastle, a division of First Bank, until the systems were converted on October 16, 2021. As ofAll branch offices have been operating as First Bank since the system conversion. For the three and six months ended June 30, 2021, Fincastle reported total assets of $267.9 million, total loans of $194.5 million and total deposits of $236.3 million. For the three-month and nine-month periods ended September 30, 2021,2022, the Company recorded merger related expenses of $1.3 million and $2.0 million, respectively,$20 thousand in connection with the acquisition of Fincastle. The Company estimates that it will incur aggregate costs related to the merger of $3.4 million, with the remaining $1.4 million of merger related expenses expected to be recorded throughout the fourth quarter of 2021 and first quarter of 2022.
Purchased performing loans were recorded at fair value, including a credit discount. The fair value discount will be accreted as an adjustment to yield over the estimated lives of the loans. A provision for loan losses on the purchased loans is expected in future periods as the accretion decreases the fair value discount amount. A provision may also be required for any deterioration in these loans in future periods.
The Company expectexpected to benefit from cost savings after the acquisition of Fincastle. As of June 30, 2022, the Company had substantially achieved all expected cost savings related to be realized as Fincastle's operations are fully integrated in future periods.the merger of Fincastle with and into First Bank.
Acquisition of SmartBank Loan Portfolio
On September 30, 2021, the Bank acquired $82.0$82.6 million of loans and certain fixed assets from SmartBank related to theirits Richmond area branch, located in Glen Allen, Virginia. First Bank paid cash consideration of $83.7 million for the loans and fixed assets. Additionally, an experienced team of bankers based out of the SmartBank location have transitioned to become employees of First Bank. First Bank did not assume any deposit liabilities from SmartBank in connection with the transaction, and SmartBank intends to closeclosed their branch operation on December 31, 2021. First Bank has agreed to assumeassumed the facility lease and acquired the remaining assets at the branch on December 31, 2021 and will continue to operatenow operates a loan production office fromin the location after the SmartBank branch is closed. First Bank’s assumption of the lease and acquisition of the remaining branch assets is expected to be completed in the fourth quarter of 2021, subject to customary closing conditions.former SmartBank branch. The Company did not incur significantincurred expenses totaling $101 thousand related to the acquisition of loans and fixed assets of SmartBank in the thirdfourth quarter of 2021. There were no additional expenses related to the acquisition for the three and six months ended June 30, 2022.
Purchased performing loans were recorded at fair value, including a credit discount. The fair value discount will be accreted as an adjustment to yield over the estimated lives of the loans. A provision for loan losses may be required for any deterioration in these loans in future periods.
Non-GAAP Financial Measures
This report refers to the efficiency ratio, which is computed by dividing noninterest expense, excluding amortization of intangibles, net gains on disposal of premises and equipment, and merger related expenses, by the sum of net interest income on a tax-equivalent basis and noninterest income, excluding securities gains. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with GAAP and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands).
| | | Efficiency Ratio | | | Efficiency Ratio | |
| | | Three Months Ended | | | Nine Months Ended | | | Three Months Ended | | | Six Months Ended | |
| | | September 30, 2021 | | | September 30, 2020 | | | September 30, 2021 | | | September 30, 2020 | | | June 30, 2022 | | | June 30, 2021 | | | June 30, 2022 | | | June 30, 2021 | |
Noninterest expense | | $ | 9,426 | | | $ | 6,135 | | | $ | 22,706 | | | $ | 17,892 | | | $ | 8,918 | | | $ | 6,630 | | | $ | 17,562 | | | $ | 13,280 | |
Add/(Subtract): other real estate owned (expense), net | | | (41 | ) | | — | | | (69 | ) | | — | |
Subtract: amortization of intangibles | | (5 | ) | | (33 | ) | | (24 | ) | | (127 | ) | | (5 | ) | | (5 | ) | | (9 | ) | | (19 | ) |
Add: gains on disposal of premises and equipment, net | | — | | | — | | | 26 | | | 9 | | | — | | 14 | | — | | 26 | |
Subtract: loss on disposal of premises and equipment, net | | | — | | — | | (2 | ) | | — | |
Subtract: merger related expenses | | | (1,341 | ) | | | — | | | (2,023 | ) | | | — | | | | — | | | | (277 | ) | | | (20 | ) | | | (682 | ) |
| | | $ | 8,080 | | | $ | 6,102 | | | $ | 20,685 | | | $ | 17,774 | | | $ | 8,872 | | | $ | 6,362 | | | $ | 17,462 | | | $ | 12,605 | |
Tax-equivalent net interest income | | $ | 9,810 | | | $ | 7,623 | | | $ | 24,938 | | | $ | 22,158 | | | $ | 11,372 | | | $ | 7,560 | | | $ | 22,008 | | | $ | 15,128 | |
Noninterest income | | 2,648 | | | 2,201 | | | 7,226 | | | 6,073 | | | 2,780 | | | 2,435 | | | 5,491 | | | 4,578 | |
Subtract: securities gains, net | | | — | | | | (38 | ) | | | (37 | ) | | | (38 | ) | | | — | | | | — | | | | — | | | | (37 | ) |
| | | $ | 12,458 | | | $ | 9,786 | | | $ | 32,127 | | | $ | 28,193 | | | $ | 14,152 | | | $ | 9,995 | | | $ | 27,499 | | | $ | 19,669 | |
Efficiency ratio | | | 64.86 | % | | | 62.35 | % | | | 64.39 | % | | | 63.04 | % | | | 62.69 | % | | | 63.65 | % | | | 63.50 | % | | | 64.09 | % |
This report also refers to net interest margin, which is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for both 20212022 and 20202021 is 21%. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands).
| | | Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income | | | Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income | |
| | | Three Months Ended | | | Nine Months Ended | | | Three Months Ended | | | Six Months Ended | |
| | | September 30, 2021 | | | September 30, 2020 | | | September 30, 2021 | | | September 30, 2020 | | | June 30, 2022 | | | June 30, 2021 | | | June 30, 2022 | | | June 30, 2021 | |
GAAP measures: | | |
Interest income – loans | | $ | 9,215 | | | $ | 7,568 | | | $ | 23,432 | | | $ | 22,187 | | | $ | 9,963 | | | $ | 7,074 | | | $ | 19,459 | | | $ | 14,217 | |
Interest income – investments and other | | 1,116 | | | 775 | | | 3,039 | | | 2,569 | | | 1,876 | | | 971 | | | 3,404 | | | 1,923 | |
Interest expense – deposits | | (369 | ) | | (541 | ) | | (1,060 | ) | | (2,179 | ) | | (413 | ) | | (328 | ) | | (753 | ) | | (691 | ) |
Interest expense – subordinated debt | | (156 | ) | | (160 | ) | | (464 | ) | | (341 | ) | | (69 | ) | | (154 | ) | | (138 | ) | | (308 | ) |
Interest expense – junior subordinated debt | | | (68 | ) | | | (68 | ) | | | (202 | ) | | | (225 | ) | | | (67 | ) | | | (68 | ) | | | (134 | ) | | | (134 | ) |
Total net interest income | | $ | 9,738 | | | $ | 7,574 | | | $ | 24,745 | | | $ | 22,011 | | | $ | 11,290 | | | $ | 7,495 | | | $ | 21,838 | | | $ | 15,007 | |
Non-GAAP measures: | | |
Tax benefit realized on non-taxable interest income – loans | | $ | 8 | | | $ | 8 | | | $ | 24 | | | $ | 26 | | | $ | - | | | $ | 8 | | | $ | 7 | | | $ | 16 | |
Tax benefit realized on non-taxable interest income – municipal securities | | | 64 | | | | 41 | | | | 169 | | | | 121 | | | | 82 | | | | 57 | | | | 163 | | | | 105 | |
Total tax benefit realized on non-taxable interest income | | $ | 72 | | | $ | 49 | | | $ | 193 | | | $ | 147 | | | $ | 82 | | | $ | 65 | | | $ | 170 | | | $ | 121 | |
Total tax-equivalent net interest income | | $ | 9,810 | | | $ | 7,623 | | | $ | 24,938 | | | $ | 22,158 | | | $ | 11,372 | | | $ | 7,560 | | | $ | 22,008 | | | $ | 15,128 | |
Critical Accounting Policies
General
The Company’s consolidated financial statements and related notes are prepared in accordance with GAAP. The financial information contained within the statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset, or relieving a liability. The Bank uses historical losses as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact transactions could change.
Presented below is a discussion of those accounting policies that management believes are the most important (Critical Accounting Policies) to the portrayal and understanding of the Company’s financial condition and results of operations. The Critical Accounting Policies require management’s most difficult, subjective, and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management determines that the loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance. For further information about the Company’s loans and the allowance for loan losses, see Notes 3 and 4 to the Consolidated Financial Statements included in this Form 10-Q.
The allowance for loan losses is evaluated on a quarterly basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
Loans Acquired in a Business Combination
Acquired loans are classified as either (i) purchased credit-impaired (PCI) loans or (ii) purchased performing loans and are recorded at fair value on the date of acquisition.
PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Corporation will not collect all contractually required principal and interest payments. When determining fair value, PCI loans are aggregated into pools of loans based on common risk characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the “nonaccretable difference.” Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the “accretable yield” and is recognized as interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows.
There were no acquired loans classified as PCI in the acquisition of Fincastle and the Smartbank loan portfolio acquisition during the third quarter of 2021.
Goodwill
The Company's goodwill was recognized in connection with business combinations that occurred in the third quarter of 2021. The Company will review the carrying value of goodwill at least annually or more frequently if certain impairment indicators exist. In testing goodwill for impairment, the Company may first consider qualitative factors to determine whether the existence of events or circumstances lead to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events and circumstances, we conclude that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then no further testing would be required and the goodwill of the reporting unit would not be impaired. If the Company elects to bypass the qualitative assessment or if we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the fair value of the reporting unit will be compared with its carrying value to determine whether an impairment exists.
The Company performs regular credit reviews of the loan portfolio to review credit quality and adherence to underwriting standards. The credit reviews consist of reviews by its internal credit administration department and reviews performed by an independent third party. Upon origination, each loan is assigned a risk rating ranging from one to nine, with loans closer to one having less risk. This risk rating scale is the Company's primary credit quality indicator. The Company has various committees that review and ensure that the allowance for loans losses methodology is in accordance with GAAP and loss factors used appropriately reflect the risk characteristics of the loan portfolio.
The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management’s judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of the collateral, overall portfolio quality, and review of specific potential losses. The evaluation also considers the following risk characteristics of each loan portfolio class:
| | • | 1-4 family residential mortgage loans carry risks associated with the continued creditworthiness of the borrower and changes in the value of the collateral. |
| | • | Real estate construction and land development loans carry risks that the project may not be finished according to schedule, the project may not be finished according to budget, and the value of the collateral may, at any point in time, be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure or other factors unrelated to the project. |
| | • | Other real estate loans carry risks associated with the successful operation of a business or a real estate project, in addition to other risks associated with the ownership of real estate, because repayment of these loans may be dependent upon the profitability and cash flows of the business or project. |
| | • | Commercial and industrial loans carry risks associated with the successful operation of a business because repayment of these loans may be dependent upon the profitability and cash flows of the business. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much reliability. |
| | • | Consumer and other loans carry risk associated with the continued creditworthiness of the borrower and the value of the collateral, if any. Consumer loans are typically either unsecured or secured by rapidly depreciating assets such as automobiles. These loans are also likely to be immediately and adversely affected by job loss, divorce, illness, personal bankruptcy, or other changes in circumstances. Other loans included in this category include loans to states and political subdivisions. |
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows, fair value of collateral less estimated costs to sell, or observable market price of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal is ordered if a current one is not on file. Appraisals are typically performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions among other considerations.
The general component covers loans that are not considered impaired and is based on historical loss experience adjusted for qualitative factors. The historical loss experience is calculated by loan type and uses an average loss rate during the preceding twelve quarters. The qualitative factors are assigned by management based on delinquencies and asset quality, national and local economic trends, effects of the changes in the value of underlying collateral, trends in volume and nature of loans, effects of changes in the lending policy, the experience and depth of management, concentrations of credit, quality of the loan review system, and the effect of external factors such as competition and regulatory requirements. The factors assigned differ by loan type. The general allowance estimates losses whose impact on the portfolio has yet to be recognized by a specific allowance. Allowance factors and the overall size of the allowance may change from period to period based on management’s assessment of the above described factors and the relative weights given to each factor. For further information regarding the allowance for loan losses, see Note 4 to the Consolidated Financial Statements included in this Form 10-Q.
Loans acquired from Fincastle and SmartBank were recorded at fair value. Accordingly, noThere was $254 thousand of allowance for loan losses attributable to purchased loans at June 30, 2022.
Loans Acquired in a Business Combination
Acquired loans are classified as either (i) purchased credit-impaired (PCI) loans or (ii) purchased performing loans and are recorded at fair value on the date of acquisition.
PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Corporation will not collect all contractually required for thoseprincipal and interest payments. When determining fair value, PCI loans are aggregated into pools of loans based on common risk characteristics as of Septemberthe date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the “nonaccretable difference.” Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the “accretable yield” and is recognized as interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows. There were no acquired loans classified as PCI in the acquisition of the Fincastle and the SmartBank loan portfolios.
Goodwill and Other Intangible Assets
Goodwill arises from business combinations and is determined as the excess fair value of the consideration transferred 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 Company has selected June 30 2021. A provision for loan losses may be required for any deterioration in these loans in future periods. as the date to perform the annual impairment test. Intangible assets with finite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the balance sheet.
Other intangible assets consist of core deposit intangible assets arising from whole bank and branch acquisitions and are amortized on an accelerated method over their estimated useful lives, which range from 6 to 10 years.
Lending Policies
General
In an effort to manage risk, the Bank’s loan policy gives loan amount approval limits to individual loan officers based on their position within the Bank and level of experience. The Management Loan Committee can approve new loans up to the Bank's legal lending limit. The Board Loan Committee reviews all loans greater than $1.0 million. The Board Loan Committee currently consists of six directors, five of which are non-management directors. The Board Loan Committee approves the Bank’s Loan Policy and reviews risk management reports, including watch list reports and concentrations of credit. The Board Loan Committee meets at least two times per quarter and the Chairman of the Committee then reports to the Board of Directors.
Residential loan originations are primarily generated by mortgage loan officer solicitations and referrals by employees, real estate professionals, and customers. Commercial real estate loan originations and commercial and industrial loan originations are primarily obtained through direct solicitation and additional business from existing customers. All completed loan applications are reviewed by the Bank’s loan officers. As part of the application process, information is obtained concerning the income, financial condition, employment, and credit history of the applicant. The Bank also participates in commercial real estate loans and commercial and industrial loans originated by other financial institutions that are typically outside its market area. In addition, the Bank has purchased consumer loans originated by other financial institutions that are typically outside its market area. Loan quality is analyzed based on the Bank’s experience and credit underwriting guidelines depending on the type of loan involved. Except for loan participations with other financial institutions, real estate collateral is valued by independent appraisers whoThere have been pre-approved by the Board Loan Committee.
As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, certain appraisals are analyzed by management or by an outsourced appraisal review specialist throughout the year in order to ensure standards of quality are met. The Company also obtains an independent review of loans within the portfolio on an annual basis to analyze loan risk ratings and validate specific reserves on impaired loans.
In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities which are disclosed but not reflected in its financial statements, including commitments to extend credit. At September 30, 2021, commitments to extend credit, stand-by letters of credit, and rate lock commitments totaled $171.1 million.
Construction and Land Development Lending
The Bank makes local construction loans, including residential and land acquisition and development loans. These loans are secured by the property under construction and the underlying land for which the loan was obtained. The majority of these loans mature in one year. Construction lending entails significant additional risks, compared with residential mortgage lending. Construction and land development loans sometimes involve larger loan balances concentrated with single borrowers or groups of related borrowers. Another risk involved in construction and land development lending is the fact that loan funds are advanced upon the security of the land or property under construction, which value is estimated based on the completion of construction. Thus, there is risk associated with failure to complete construction and potential cost overruns. To mitigate the risks associated with this type of lending, the Bank generally limits loan amounts relative to the appraised value and/or cost of the collateral, analyzes the cost of the project and the creditworthiness of its borrowers, and monitors construction progress. The Bank typically obtains a first lien on the property as security for its construction loans, typically requires personal guarantees from the borrower’s principal owners, and typically monitors the progress of the construction project during the draw period.
1-4 Family Residential Real Estate Lending
1-4 family residential lending activity may be generated by Bank loan officer solicitations and referrals by real estate professionals and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment, and credit history of the applicant. Residential mortgage loans generally are made on the basis of the borrower’s ability to make payments from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In addition to the Bank’s underwriting standards, loan quality may be analyzed based on guidelines issued by a secondary market investor. The valuation of residential collateral is generally provided by independent fee appraisers who have been approved by the Board Loan Committee. In addition to originating mortgage loans with the intent to sell to correspondent lenders or broker to wholesale lenders, the Bank also originates and retains certain mortgage loans in its loan portfolio.
Commercial Real Estate Lending
Commercial real estate loans are secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, office and retail buildings, hotels, industrial buildings, and religious facilities. Commercial real estate loan originations are primarily obtained through direct solicitation of customers and potential customers. The valuation of commercial real estate collateral is provided by independent appraisers who have been approved by the Board Loan Committee. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history, and reputation. The Bank typically requires personal guarantees of the borrowers’ principal owners and considers the valuation of the real estate collateral.
Commercial and Industrial Lending
Commercial and industrial loans generally have a higher degree of risk than loans secured by real estate, but typically have higher yields. Commercial and industrial loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business. The loans may be unsecured or secured by business assets, such as accounts receivable, equipment, and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, any collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much reliability as real estate.
Also included in this category are loans originated under the SBA's PPP. PPP loans are fully guaranteed by the SBA, and in some cases borrowers may be eligible to obtain forgiveness of the loans, in which case loans would be repaid by the SBA.
Consumer Lending
Loans to individual borrowers may be secured or unsecured, and include unsecured consumer loans and lines of credit, automobile loans, deposit account loans, and installment and demand loans. These consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss, or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.
The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on a proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income.
Also included in this category are loans purchased through a third-party lending program. These portfolios include consumer loans and carry risks associated with the borrower,no material changes in the economic environment, andCompany’s lending policies disclosed in the vendor itself. The Company manages these risks through policies that require minimum credit scores and other underwriting requirements, robust analysis of actual performance versus expected performance, as well as ensuring compliance withAnnual Report on Form 10-K for the Company's vendor management program.year ended December 31, 2021.
Results of Operations
General
Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on interest-earning assets, predominantly loans and securities, exceeds interest expense on interest-bearing liabilities, including deposits, other borrowings, subordinated debt, and junior subordinated debt. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, are the components that impact the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The provision for loan losses, noninterest income, and noninterest expense are the other components that determine net income. Noninterest income and expense primarily consists of income from service charges on deposit accounts, revenue from wealth management services, ATM and check card income, revenue from other customer services, income from bank owned life insurance, general and administrative expenses, amortization expense, and other real estate owned expense.
Net Income
Three Month Period Ended June 30, 2022
Net income increased by $493 thousand, or 15%, to $3.8 million, or $0.61 per diluted share, for the three months ended June 30, 2022, compared to $3.3 million, or $0.69 per diluted share, for the same period in 2021. Return on average assets was 1.08% and return on average equity was 15.04% for the second quarter of 2022, compared to 1.31% and 15.33%, respectively, for the same period in 2021.
The increase in net income resulted primarily from a $3.8 million, or 51%, increase in net interest income and a $345 thousand, or 14%, increase in total noninterest income, which were partially offset by a $2.3 million, or 35%, increase in total noninterest expense and an increase in the provision for loan losses. The provision for loan losses totaled $400 thousand for the second quarter of 2022, compared to a recovery of loan losses of $1.0 million for the same period of 2021.
Six Month Period Ended June 30, 2022
Net income increased by $1.8 million, or 31%, to $7.6 million, or $1.21 per diluted share, for the six months ended June 30, 2022, compared to $5.8 million, or $1.19 per diluted share, for the same period in 2021. Return on average assets was 1.07% and return on average equity was 14.16% for the six months ended June 30, 2022, compared to 1.15% and 13.44%, respectively, for the same period in 2021.
The increase in net income resulted primarily from a $6.8 million, or 46%, increase in net interest income and a $913 thousand, or 20%, increase in total noninterest income, which were partially offset by a $4.3 million, or 32%, increase in total noninterest expense and an increase in the provision for loan losses. The provision for loan losses totaled $400 thousand for the six months ended June 30, 2022, compared to a recovery of loan losses of $1.0 million for the same period of 2021.
Net Interest Income
For the three-month period ended SeptemberThree Month Period Ended June 30, 20212022
Net interest income increased $2.2$3.8 million, or 29%51%, forcomparing the three-month period ended September 30, 2021, comparedsecond quarter of 2022 to the same period of 2020. An2021, and was positively impacted by a higher interest rate environment, a significant increase in average earning assets, of $383.8 million, or 43%, was partially offset byand a 35-basis point decrease in the net interest margin to 3.06%. The acquisition of The Bank of Fincastle on July 1, 2021 and an increase in average deposit balances resulted in growth of average earning assets. The decrease in the net interest margin was primarily attributable to the change in the compositionCompany’s earning asset composition. During the second quarter of average earning assets.2022, the high-end of the Federal funds target increased from 0.50% to 1.75%, compared to a Federal funds rate that remained at 0.25% throughout the second quarter of 2021. The higher rate environment resulted in a 14-basis point increase in the yield on loans and a 72-basis point increase in the yield on interest-bearing deposits in other banks, while the total cost of interest-bearing deposits decreased two basis points. The cost of subordinated debt decreased by 64-basis points from the redemption of $5.0 million of higher rate subordinated debt on January 1, 2022. Although the Federal funds rate increased by 150 basis points, the Company’s total cost of funds decreased seven basis points, when comparing the periods. Average loans, which was the highest yielding category, decreased to 60% of average earning assets forincreased $358.0 million, or 37%, as a result of the acquisition of Fincastle in the third quarter of 2021 comparedand growth of the Bank’s deposit portfolio over the last twelve months. Additionally, the composition of earning assets contributed to 73% for the third quarter of 2020. Although average loans increased $118.3 million, lower yielding categories experienced higher growth,increase in total interest and dividend income as total average securities increased $106.4 million and Federal funds sold andfrom 20% to 27% of average earning assets, while average interest-bearing deposits in other banks combined increased $159.2 million. decreased from 16% to 9%. Average loans were unchanged at 64% of average earning assets when comparing the same periods.
The $3.8 million increase in net interest income was primarily attributable toresulted from a $2.0$3.8 million, or 24%47%, increase in total interest and dividend income, from increaseswhile total interest expense was unchanged. The increase in bothtotal interest and dividend income was attributable to a $2.9 million increase in interest income and fees on loans, a $214 thousand increase in interest on deposits in banks, and a $691 thousand increase in interest income and dividends on securities. Interest and fees on loans increased $1.6 million, or 22%, fromThere was no change in total interest expense as an 18% increase in average loan balances andinterest expense on deposits was offset by a 13-basisdecrease in interest expense on subordinated debt. The net interest margin increased to 3.42%, a 32-basis point increase from 3.10% in the yield on loans. same period one year ago.
Accretion on deferredof PPP fee income, net of origination costs, and accretion of discounts on purchased loans, net of premiums, were included in interest and fees on loansloans. Net accretion of PPP income totaled $737$35 thousand forin the periodsecond quarter of 2022, compared to $247$509 thousand for the same period of 2020. Accretion2021. Net accretion of loan discounts net of premium amortization, on acquired loans included in interest and fees onpurchased loans totaled $238$351 thousand forin the thirdsecond quarter of 2021.2022. There were no purchased loans in the second quarter of 2021, and as a result, there was no net accretion or amortization of discounts or premiumson purchased loans during the same period of 2020. Interest and dividends on securities increased $279 thousand, or 37%, from a 78% increase in average securities balances, which was partially offset by a 53-basis point decrease in the yield on total securities to 1.79%.
Total interest expense decreased by $176 thousand, or 23%, which also contributed to the increase in net interest income. Interest expense on deposits decreased $172 thousand, or 32%, from a 19-basis point decrease in the cost of interest-bearing deposits and was partially offset by a 35% increase in average interest-bearing deposit balances. The decrease in the cost of interest-bearing deposits was attributable to a reduction in interest rates paid on checking, money market and time deposits. period.
For the nine-month period ended SeptemberSix Month Period Ended June 30, 20212022
Net interest income increased $2.7$6.8 million, or 12%46%, forcomparing the nine-month periodsix months ended SeptemberJune 30, 2021, compared2022, to the same period of 2020. An2021, and was positively impacted by a higher interest rate environment, a significant increase in average earning assets, of $236.4 million, or 29%, and was partially offset by a 45-basis point decrease in the net interest margin to 3.13%. The acquisition of The Bank of Fincastle on July 1, 2021 and an increase in average deposit balances resulted in growth of average earning assets. The decrease in the net interest margin was attributable to decreases in earning asset yields and a change in the compositionCompany’s earning asset composition. During the six months ended June 30, 2022, the high-end of average earning assets. Average loans, which was the highest yielding category, decreasedFederal funds target increased from 0.25% to 64% of average earning assets for the nine-month period ending September 30, 2021,1.75%, compared to 75% fora Federal funds rate that remained at 0.25% throughout the same period of 2020. Although average2021. The higher rate environment resulted in a 11-basis point increase in the yield on loans increased $58.6 million, increasesand a 34-basis point increase in lower yielding categories experienced higher growth, as average securities increased $57.6 million and Federal funds sold andthe yield on interest-bearing deposits in other banks, combinedwhile the cost of interest-bearing deposits decreased six basis points. The cost of subordinated debt decreased by 133-basis points from the redemption of $5.0 million of higher rate subordinated debt on January 1, 2022. Although the Federal funds rate increased $120.2 million. by 150 basis points, the Company’s total cost of funds decreased nine basis points, when comparing the periods. Average earning assets increased $353.8 million, or 37%, as a result of the acquisition of Fincastle in the third quarter of 2021 and growth of the Bank’s deposit portfolio over the last twelve months. Additionally, the composition of earning assets contributed to the increase in total interest and dividend income as total average securities increased from 18% to 24% of average earning assets, while average interest-bearing deposits in other banks decreased from 16% to 12% and average loans decreased from 66% to 64%.
The $6.8 million increase in net interest income was attributable toresulted from a $1.7$6.7 million, or 7%42%, increase in total interest and dividend income, from increaseswhile total interest expense decreased by $108 thousand. The increase in bothtotal interest and dividend income was attributable to a $5.2 million increase in interest income and fees on loans, a $251 thousand increase in interest on deposits in banks, and a $1.2 million increase in interest income and dividends on securities. Interest and feesThe decrease in total interest expense resulted from a $170 thousand decrease in interest expense on loans increased $1.2 million, or 6%, from an 9% increase in average loan balances,subordinated debt, which was partially offset by a 17-basis$62 thousand increase in interest expense on deposits. The net interest margin increased to 3.39%, a 30-basis point decreaseincrease from 3.19% in the yield on total loans to 4.63%. Accretion on deferredthe same period one year ago.
Accretion of PPP fee income, net of costs, included in net interest income for the nine months ended September 30, 2021 totaled $1.8 million compared to $429 thousand for the same periodand accretion of 2020. Accretion of loan discounts on purchased loans, net of premium amortization, on acquired loanspremiums, were included in interest and fees on loansloans. Net accretion of PPP income totaled $238$358 thousand for the ninesix months ended SeptemberJune 30, 2021. There was no accretion or amortization of discounts or premiums during2022, compared to $1.1 million for the same period of 2020. Interest and dividends2021. Net accretion of discounts on securities increased $472purchased loans totaled $718 thousand or 20%, from a 41% increase in average securities balances, which was partially offset by a 34-basis point decreasefor the six months ended June 30, 2022. There were no purchased loans in the yieldsix months ended June 30, 2021, and as a result, there was no net accretion of discounts on total securities to 2.06%.
Total interest expense decreased by $1.0 million, or 37%, which also contributed to the increase in net interest income. Interest expense on deposits decreased $1.1 million, or 51%, from a 31-basis point decrease in the cost of interest-bearing deposits and was partially offset by a 21% increase in average interest-bearing deposit balances. The decrease in the cost of interest-bearing deposits was attributable to a reduction in interest rates paid on checking, money market and time deposits.
COVID-19 Pandemic Impact on Net Interest Income
Net interest income was negatively impacted by higher levels of nonaccrualpurchased loans during the beginning of the pandemic. Subsequently, nonaccrual loans decreased to $2.2 million at September 30, 2021, from $7.0 million at September 30, 2020. Loans to customers who are not able to make their loan payments to the Bank are placed on nonaccrual status, which causes a reversal of accrued interest receivable and interest income on loans. Recognition of interest on the loans will not resume until the borrowers can once again demonstrate their ability to repay. Net interest income may also be negatively impacted in future periods if total average earning assets decrease or unfavorable changes in the earning asset composition occur. An unfavorable change in the Company’s earning asset composition could occur if a decrease in loan demand causes a reduction in loan balances, the Bank’s highest yielding asset category. Decreases in market rates on earning asset yields could also have an unfavorable impact on net interest income in future periods.
The ability of loan customers to make loan payments and the potential of decreasing loan demand may depend on the length of time and extent the Bank’s loan customers experience business interruptions from the pandemic. During the fourth quarter of 2020 and the first half of 2021, the Bank modified certain loan agreements to provide payment relief to its customers by providing interest only payments for periods ranging between 6 and 24 months. The extent of asset quality deterioration that could result from the modified loans may be impacted by the continuation of customers' business interruptions beyond the modification periods.period.
The following tables show interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated (dollars in thousands):
Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent Basis)
| | | Three Months Ended | | | Three Months Ended | |
| | | September 30, 2021 | | | September 30, 2020 | | | June 30, 2022 | | | June 30, 2021 | |
| | | Average Balance | | | Interest Income/Expense | | | Yield/Rate | | | Average Balance | | | Interest Income/Expense | | | Yield/Rate | | | Average Balance | | | Interest Income/Expense | | | Yield/Rate | | | Average Balance | | | Interest Income/Expense | | | Yield/Rate | |
Assets | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Securities: | | | | | | | | | | | | | | | | | | | | | | | | | | |
Taxable | | $ | 190,182 | | | $ | 767 | | | 1.60 | % | | $ | 106,852 | | | $ | 575 | | | 2.14 | % | | $ | 296,318 | | | $ | 1,295 | | | 1.75 | % | | $ | 147,285 | | | $ | 697 | | | 1.90 | % |
Tax-exempt (1) | | 49,492 | | | 306 | | | 2.46 | % | | 26,994 | | | 193 | | | 2.83 | % | | 55,908 | | | 391 | | | 2.81 | % | | 42,712 | | | 271 | | | 2.54 | % |
Restricted | | | 2,408 | | | | 21 | | | 3.48 | % | | | 1,848 | | | | 23 | | | 5.07 | % | | | 1,908 | | | | 21 | | | 4.48 | % | | | 1,631 | | | | 22 | | | 5.37 | % |
Total securities | | $ | 242,082 | | | $ | 1,094 | | | 1.79 | % | | $ | 135,694 | | | $ | 791 | | | 2.32 | % | | $ | 354,134 | | | $ | 1,707 | | | 1.93 | % | | $ | 191,628 | | | $ | 990 | | | 2.07 | % |
Loans: (2) | | | | | | | | | | | | | | | | | | | | | | | | | | |
Taxable | | $ | 762,623 | | | $ | 9,185 | | | 4.78 | % | | $ | 644,259 | | | $ | 7,537 | | | 4.65 | % | | $ | 858,045 | | | $ | 9,963 | | | 4.66 | % | | $ | 625,587 | | | $ | 7,044 | | | 4.52 | % |
Tax-exempt (1) | | | 3,378 | | | | 38 | | | 4.49 | % | | | 3,476 | | | | 39 | | | 4.51 | % | | | — | | | | — | | | — | | | | 3,400 | | | | 38 | | | 4.49 | % |
Total loans | | $ | 766,001 | | | $ | 9,223 | | | 4.78 | % | | $ | 647,735 | | | $ | 7,576 | | | 4.65 | % | | $ | 858,045 | | | $ | 9,963 | | | 4.66 | % | | $ | 628,987 | | | $ | 7,082 | | | 4.52 | % |
Federal funds sold | | 65,514 | | 8 | | 0.05 | % | | — | | — | | 0.00 | % | | — | | — | | — | | — | | — | | — | |
Interest-bearing deposits with other institutions | | | 199,372 | | | | 78 | | | 0.15 | % | | | 105,698 | | | | 25 | | | 0.09 | % | | | 122,797 | | | | 251 | | | 0.82 | % | | | 156,317 | | | | 38 | | | 0.10 | % |
Total earning assets | | $ | 1,272,969 | | | $ | 10,403 | | | 3.25 | % | | $ | 889,127 | | | $ | 8,392 | | | 3.75 | % | | $ | 1,334,976 | | | $ | 11,921 | | | 3.58 | % | | $ | 976,932 | | | $ | 8,110 | | | 3.33 | % |
Less: allowance for loan losses | | (5,450 | ) | | | | | | (6,323 | ) | | | | | | | (5,845 | ) | | | | | | (7,466 | ) | | | | | |
Total non-earning assets | | | 69,728 | | | | | | | | 61,586 | | | | | | | | | 90,747 | | | | | | | | 57,117 | | | | | | |
Total assets | | $ | 1,337,247 | | | | | | | $ | 944,390 | | | | | | | | $ | 1,419,878 | | | | | | | $ | 1,026,583 | | | | | | |
Liabilities and Shareholders’ Equity | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Interest bearing deposits: | | | | | | | | | | | | | | | | | | | | | | | | | | |
Checking | | $ | 266,623 | | | $ | 105 | | | 0.16 | % | | $ | 203,790 | | | $ | 139 | | | 0.27 | % | | $ | 300,473 | | | $ | 157 | | | 0.21 | % | | $ | 233,720 | | | $ | 100 | | | 0.17 | % |
Regular savings | | 196,025 | | | 41 | | | 0.08 | % | | 114,202 | | | 16 | | | 0.06 | % | | 209,513 | | | 26 | | | 0.05 | % | | 134,266 | | | 20 | | | 0.06 | % |
Money market accounts | | 182,350 | | | 47 | | | 0.10 | % | | 157,769 | | | 110 | | | 0.27 | % | | 220,182 | | | 75 | | | 0.14 | % | | 160,462 | | | 45 | | | 0.11 | % |
Time deposits: | | | | | | | | | | | | | | | | | | | | | | | | | | |
$100,000 and over | | 60,977 | | | 110 | | | 0.72 | % | | 50,864 | | | 166 | | | 1.30 | % | | 62,346 | | | 80 | | | 0.51 | % | | 40,212 | | | 83 | | | 0.83 | % |
Under $100,000 | | 86,565 | | | 66 | | | 0.30 | % | | 58,861 | | | 110 | | | 0.74 | % | | 75,025 | | | 75 | | | 0.40 | % | | 55,485 | | | 80 | | | 0.57 | % |
Brokered | | | 767 | | | | 1 | | | 0.28 | % | | | 592 | | | | — | | | 0.27 | % | | | 553 | | | | — | | | 0.12 | % | | | 578 | | | | — | | | 0.20 | % |
Total interest-bearing deposits | | $ | 793,307 | | | $ | 370 | | | 0.18 | % | | $ | 586,078 | | | $ | 541 | | | 0.37 | % | | $ | 868,092 | | | $ | 413 | | | 0.19 | % | | $ | 624,723 | | | $ | 328 | | | 0.21 | % |
Federal funds purchased | | — | | | — | | | 0.00 | % | | — | | | — | | | 0.00 | % | | 2 | | | — | | | — | % | | — | | | — | | | 0.00 | % |
Subordinated debt | | 9,993 | | | 155 | | | 6.17 | % | | 9,984 | | | 160 | | | 6.37 | % | | 4,994 | | | 69 | | | 5.56 | % | | 9,992 | | | 155 | | | 6.20 | % |
Junior subordinated debt | | | 9,279 | | | | 68 | | | | 2.91 | % | | | 9,279 | | | | 68 | | | | 2.92 | % | | | 9,279 | | | | 67 | | | | 2.91 | % | | | 9,279 | | | | 67 | | | | 2.91 | % |
Total interest-bearing liabilities | | $ | 812,579 | | | $ | 593 | | | 0.29 | % | | $ | 605,341 | | | $ | 769 | | | 0.51 | % | | $ | 882,367 | | | $ | 549 | | | 0.25 | % | | $ | 643,994 | | | $ | 550 | | | 0.34 | % |
Non-interest bearing liabilities | | | | | | | | | | | | | | | | | | | | | | | | | | |
Demand deposits | | 410,439 | | | | | | | 253,597 | | | | | | | | 431,995 | | | | | | | 292,960 | | | | | | |
Other liabilities | | | 4,076 | | | | | | | | 3,558 | | | | | | | | | 3,247 | | | | | | | | 2,187 | | | | | | |
Total liabilities | | $ | 1,227,094 | | | | | | | $ | 862,496 | | | | | | | | $ | 1,317,609 | | | | | | | $ | 939,141 | | | | | | |
Shareholders’ equity | | | 110,153 | | | | | | | | 81,894 | | | | | | | | | 102,269 | | | | | | | | 87,442 | | | | | | |
Total liabilities and Shareholders’ equity | | $ | 1,337,247 | | | | | | | $ | 944,390 | | | | | | | | $ | 1,419,878 | | | | | | | $ | 1,026,583 | | | | | | |
Net interest income | | | | $ | 9,810 | | | | | | | $ | 7,623 | | | | | | | | $ | 11,372 | | | | | | | $ | 7,560 | | | | |
Interest rate spread | | | | | | 2.95 | % | | | | | | 3.24 | % | | | | | | 3.33 | % | | | | | | 2.99 | % |
Cost of funds | | | | | | 0.19 | % | | | | | | 0.36 | % | | | | | | 0.17 | % | | | | | | 0.24 | % |
Interest expense as a percent of average earning assets | | | | | | 0.18 | % | | | | | | 0.34 | % | | | | | | 0.16 | % | | | | | | 0.23 | % |
Net interest margin | | | | | | 3.06 | % | | | | | | 3.41 | % | | | | | | 3.42 | % | | | | | | 3.10 | % |
(1) | Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $72$82 and $49$65 thousand for the three months ended SeptemberJune 30, 20212022 and 2020,2021, respectively. |
(2) | Loans on non-accrual status are reflected in the balances. |
| | | Nine Months Ended | | | Six Months Ended | |
| | | September 30, 2021 | | | September 30, 2020 | | | June 30, 2022 | | | June 30, 2021 | |
| | | Average Balance | | | Interest Income/Expense | | | Yield/Rate | | | Average Balance | �� | | Interest Income/Expense | | | Yield/Rate | | | Average Balance | | | Interest Income/Expense | | | Yield/Rate | | | Average Balance | | | Interest Income/Expense | | | Yield/Rate | |
Assets | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Securities: | | | | | | | | | | | | | | |
Taxable | | $ | 153,793 | | | $ | 2,180 | | | 1.90 | % | | $ | 112,166 | | | $ | 1,881 | | | 2.24 | % | | $ | 257,529 | | | $ | 2,427 | | | 1.90 | % | | $ | 135,305 | | | $ | 1,413 | | | 2.11 | % |
Tax-exempt (1) | | 42,446 | | | 806 | | | 2.54 | % | | 26,651 | | | 575 | | | 2.88 | % | | 58,647 | | | 777 | | | 2.67 | % | | 38,856 | | | 499 | | | 2.59 | % |
Restricted | | | 1,964 | | | | 65 | | | 4.45 | % | | | 1,835 | | | | 75 | | | 5.48 | % | | | 1,867 | | | | 42 | | | 4.60 | % | | | 1,738 | | | | 44 | | | 5.12 | % |
Total securities | | $ | 198,203 | | | $ | 3,051 | | | 2.06 | % | | $ | 140,652 | | | $ | 2,531 | | | 2.40 | % | | $ | 318,043 | | | $ | 3,246 | | | 2.06 | % | | $ | 175,899 | | | $ | 1,956 | | | 2.24 | % |
Loans: (2) | | | | | | | | | | | | | | |
Taxable | | $ | 673,375 | | | $ | 23,342 | | | 4.63 | % | | $ | 614,439 | | | $ | 22,088 | | | 4.80 | % | | $ | 841,608 | | | $ | 19,439 | | | 4.66 | % | | $ | 628,012 | | | $ | 14,157 | | | 4.55 | % |
Tax-exempt (1) | | | 3,400 | | | | 114 | | | 4.49 | % | | | 3,737 | | | | 125 | | | 4.49 | % | | | 1,106 | | | | 27 | | | 4.49 | % | | | 3,412 | | | | 76 | | | 4.49 | % |
Total loans | | $ | 676,775 | | | $ | 23,456 | | | 4.63 | % | | $ | 618,176 | | | $ | 22,213 | | | 4.80 | % | | $ | 842,714 | | | $ | 19,466 | | | 4.66 | % | | $ | 631,424 | | | $ | 14,233 | | | 4.55 | % |
Federal funds sold | | 22,122 | | | 8 | | | 0.05 | % | | 6 | | | — | | | 0.10 | % | | — | | | — | | | — | | | 67 | | | — | | | 0.10 | % |
Interest-bearing deposits with other institutions | | | 166,497 | | | | 148 | | | 0.12 | % | | | 68,406 | | | | 159 | | | 0.31 | % | | | 150,222 | | | | 321 | | | 0.43 | % | | | 149,786 | | | | 70 | | | 0.09 | % |
Total earning assets | | $ | 1,063,597 | | | $ | 26,663 | | | 3.35 | % | | $ | 827,240 | | | $ | 24,903 | | | 4.02 | % | | $ | 1,310,979 | | | $ | 23,033 | | | 3.54 | % | | $ | 957,176 | | | $ | 16,259 | | | 3.43 | % |
Less: allowance for loan losses | | (6,468 | ) | | | | | | | (5,591 | ) | | | | | | | (5,806 | ) | | | | | | | (7,475 | ) | | | | | |
Total non-earning assets | | | 64,096 | | | | | | | | | | 62,092 | | | | | | | | | | 120,409 | | | | | | | | | 59,929 | | | | | | |
Total assets | | $ | 1,121,225 | | | | | | | | | $ | 883,741 | | | | | | | | | $ | 1,425,582 | | | | | | | | $ | 1,009,630 | | | | | | |
Liabilities and Shareholders’ Equity | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Interest bearing deposits: | | | | | | | | | | | | | | |
Checking | | $ | 242,821 | | | $ | 321 | | | 0.18 | % | | $ | 187,755 | | | $ | 569 | | | 0.40 | % | | $ | 295,005 | | | $ | 256 | | | 0.17 | % | | $ | 230,723 | | | $ | 217 | | | 0.19 | % |
Regular savings | | 152,424 | | | 80 | | | 0.07 | % | | 109,600 | | | 49 | | | 0.06 | % | | 208,163 | | | 51 | | | 0.05 | % | | 130,262 | | | 39 | | | 0.06 | % |
Money market accounts | | 166,141 | | | 135 | | | 0.11 | % | | 145,530 | | | 649 | | | 0.60 | % | | 233,496 | | | 126 | | | 0.11 | % | | 157,902 | | | 88 | | | 0.11 | % |
Time deposits: | | | | | | | | | | | | | | |
$100,000 and over | | 47,991 | | | 292 | | | 0.81 | % | | 52,533 | | | 555 | | | 1.41 | % | | 63,429 | | | 163 | | | 0.52 | % | | 41,392 | | | 182 | | | 0.88 | % |
Under $100,000 | | 66,078 | | | 231 | | | 0.47 | % | | 60,675 | | | 356 | | | 0.78 | % | | 76,566 | | | 154 | | | 0.40 | % | | 55,667 | | | 164 | | | 0.60 | % |
Brokered | | | 647 | | | | 2 | | | 0.37 | % | | | 575 | | | | 1 | | | 0.26 | % | | | 558 | | | | 3 | | | 1.03 | % | | | 586 | | | | 1 | | | 0.43 | % |
Total interest-bearing deposits | | $ | 676,102 | | | $ | 1,061 | | | 0.21 | % | | $ | 556,668 | | | $ | 2,179 | | | 0.52 | % | | $ | 877,217 | | | $ | 753 | | | 0.17 | % | | $ | 616,532 | | | $ | 691 | | | 0.23 | % |
Federal funds purchased | | 1 | | | — | | | 0.46 | % | | 1 | | | — | | | 1.61 | % | | 2 | | | — | | | — | | | 1 | | | — | | | 0.47 | % |
Subordinated debt | | 9,992 | | | 464 | | | 6.20 | % | | 6,701 | | | 341 | | | 6.79 | % | | 5,708 | | | 138 | | | 4.89 | % | | 9,992 | | | 308 | | | 6.22 | % |
Junior subordinated debt | | 9,279 | | | 202 | | | 2.91 | % | | 9,279 | | | 225 | | | 3.25 | % | | 9,279 | | | 134 | | | 2.91 | % | | 9,279 | | | 134 | | | 2.91 | % |
Other borrowings | | | — | | | | — | | | — | % | | | — | | | | — | | | 0.00 | % | | | — | | | | — | | | — | % | | | — | | | | — | | | 0.00 | % |
Total interest-bearing liabilities | | $ | 695,374 | | | $ | 1,727 | | | 0.33 | % | | $ | 572,649 | | | $ | 2,745 | | | 0.64 | % | | $ | 892,206 | | | $ | 1,025 | | | 0.23 | % | | $ | 635,804 | | | $ | 1,133 | | | 0.36 | % |
Non-interest bearing liabilities | | | | | | | | | | | | | | |
Demand deposits | | 327,263 | | | | | | | | 228,042 | | | | | | | | 421,785 | | | | | | | | 284,542 | | | | | | |
Other liabilities | | | 2,728 | | | | | | | | | | 2,822 | | | | | | | | | | 3,904 | | | | | | | | | 2,617 | | | | | | |
Total liabilities | | $ | 1,025,365 | | | | | | | | $ | 803,513 | | | | | | | | $ | 1,317,895 | | | | | | | | $ | 922,963 | | | | | | |
Shareholders’ equity | | | 95,860 | | | | | | | | | | 80,228 | | | | | | | | | | 107,686 | | | | | | | | | 86,667 | | | | | | |
Total liabilities and Shareholders’ equity | | $ | 1,121,225 | | | | | | | | | $ | 883,741 | | | | | | | | | $ | 1,425,581 | | | | | | | | $ | 1,009,630 | | | | | | |
Net interest income | | | | | $ | 24,936 | | | | | | | | | $ | 22,158 | | | | | | | | | $ | 22,008 | | | | | | | | $ | 15,126 | | | | |
Interest rate spread | | | | | | | 3.02 | % | | | | | | | 3.38 | % | | | | | | | 3.31 | % | | | | | | | 3.07 | % |
Cost of funds | | | | | | | 0.23 | % | | | | | | | 0.46 | % | | | | | | | 0.16 | % | | | | | | | 0.25 | % |
Interest expense as a percent of average earning assets | | | | | | | 0.22 | % | | | | | | | 0.44 | % | | | | | | | 0.16 | % | | | | | | | 0.24 | % |
Net interest margin | | | | | | | 3.13 | % | | | | | | | 3.58 | % | | | | | | | 3.39 | % | | | | | | | 3.19 | % |
(1) | Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustmentadjustment was $193$170 and $147$121 thousand for the ninethe six months ended Septemberended June 30, 20212022 and 2020,2021, respectively. |
(2) | Loans on non-accrual status are reflected in the balances. |
Provision for Loan Losses
The Bank did not record a provision for loan losses for the third quarter of 2021, which resulted in a total allowance for loan losses of $5.4 million, or 0.66% of total loans, at SeptemberThree Month Period Ended June 30, 2021. Excluding loans acquired from Fincastle and SmartBank, which did not require an allowance for loan losses under acquisition accounting, the allowance for loan losses totaled 0.94% of total loans at September 30, 2021. This compared to a provision for loan losses of $1.5 million for the third quarter of 2020 and an allowance for loan losses of $7.8 million, or 1.20% of total loans, at September 30, 2020. The allowance for loan losses totaled $7.5 million, or 1.19% of total loans, at December 31, 2020.2022
A provision for loan losses was not recorded for the third quarter of 2021 as a decrease in the general reserve component of the allowance for loan losses was offset by net charge-offs on loans. The general reserve component of the allowance for loan losses decreased primarily from adjustments to qualitative factors, which resulted from the Bank's observation of improved economic conditions. Net charge-offs totaled $31 thousand for the third quarter of 2021, compared to $19 thousand for the same period in 2020. There were no significant changes to the specific reserve component of the allowance for loan losses during the quarter.
The provision for loan losses totaled $400 thousand for the thirdsecond quarter of 2020 was primarily attributable2022, compared to an increase in the specific reserve component of the allowance for loan losses, which was partially offset by a decrease in the general reserve component. The increase in the specific reserve component of the allowance for loan losses included reserves placed on newly identified impaired loans and an increase in a reserve on a loan evaluated in a prior period. The general reserve component of the allowance for loan losses decreased primarily from adjustments to qualitative factors, which resulted from the Bank's observation of improved economic conditions and a reduction in the number and amount of loans participating in the Bank's loan payment deferral program.
For the nine months ended September 30, 2021, the Bank recorded a$1.0 million recovery of loan losses for the same period of $1.0 million as2021. The provision for loan losses resulted primarily from an increase in the general reserve component of the allowance for loan losses, which was offset by a decrease inattributable to loan growth during the quarter. There were no specific reserve component. reserves on impaired loans at June 30, 2022, compared to $78 thousand of specific reserves at June 30, 2021. Net charge-offs totaled $26 thousand during the second quarter of 2022, compared to $1.0 million of net charge-offs for the same period of 2021.
The general reserve component$1.0 million recovery of the allowance for loan losses increased primarily from a higher historical loss reserve. These increases were partially offset by decreases infor the general reserve thatsecond quarter of 2021 resulted from upgrades to qualitative factorsthe resolution of a previously impaired loan and a related to asset quality and economic conditions. The decrease inof the specific reserve component of the allowance for loan losses resulted primarily fromduring the resolution of a previously impaired loan.period.
The Bank recorded aallowance for loan losses totaled $6.2 million, or 0.70% of total loans at June 30, 2022, compared to $5.5 million, or 0.89% of total loans at June 30, 2021. The net discount on purchased loans totaled $2.9 million, or 0.33% of total loans at June 30, 2022. There were no discounts on purchased loans at June 30, 2021.
Six Month Period Ended June 30, 2022
The provision for loan losses of $3.2 millionalso totaled $400 thousand for the ninesix months ended SeptemberJune 30, 2020, which was attributable2022, compared to increases in both the general and specific reserve componentsa $1.0 million recovery of the allowance for loan losses. The general reserve component of the allowance for loan losses increased primarily from adjustments to qualitative factors, which resulted fromfor the Bank’s observationsame period of unfavorable changes in economic indicators impacted by2021. Like the pandemic, consideration of risks associated with loans participating in the Bank's loan payment deferral program, and an increase in substandard loan amounts. The increase in the specific reserve component of the allowance for loan losses included reserves placed on newly identified impaired loans and an increase in a reserve on a loan evaluated in a prior period. Net charge offs on loans also contributed tosecond quarter ended June 30, 2022, the provision for loan losses which totaled $357 thousand for the first nine months of 2020.
COVID-19 Pandemic Impact on Provision for Loan Losses
The Bank may experience a higher provision for loan losses in future periodssix-month period resulted primarily from factors including higher specific reserves on newly identified impaired loans, higher levels of net charge-offs, and additional adjustments to qualitative factorsan increase in the general reserve component of the allowance for loan losses. The Bank believeslosses and was attributable to loan growth. There were net recoveries of previously charged-off loans totaling $92 thousand for the lengthfirst six months of time and extent that2022, compared to $1.0 of net charge-offs for the Bank’s customers experience business interruptions from the pandemic will impact the amountsame period of provision for loan losses in future periods.2021.
Noninterest Income
For the three-month period ended SeptemberThree Month Period Ended June 30, 20212022
Noninterest income increased $447$345 thousand, or 20%14%, to $2.6$2.8 million for the second quarter of 2022, compared to the same period of 2020. The increase was primarily attributable to a $1012021. Service charges on deposits increased $251 thousand, or 23%56%, increaseATM and check card fees increased $115 thousand, or 17%, fees for other customer services increased $38 thousand, or 25%, and wealth management fees increased $103 thousand, or 16%. The increases were partially offset by a $99 thousand, or 63%, decrease in brokered mortgage fees, and a $77 thousand, or 34%, decrease in other operating income.
The increases in service charges on deposits, a $84 thousand, or 23%, increase in ATM and check card fees, a $123 thousand, or 21%, increase in wealth management fees, and a $111 thousand, or 34%, increase in fees for other customer services.
Service charges on deposits benefited from an increase in overdraft fee income, the increase in ATM and check card fees was attributable to the addition of new customer deposit accounts through the Merger with Fincastle, wealth management revenue increased from a higher amount of assets under management, and the increase in fees for other customer services waswere favorably impacted by an increase in customer transactions and additional deposit accounts that resulted from the acquisition of Fincastle. The increase in wealth management income was attributable to an increase in the number of client accounts. Brokered mortgage fee income.fees and net gains on sale of loans held for sale decreased from a reduction in the number of mortgage loans originated, as well as an increase in the number of mortgage loans retained in the Bank’s loan portfolio and not sold or brokered when comparing the periods. The decrease in other operating income was a result of income earned from an investment in a small business investment company partnership in the second quarter of 2021.
For the nine-month period ended SeptemberSix Month Period Ended June 30, 20212022
Noninterest income increased $1.2 million,$913 thousand, or 19%20%, to $7.2$5.5 million for the six months ended June 30, 2022, compared to the same period of 2020. The increase was primarily attributable to a $2982021. Service charges on deposits increased $418 thousand, or 17%47%, increase in ATM and check card fees a $386increased $264 thousand, or 24%21%, increase in wealth management fees, and a $260 thousand, or 34%, increase in fees for other customer services.services increased $90 thousand, or 27%, and wealth management fees increased $263 thousand, or 20%. The increases were partially offset by a $110 thousand, or 42%, decrease in brokered mortgage fees and a $25 thousand decrease in gains on sale of loans held for sale.
The increaseincreases in service charges on deposits, ATM and check card fees, was attributable to the addition of new customer deposit accounts through the Merger with Fincastle and an increase in customer check card transactions. Wealth management revenue increased from a higher amount of assets under management. The increase in fees for other customer services waswere favorably impacted by an increase in customer transactions and additional deposit accounts that resulted from the acquisition of Fincastle. The increase in wealth management income was attributable to an increase in the number of client accounts. Brokered mortgage fee incomefees and net gains on sale of loans held for sale decreased from a reduction in the number of mortgage loans originated, as well as an increase in the number of mortgage loans retained in the Bank’s loan portfolio and not sold or brokered when comparing the periods.
COVID-19 Pandemic Impact on Noninterest Income
The number of customer overdrafts and resulting income from service charges on deposits decreased significantly in the second quarter of 2020. The Bank believes this may have resulted from a reduction in consumer spending due to government stay at home orders, social distancing, and an increase in unemployment. The lower amount of overdrafts may have also been impacted by receipt of government stimulus checks and an increase in the average balances of customer deposit accounts. The Bank also suspended certain overdraft fees at the beginning of the second quarter of 2020 in an effort to provide relief to its customers who may have experienced financial difficulties related to the pandemic. The suspension of the overdraft fees ended on September 30, 2020. Service charges on deposits may continue to remain at recent levels, or decrease, depending on factors that include customer spending behaviors and the balances of customer deposit accounts.
ATM and check card fee revenue could also decrease in future periods as customers may spend and visit ATM machines less during periods of uncertainty. Wealth management revenue may decrease in future periods if the market values of investments decline and mortgage fee income may decrease if the number of home purchases and refinancing activity slows in the Bank's market area.
Noninterest Expense
For the three-month period ended SeptemberThree Month Period Ended June 30, 20212022
Noninterest expense increased $3.3$2.3 million, or 54%35%, to $9.4$8.9 million for the three-month period ended June 30, 2022, compared to the same period one year ago. Merger related expenses totaled $1.3The increase was primarily attributable to a $1.4 million, during the quarter and were comprised of $911 thousand ofor 38% increase in salaries and employee benefits, $37a $146 thousand, ofor 37%, increase in occupancy expense, a $187 thousand, or 43%, increase in equipment expense, an $85 thousand, or 62%, increase in marketing, expense, $25a $79 thousand, of supplies, $196 thousand of legal and professional fees, $106 thousand data processing fees, and $24 thousand of other operating expense. In addition, several noninterest expense categories also increased during the third quarter as a result of adding employees, customers and branch offices from the merger of The Bank of Fincastle with and into First Bank on July 1, 2021. Expenses that increased during the quarter as a result of the merger were salaries and employee benefits, occupancy, equipment, marketing, supplies,or 30%, increase in ATM and check card expense, FDIC assessment, data processing, and a $280 thousand, or 42%, increase in other operating expense. These increases were partially offset by a $102 thousand decrease in legal and professional fees.
The Company estimates it will incur an additional $1.4 millionincreases were primarily attributable to the increase in the number of employees, branch offices and customers that resulted from the acquisition of Fincastle and the acquisition of the loan portfolio, branch assets and the addition of employees from the SmartBank office. The increase in marketing was also related to the timing of campaigns and promotion activities. The decrease in legal and professional fees was primarily attributable to merger related expense throughoutcosts in the fourthsecond quarter of 2021 and first2021. Although there were no merger expenses in the second quarter of 2022.2022, merger expenses totaled $277 thousand in the second quarter of 2021.
For the nine-month period ended SeptemberSix Month Period Ended June 30, 20212022
Noninterest expense increased $4.8$4.3 million, or 27%32%, to $22.7$17.6 million for the six-month period ended June 30, 2022, compared to the same period one year ago. Merger related expenses totaled $2.0The increase was primarily attributable to a $3.0 million, and were comprised of $911 thousand ofor 41% increase in salaries and employee benefits, $53a $315 thousand, of marketingor 36%, increase in equipment expense, $79a $271 thousand, of supplies, $782or 32%, increase in occupancy expense, a $151 thousand, of legal and professional fees, $106 thousand data processing fees, and $51 thousand of other operating expense. In addition, several noninterest expense categories also increased during the nine-month period as a result of adding employees, customers and branch offices from the merger with Fincastle. Expenses that increased during the period as a result of the merger were salaries and employee benefits, occupancy, equipment, marketing, supplies,or 30%, increase in ATM and check card expense, a $137 thousand, or 93%, increase in FDIC assessment, data processing,a $130 thousand, or 53%, increase in marketing, a $114 thousand, or 34%, increase in bank franchise tax, and a $510 thousand, or 40%, increase in other operating expense. These increases were partially offset by a $506 thousand, or 41%, decrease in legal and professional fees.
COVID-19 Pandemic Impact on Noninterest Expense
If asset quality deteriorates as a resultThe increases were primarily attributable to the increase in the number of employees, branch offices and customers that resulted from the acquisition of Fincastle and the acquisition of the pandemic,loan portfolio, branch assets and the Bank may incur anaddition of employees from the SmartBank office. The increase in expensesmarketing was also related to the resolutiontiming of problem loans including appraisal costs,campaigns and promotion activities. The decrease in legal and professional fees OREOwas primarily attributable to merger related costs during the first six months of 2021. Merger expenses and losses ontotaled $20 thousand for the salefirst six months of OREO. The Bank believes2022 compared to $682 thousand for the lengthsame period of time and extent that the Bank’s customers experience business interruptions from the pandemic may impact the amount of noninterest expense in future periods.2021.
Income Taxes
Three Month Period Ended June 30, 2022
Income tax expense increased $176decreased $41 thousand forfor the thirdsecond quarter of 2021, and increased by $799 for the nine months ended September 30, 2021,2022, compared to the same periodsperiod one year ago. The effective tax rate for the second quarter of 2022 was 19.3% compared to 22.3% for the same period in 2021. The reduced effective tax rate for 2022 was the result of lower non-deductible expenses in 2022 compared to 2021. The Company’s income tax expense differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the three and nine months ended SeptemberJune 30, 20212022, and 2020.2021. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income, and income from bank owned life insurance. A more detailed discussion of the Company’s tax calculation is contained in Note 11 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.2021.
Six Month Period Ended June 30, 2022
Income tax expense increased $276 thousand, or 18%, for the first six months of 2022 compared with the same period in 2021. The effective tax rate for the first six months of 2022 was 19.2% compared with 20.9% for the same period in 2021. Like the three month period ended June 30, 2022, the reduced effective tax rate for 2022 was also the result of lower non-deductible expenses in 2022 compared to 2021.
Financial Condition
General
Total assets increased $404.9$25.3 million to $1.4 billion at SeptemberJune 30, 20212022, compared to $950.9 million at December 31, 20202021. The increase was primarily attributable to the acquisition of the Bank of Fincastle which added $267.2an $54.5 million, or 7.0%, increase in assets on July 1, 2021. Loans,loans, net of the allowance for loan losses, increased $194.5and a $43.7 million, or 31%. Securities increased $126.3130.7%, increase in securities held to maturity. These increases were partially offset by a decrease in interest-bearing deposits in banks of $52.8 million, or 90%. Federal funds purchased increased by $80.6 million. The increase in the loan portfolio was impacted by $194.5 million of loans purchased on July 1, 2021 through the acquisition of Fincastle, an $82.0 million loan portfolio acquisition from SmartBank on September 30, 2021,33.5%, and a $41.9 million decrease in PPP loan balances, comparingsecurities available for sale of $24.7 million, or 8.5%, during the same periods.first quarter of 2022.
At SeptemberJune 30, 20212022, total liabilities increased $372.9$42.0 million to $1.2$1.3 billion compared to $866.0 million at December 31, 20202021. The increase was primarily attributable to the acquisition of Fincastle which added total liabilities of $238.0 million in July 1, 2021. Total deposits increased by $370.1 million, which included $236.3 million in total deposits acquired from Fincastle on July 1, 2021. Proceeds from PPP loan originations and the receipt of government stimulus checks by customers during 2021 also contributed to thean increase in deposits. Noninterest-bearing demand deposits and savings and interest-bearing demand deposits increased $148.3of $41.1 million and $173.6 million, respectively, whilein increase in noninterest-bearing deposits of $18.1 million. These increases were partially offset by a decrease in time deposits increased $48.2 million.of $11.8 million during the first six months of 2022 and the Company's repayment of $5.0 million of subordinated debt on January 1, 2022.
Total shareholders’ equity increased $32.0decreased $16.7 million to $116.9$100.3 million at SeptemberJune 30, 20212022, compared to $84.9$117.0 million at December 31, 20202021. The increaseThis was primarily attributable to the issuance of common stock in the amount of $1.7 million and acquired surplus of $25.4 million in the acquisition of Fincastle. Other notable increases include a $6.2 million increase in retained earnings. This increase was partially offset by a $1.7$23.0 million decrease in accumulated other comprehensive income. Tangible common equity totaled $112.7(loss) income (AOCI). The decrease in AOCI is related to unrealized losses in the securities portfolio stemming from market rate increases during the first quarter. This decrease was partially offset by a $5.8 million at the end of the third quarter, an increase of 33% compared to $84.9 million at December 31, 2020.in retained earnings. The Company's capital ratios continued to exceed the minimum capital requirements for regulatory purposes.
Loans
Loans, net of the allowance for loan losses, increased $194.5$54.5 million to $817.0$873.9 million at SeptemberJune 30, 2021,2022, compared to $622.4$819.4 million at December 31, 2020. Construction loans increased by $17.8 million. Commercial real estate loans and2021. This change was primarily due to increases in residential real estate, commercial real estate and commercial and industrial loans also increased by $115.8of $20.1 million, $36.1 million and $58 thousand,$9.7 million, respectively, during the first ninesix months of 2021. Commercial and industrial loans decreased by $4.2 million during the first nine months of 2021. The decrease in commercial and industrial loans was a result of $41.2 million decrease in PPP loans during the first nine months of 2021.
The Company, through its banking subsidiary, grants mortgage, commercial, and consumer loans to customers. The Bank segments its loan portfolio into real estate loans, commercial and industrial2022. Construction loans and consumer and other loans. Real estate loans are further divided intodecreased by $6.6 million and $4.4 million, respectively, during the following classes: Construction and Land Development; 1-4 Family Residential; and Other Real Estate Loans. Descriptionsfirst six months of the Company’s loan classes are as follows:
Real Estate Loans – Construction and Land Development: The Company originates construction loans for the acquisition and development of land and construction of commercial buildings, condominiums, townhomes, and one-to-four family residences.
Real Estate Loans – 1-4 Family: This class of loans includes loans secured by one-to-four family homes. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.
Real Estate Loans – Other: This loan class consists primarily of loans secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, office and retail buildings, industrial and warehouse buildings, hotels, and religious facilities.
Commercial and Industrial Loans: Commercial loans may be unsecured or secured with non-real estate commercial property. The Company's banking subsidiary makes commercial loans to businesses located within its market area and also to businesses outside of its market area through loan participations with other financial institutions. Loans originated under the SBA's PPP are also included in this loan class.
Consumer and Other Loans: Consumer loans include all loans made to individuals for consumer or personal purposes. They include new and used automobile loans, unsecured loans, and lines of credit. The Company's banking subsidiary makes consumer loans to individuals located within its market area. The Bank has also made loans to individuals outside of its market area through the purchase of loans from another financial institution. Other loans in this category include loans to state and political subdivisions.2022.
A substantial portionThe Bank actively participated as a lender in the U.S. Small Business Administration’s (“SBA”) Paycheck Protection Program (“PPP”) to support local small businesses and non-profit organizations by providing forgivable loans. Loan fees received from the SBA are accreted by the Bank into income evenly over the life of the loans, net of loan portfolioorigination costs, through interest and fees on loans. PPP loans totaled $845 thousand at June 30, 2022, with $32 thousand scheduled to mature in the second and third quarters of 2022, and $813 thousand scheduled to mature in the first and second quarters of 2026. The total amount of deferred PPP income, net of origination costs, that has not yet been recognized through interest and fees on loans totaled $8 thousand at June 30, 2022. The Company believes the majority of these loans will ultimately be forgiven and repaid by the SBA in accordance with the terms of the program. It is representedthe Company’s understanding that loans funded through the PPP program are fully guaranteed by residentialthe U.S. government. Should those circumstances change, the Company could be required to establish additional allowance for loan losses through additional provision for loan losses charged to earnings.
During the fourth quarter of 2020, the Bank modified terms of certain loans for customers that continued to be negatively impacted by the pandemic. The loan modifications lowered borrower loan payments by allowing interest only payments for periods ranging between 6 and commercial24 months. All loans secured by real estate throughoutmodified were in the Bank's market area. The abilitylodging sector of the Bank’s debtors to honor their contracts may be impacted by thecommercial real estate loan portfolio and general economic conditions in this area.totaled $4.7 million at June 30, 2022. All modified loans were performing under their modified terms at June 30, 2022.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances less the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued and credited to income based on the unpaid principal balance. Loan origination fees, net of certain origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. Interest income includes amortization of purchase premiums and discounts, recognized evenly over the life of the loans.
A loan’s past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on non-accrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. Loans greater than 90 days past due and still accruing totaled $7$92 thousand at SeptemberJune 30, 2021, compared to $302 thousand at2022. There were no loans greater than 90 days past due and still accruing at December 31, 2020.2021. For those loans that are carried on non-accrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio.
All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. When a loan is returned to accrual status, interest income is recognized based on the new effective yield to maturity of the loan.
Any unsecured loan that is deemed uncollectible is charged-off in full. Any secured loan that is considered by management to be uncollectible is partially charged-off and carried at the fair value of the collateral less estimated selling costs. This charge-off policy applies to all loan segments.
Impaired Loans
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value (net of selling costs), and the probability of collecting scheduled principal and interest payments when due. Additionally, management generally evaluates substandard and doubtful loans greater than $250 thousand for impairment. 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 by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair market value of the collateral, net of selling costs, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company typically does not separately identify individual consumer, residential, and certain small commercial loans that are less than $250 thousand for impairment disclosures, except for troubled debt restructurings (TDRs) as noted below. The recorded investment in impaired loans totaled $2.2 million$586 thousand and $6.7$2.3 million at SeptemberJune 30, 20212022 and December 31, 2020,2021, respectively.
Troubled Debt Restructurings (TDR)
In situations where, for economic or legal reasons related to a borrower’s financial condition, management grants a concession to the borrower that it would not otherwise consider, the related loan is classified as a TDR. TDRs are considered impaired loans. Upon designation as a TDR, the Company evaluates the borrower’s payment history, past due status, and ability to make payments based on the revised terms of the loan. If a loan was accruing prior to being modified as a TDR and if the Company concludes that the borrower is able to make such payments, and there are no other factors or circumstances that would cause it to conclude otherwise, the loan will remain on an accruing status. If a loan was on non-accrual status at the time of the TDR, the loan will remain on non-accrual status following the modification and may be returned to accrual status based on the policy for returning loans to accrual status as noted above. There were $1.7 million were $116 thousand in loans classified as TDRs asas of SeptemberJune 30, 20212022 and $6.0$1.6 million as of December 31, 2020.2021.
Asset Quality
Management classifies non-performing assets as non-accrual loans and OREO. OREO represents real property taken by the Bank when its customers do not meet the contractual obligation of their loans, either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for branch operations or expansion but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank had $1.7 million and $1.8 million in assets classified as OREO at SeptemberJune 30, 20212022. The Bank did not have any assets classified as OREO at and December 31, 20202021., respectively.
Non-performing assets totaled $4.0$2.1 million and $6.7$4.2 million at SeptemberJune 30, 20212022 and December 31, 20202021, representing approximately 0.30%0.15% and 0.71%0.30% of total assets, respectively. Non-performing assets consisted of OREO and non-accrual loans at SeptemberJune 30, 2022 and December 31, 2021. Non-performing assets consisted only of non-accrual loans at December 31, 2020. The decrease in non-accrual loans was primarily attributable to the resolution of a $4.3 million loan that was partially charged-off. This decrease was partially offset by $2.0 million of nonperforming assets acquired from the Bank of Fincastle, including $1.8included $1.7 million in properties formerly classified as bank premises by theThe Bank of Fincastle which are now classified as held for sale.
At SeptemberJune 30, 20212022, 4% of non-performing assets were commercial real estate loans 3% were construction loans, 38% were commercial and industrial loans, and 12%21% were residential real estate loans. Additionally, 43%79% was related to bank-owned properties acquired from theThe Bank of Fincastle which will not be used in the Company's operations and are classified as held for sale. Non-performing assets could increase due to other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $319$308 thousand and $1.4$1.1 million at SeptemberJune 30, 20212022 and December 31, 20202021, respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing a customers’ ability to meet their debt requirements.
Loans greater than 90 days past due and still accruing totaled $7$92 thousand at SeptemberJune 30, 20212022. Loans thatThere were no loans greater than 90 days past due and still accruing totaled $302 thousand at December 31, 20202021.
The allowance for loan losses represents management’s analysis of the existing loan portfolio and related credit risks. The provision for loan losses is based upon management’s current estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio. The allowance for loan losses totaled $5.4$6.2 million at SeptemberJune 30, 20212022 and $7.5$5.7 million December 31, 20202021, representing 0.66%0.70% and 1.19%0.69% of total loans, respectively. For further discussion regarding the allowance for loan losses, see “Provision for Loan Losses” above.
Recoveries of loan losses of $25 thousand, $97 thousand, $813$9 thousand and $81$40 thousand were recorded in the construction and land development, 1-4 family residential, other real estate, and commercial and industrial loan classes, respectively, during the nine months ended September 30, 2021. The recovery of loan losses in the construction and land development and 1-4 family residential loanloans classes resulted primarily from decreases inrespectively, during the general reserves. The decrease in the general reserve for the construction and land development loan class resulted primarily from adjustments to qualitative factors for improvements in asset quality and economic conditions. The decrease in the general reserve for the 1-4 family residential loan class resulted primarily from improvements in the historical loss rate and an adjustment to qualitative factors for improvements in economic conditions. Thesix months ended June 30, 2022. This recovery of loan losses in the other real estate loan category resulted primarily from a decrease in the specific reserve, which was partially offset by charge-offs on loans. The decrease in the specific reserve resulted from the resolution of a previously impaired loan for which a specific reserve was calculated. The recovery of loan losses in the commercial and industrial loan category resulted primarily from a decrease in the specific reserve. The decrease in the specific reserve resulted from a decrease in a reserve on a loan evaluated in a prior period. These recoveries were partially offset by provision for loan losses of $16totaling $334 thousand, $20 thousand, and $95 thousand in the other real estate, commercial and industrial, and consumer and other loan class.classes, respectively. For more detailed information regarding the (recovery of) provision for loan losses, see Note 4 to the Consolidated Financial Statements.
Impaired loans totaled $2.2 million$586 thousand and $6.7$2.3 million at SeptemberJune 30, 20212022 and December 31, 20202021, respectively. There was no related allowance for loan losses recorded for these loans at June 30, 2022. The related allowance for loan losses provided for these loans totaled $84$55 thousand and $2.2 million atSeptember 30, 2021 and December 31, 20202021. The average recorded investment in impaired loans during the ninesix months ended SeptemberJune 30, 20212022 and the year ended December 31, 20202021 was $5.4$1.9 million and $3.9$4.5 million, respectively. Included in the impaired loans total are loans classified as TDRs totaling $1.7 million$116 thousand and $6.0$1.6 million at SeptemberJune 30, 20212022 and December 31, 20202021., respectively. Loans classified as TDRs represent situations in which a modification to the contractual interest rate or repayment structure has been granted to address a financial hardship. As of SeptemberJune 30, 20212022, none of these TDRs were performing under the restructured terms and all were considered non-performing assets.
Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover losses inherent within the loan portfolio. For each period presented, the provision for loan losses charged to expense was based on management’s judgment after taking into consideration all factors connected with the collectability of the existing portfolio. Management considers economic conditions, historical loss factors, past due percentages, internally generated loan quality reports, and other relevant factors when evaluating the loan portfolio. There can be no assurance, however, that an additional provision for loan losses will not be required in the future, including as a result of changes in the qualitative factors underlying management’s estimates and judgments, changes in accounting standards, adverse developments in the economy, on a national basis or in the Company’s market area, loan growth, or changes in the circumstances of particular borrowers. For further discussion regarding the allowance for loan losses, see “Critical Accounting Policies” above.
COVID-19 Pandemic Impact on Asset Quality
The Bank anticipated the pandemic to have an unfavorable impact on the financial condition of many of its customers, and as a result, identified the related credit risk within its loan portfolio throughout 2020 and the first half of 2021, with the goal of mitigating the risk and minimizing potential loan charge-offs. In keeping with guidance from regulators, the Company worked with certain COVID-19 affected borrowers to reduce their loan payments by modifying the loan agreements to allow for interest only payments. These loans were not considered TDRs because they were modified in accordance with relief provisions of the CARES Act. The loan modification periods ranged from 6 months to 24 months and were intended to provide payment relief to borrowers over the period of time that COVID-19 is expected to continue to negatively affect the profitability of the borrowers’ businesses. Although the modified loan payments have been made as agreed and interest income has been recognized by the Company, should the borrowers be negatively affected by COVID-19 for a period of time that extends beyond the loan modification periods, it’s possible the borrowers may not be able to resume regular principal and interest payments in future periods and the Company may no longer be able to accrue interest income on the loans. The extent of asset quality deterioration that could result from these modified loans may be impacted by the continuation of customers' business interruptions beyond the modification periods.
Securities
The securities portfolio plays a primary role in the management of the Company’s interest rate sensitivity and serves as a source of liquidity. The portfolio is used as needed to meet collateral requirements, such as those related to secure public deposits and balances with the Reserve Bank. The investment portfolio consists of held to maturity, available for sale, and restricted securities. Securities are classified as available for sale or held to maturity based on the Company’s investment strategy and management’s assessment of the intent and ability to hold the securities until maturity. Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Securities available for sale may be sold in response to changes in market interest rates, changes in prepayment risk, increases in loan demand, general liquidity needs and other similar factors and are carried at estimated fair value. Restricted securities, including Federal Home Loan Bank, Federal Reserve Bank, and Community Bankers’ Bank stock, are generally viewed as long-term investments because there is minimal market for the stock and are carried at cost.
Securities at SeptemberJune 30, 20212022 totaled $278.5$343.8 million, an increase of $122.2$18.9 million, or 78.0%6.0%, from $156.3$324.7 million at December 31, 2020.2021. Investment securities are comprised of U.S. Treasury securities, U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate debt securities, and restricted securities. As of SeptemberJune 30, 2021,2022, neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Gross unrealized gains in the available for sale portfolio totaled $2.8totaled $147 thousand and $2.0 million at June 30, 2022and $4.0 million at September 30, 2021 and December 31, 2020,2021, respectively. Gross unrealized losses in the available for sale portfolio totaled $1.7$31.1 million and $82 thousand$2.6 million at SeptemberJune 30, 20212022 and December 31, 2020,2021, respectively. Gross unrealized gains in the held to maturity portfolio totaled $218 $2 thousand and $509 thousand$242 thousand at SeptemberJune 30, 20212022 and December 31, 2020,2021, respectively. Gross unrealized losses in the held to maturity portfolio totaled $2$6.7 million and $66 thousand at SeptemberJune 30, 2021 There were no gross unrealized losses in the held to maturity portfolio at 2022 and December 31, 2020.2021. Investments in an unrealized loss position were considered temporarily impaired at SeptemberJune 30, 20212022 and December 31, 2020.2021. The change in the unrealized gains and losses of investment securities from December 31, 20202021 to SeptemberJune 30, 20212022 was related to changes in market interest rates and was not related to credit concerns of the issuers.
DepositsAt June 30, 2022, the securities portfolio was comprised of $264.8 million of securities available for sale and $77.2 million of securities held to maturity compared to $289.5 million and $33.4 million at December 31, 2021, respectively. Securities held to maturity increased by $43.8 million during the first six months of 2022 from new purchases as a part of the Company's strategy to mitigate the risk of potential fluctuations in value and the related impact on shareholders' equity. The Company has not transferred any securities from available for sale to held to maturity during the first six months of 2022.
Deposits
At SeptemberJune 30, 2021,2022, deposits totaled $1.2$1.3 billion, an increaseincrease of $370.1$47.4 million, from $842.5 million$1.2 billion at December 31, 20202021. There was a slight change in the deposit mix when comparing the periods. At SeptemberJune 30, 20212022, noninterest-bearing demand deposits, savings and interest-bearing demand deposits, and time deposits composed 34%33%, 54%57%, and 12%10% of total deposits, respectively, compared to 31%33%, 57%, and 12%10% at December 31, 20202021.
Liquidity
Liquidity represents the ability to meet present and future financial obligations through either the sale or maturity of existing assets or with borrowings from correspondent banks or other deposit markets. The Company classifies cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, investment securities, and loans maturing within one year as liquid assets. As part of the Bank’s liquidity risk management, stress tests and cash flow modeling are performed quarterly.
As a result of the Bank’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Bank maintains overall liquidity sufficient to satisfy its depositors’ requirements and to meet its customers’ borrowing needs.
At SeptemberJune 30, 20212022, cash, interest-bearing and noninterest-bearing deposits with banks, securities, and loans maturing within one year totaled $274.5$210.8 million. At SeptemberJune 30, 20212022, 9.0%9.5% or $74.0$83.7 million of the loan portfolio matured within one year. Non-deposit sources of available funds totaled $239.0$385.0 million at SeptemberJune 30, 20212022, which included $159.4$287.8 million of secured funds available from Federal Home Loan Bank of Atlanta (FHLB), $24.6$46.2 million of secured funds available through the Federal Reserve Discount Window, and $51.0 million of unsecured federal funds lines of credit with other correspondent banks.
COVID-19 Pandemic Impact on Liquidity
Although the Bank’s liquidity has not been negatively impacted by the pandemic during the second quarter of 2021, it could be reduced in future periods. Factors that could reduce the Bank’s liquidity include a reduction in cash inflows from loan customers if they would experience financial difficulties and are not able to make contractual payments. Other factors that could reduce liquidity include decreasing customer deposit balances, increasing customer draws on their lines of credit with the Bank, and a reduction in the available lines of credit from correspondent banks. The Bank actively manages and monitors liquidity risk in order to maintain sufficient liquidity to meet the demand from its customers.
Capital Resources
The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company’s asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses. The Company meets eligibility criteria of a small bank holding company in accordance with the Federal Reserve Board’s Small Bank Holding Company Policy Statement issued in February 2015 and is no longernot obligated to report consolidated regulatory capital.
Effective January 1, 2015, the Bank became subject to capital rules adopted by federal bank regulators implementing the Basel III regulatory capital reforms adopted by the Basel Committee on Banking Supervision (the Basel Committee), and certain changes required by the Dodd-Frank Act.
The minimum capital level requirements applicable to the Bank under the final rules are as follows: a new common equity Tier 1 capital ratio of 4.5%; a Tier 1 capital ratio of 6%; a total capital ratio of 8%; and a Tier 1 leverage ratio of 4% for all institutions. The final rules also established a “capital conservation buffer” above the new regulatory minimum capital requirements. The capital conservation buffer was phased-in over four years and, as fully implemented effective January 1, 2019, requires a buffer of 2.5% of risk-weighted assets.assets. This results in the following minimum capital ratios beginning in 2019: a common equity Tier 1 capital ratio of 7.0%, a Tier 1 capital ratio of 8.5%, and a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonusesbonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. Management believes, as of SeptemberJune 30, 20212022 and December 31, 2020,2021, that the Bank met all capital adequacy requirements to which it is subject, including the capital conservation buffer.
The following table shows the Bank’s regulatory capital ratios at SeptemberJune 30, 2021:2022:
| | | First Bank | |
Total capital to risk-weighted assets | | | 14.4214.23 | % |
Tier 1 capital to risk-weighted assets | | | 13.8113.56 | % |
Common equity Tier 1 capital to risk-weighted assets | | | 13.8113.56 | % |
Tier 1 capital to average assets | | | 9.228.87 | % |
Capital conservation buffer ratio(1) | | | 6.426.23 | % |
(1) | Calculated by subtracting the regulatory minimum capital ratio requirements from the Company’s actual ratio for Common equity Tier 1, Tier 1, and Total risk based capital. The lowest of the three measures represents the Bank’s capital conservation buffer ratio. |
The prompt corrective action framework is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized:” a common equity Tier 1 capital ratio of 6.5%; a Tier 1 capital ratio of 8%; a total capital ratio of 10%; and a Tier 1 leverage ratio of 5%. The BankBank met the requirements to qualify as "well capitalized" as of SeptemberJune 30, 20212022 and December 31, 2020.2021.
On September 17, 2019 the FDIC finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio (CBLR) framework), as required by the Economic Growth Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework.
In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio greater than 9%, less than $10 billion in total consolidated assets, and limited amounts of off-balance sheet exposures and trading assets and liabilities. The CARES Act temporarily lowered the tier 1 leverage ratio requirement to 8% until December 31, 2020. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the "well-capitalized" ratio requirements under the prompt corrective action regulations and will not be required to report or calculate risk-based capital. Although, the Company did not opt into the CBLR framework at SeptemberJune 30, 2021,2022, it may opt into the CBLR framework in a future quarterly period.
During the fourth quarter of 2019, the Board of Directors of the Company authorized a stock repurchase plan pursuant to which the Company maywas authorized to repurchase up to $5.0 million of the Company’s outstanding common stock through December 31, 2020. During 2020, the Company repurchased and retired 129,035 shares at an average price paid per share of $16.05, for a total of $2.1 million. The Company has not authorized another stock repurchase plan as of September 30, 2021.
The Company’s capital resources may be affected by the Company’s acquisition of Fincastle, which was completed on July 1, 2021. Fincastle shareholders received aggregate merger consideration of $6.8 million in cash and 1,348,065 shares of the Company’s common stock.
The acquisition of Fincastle resulted in goodwill and other intangible assets that were excluded from the regulatory capital of First Bank. The addition of goodwill and other intangible assets did not result in a decrease in First Bank’s regulatory capital ratios. For the three-month and nine-month periods ended September 30, 2021, the Company recorded merger related expenses of $1.3 million and $2.0 million, respectively, in connection with the acquisition of Fincastle. The Company estimates that it will incur aggregate merger related costs of $3.4 million, with the remaining $1.4 million expected to be recorded throughout the fourth quarter of 2021 and the first quarter of 2022. First Bank remained well-capitalized at September 30, 2021.
COVID-19 Pandemic Impact on Capital Resources
The Company will continue to update its enterprise risk assessment and capital plan as the operating environment develops. As a result of its risk assessments and capital planning, the Company issued $5.0 million of subordinated debt in June 2020, primarily to further strengthen holding company liquidity and remain a source of strength for the Bank in the event of a severe economic downturn. The Company may also use the proceeds of the issuance for general corporate purposes, including the potential repayment of the Company’s existing subordinated debt, which became callable on a quarterly basis beginning in January 2021. The Company’s stock repurchase plan remainedwas suspended duringin the second third and fourth quartersquarter of 2020, and remained suspended until it ended on December 31, 2020. The Company has not authorized another stock repurchase plan due to the potential impactas of the pandemic on the economy and the Bank’s customers. The capital planning process also included consideration of whether to continue the Company’s cash dividend payments to common shareholders. The Company declared and paid a $0.12 per share dividend during the first quarter of 2021, which was a 9% increase over the prior quarter. The Company declared and paid another $0.12 per share dividend during the second and third quarters of 2021.June 30, 2022.
Contractual Obligations
There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.2021.
Off-Balance Sheet Arrangements
The Company, through the Bank, is a party to credit related financial instruments with risk not reflected in the consolidated financial statements in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments.
Commitments to extend credit, which amountedamounted to $114.0$161.3 million at SeptemberJune 30, 2021, an2022d $149.8, and $161.4 million at December 31, 2020,2021, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.
Unfunded commitments under commercial lines of credit, revolving credit lines, and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are collateralized as deemed necessary and may or may not be drawn upon to the total extent to which the Bank is committed.
Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. At SeptemberJune 30, 20212022 and December 31, 2020,2021, the Bank had $14.5$18.1 million and $10.7$18.9 million in outstanding standby letters of credit, respectively.
At September 30, 2021, the Bank had $6.8 million in locked-rate commitments to originate mortgage loans. Risks arise from the possible inability of counterparties to meet the terms of their contracts. The Bank does not expect any counterparty to fail to meet its obligations.
On April 21, 2020, the Company entered into interest rate swap agreements related to its outstanding junior subordinated debt. The Company uses derivatives to manage exposure to interest rate risk through the use of interest rate swaps. Interest rate swaps involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date with no exchange of underlying principal amounts.
The interest rate swaps qualified and are designated as cash flow hedges. The Company’s cash flow hedges effectively modify the Company’s exposure to interest rate risk by converting variable rates of interest on $9.0 million of the Company’s junior subordinated debt to fixed rates of interest. The cash flow hedges end and the junior subordinated debt matures between June 2034 and October 2036. The cash flow hedges’ total notional amount is $9.0 million. At SeptemberJune 30, 2021,2022, the cash flow hedges hadhad a fair value of $990 thousand,$2.2 million, which is recorded in other assets. The net gain/loss on the cash flow hedges is recognized as a component of other comprehensive (loss) income and reclassified into earnings in the same period(s) during which the hedged transactions affect earnings. The Company’s derivative financial instruments are described more fully in Note 16 to the Consolidated Financial Statements.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Not required.
Item 4. Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to provide assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods required by the SEC and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. An evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of SeptemberJune 30, 20212022 was carried out under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Based on and as of the date of such evaluation, the aforementioned officers concluded that the Company’s disclosure controls and procedures were effective.
The Company completed the acquisition of Fincastle on July 1, 2021. The conversion of Fincastle’s loan and deposit systems was completed in October 2021. The integration of Fincastle's legacy systems and processes does not have a material effect on our internal control over financial reporting.
The Company completed the acquisition of the SmartBank loan portfolio and certain fixed assets on September 30, 2021. There were no system conversions required as part of this acquisition. The integration of the SmartBank loan portfolio and certain fixed assets does not have a material effect on our internal control over financial reporting.
The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
There are no material pending legal proceedings, other than ordinary routine litigation incidental to the Company’s business, to which the Company is a party or to which the property of the Company is subject.
On May 7, 2021, Susan Taylor, a purported shareholder of Fincastle, filed a lawsuit in the United States District Court for the Southern District of New York against Fincastle and members of the Fincastle board of directors: Taylor v. The Bank of Fincastle et al. The lawsuit contained allegations contending, among other things that the registration statement on Form S-4 misstated or failed to disclose certain allegedly material information in violation of federal securities laws. The lawsuit was voluntarily dismissed by the plaintiff on August 20, 2021.
Item 1A. Risk Factors
There were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2020.2021.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None
Item 3. Defaults upon Senior Securities
None
Item 4. Mine Safety Disclosures
None
Item 5. Other Information
None
Item 6. Exhibits
The following documents are attached hereto as Exhibits:
31.1 | Certification of Chief Executive Officer, Section 302 Certification. |
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31.2 | Certification of Chief Financial Officer, Section 302 Certification. |
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32.1 | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350. |
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32.2 | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350. |
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101 | The following materials from First National Corporation’s Quarterly Report on Form 10-Q for the quarter ended SeptemberJune 30, 20212022 formatted in Inline eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive (Loss) Income (iv) Consolidated Statements of Cash Flows, (v) Consolidated Statements of Shareholders’ Equity, and (vi) Notes to Consolidated Financial Statements. |
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| 104 | The cover page from First National Corporation's Quarterly Report on Form 10-Q for the quarter ended SeptemberJune 30, 2021,2022, formatted in Inline XBRL (included with Exhibit 101). |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | | |
FIRST NATIONAL CORPORATION | | | | |
(Registrant) | | | | |
| | |
/s/ Scott C. Harvard | | | | NovemberAugust 15, 20212022
|
Scott C. Harvard | | | | Date |
President and Chief Executive Officer | | | | |
| | |
/s/ M. Shane Bell | | | | NovemberAugust 15, 20212022 |
M. Shane Bell | | | | Date |
Executive Vice President and Chief Financial Officer | | | | |
