|EX-32.2 - EX-32.2 - ENB Financial Corp||ex32-2.htm|
|EX-32.1 - EX-32.1 - ENB Financial Corp||ex32-1.htm|
|EX-31.2 - EX-31.2 - ENB Financial Corp||ex31-2.htm|
|EX-31.1 - EX-31.1 - ENB Financial Corp||ex31-1.htm|
|EX-23 - EX-23 - ENB Financial Corp||ex23.htm|
|EX-21 - EX-21 - ENB Financial Corp||ex21.htm|
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
|☒||ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934|
|For the fiscal year ended||December 31, 2019|
|☐||TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934|
For the transition period from to
Commission File Number 000-53297
ENB Financial Corp
(Exact name of registrant as specified in its charter)
|State or other jurisdiction of incorporation or organization||(IRS Employer Identification No.)|
|31 E. Main St. Ephrata, PA||17522|
|(Address of principal executive offices)||(Zip Code)|
Registrant’s telephone number, including area code (717) 733-4181
Securities registered pursuant to Section 12(b) of the Act:
|Title of each class||Trading Symbol(s)||Name of each exchange on which registered|
Securities registered pursuant to Section 12(g) of the Act:
Title of each class
Common Stock, Par Value $0.20 Per Share
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ☐ No ☒
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes ☐ No ☒
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
|Large Accelerated filer ☐||Accelerated filer ☒|
|Non-accelerated filer ☒||Smaller reporting company ☒|
|Emerging growth company ☐|
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2019, was approximately $70,576,836.
The number of shares of the registrant’s Common Stock outstanding as of March 6, 2020, was 5,611,832.
DOCUMENTS INCORPORATED BY REFERENCE
The Registrant’s Definitive Proxy Statement for its 2020 Annual Meeting of Shareholders to be held on May 5, 2020, is incorporated into Parts III and IV hereof.
ENB FINANCIAL CORP
|Item 1A.||Risk Factors||17|
|Item 1B.||Unresolved Staff Comments||25|
|Item 3.||Legal Proceedings||28|
|Item 4.||Mine Safety Disclosures||28|
|Item 5.||Market for Registrant’s Common Equity, Related Shareholder Matters, and Issuer Purchases of Equity Securities||28|
|Item 6.||Selected Financial Data||31|
|Item 7.||Management’s Discussion and Analysis of Financial Condition and Results of Operations||32|
|Item 7A.||Quantitative and Qualitative Disclosures about Market Risk||69|
|Item 8.||Financial Statements and Supplementary Data||76|
|Item 9.||Changes in and Disagreements with Accountants on Accounting and Financial Disclosure||128|
|Item 9A.||Controls and Procedures||128|
|Item 9B.||Other Information||129|
|Item 10.||Directors, Executive Officers, and Corporate Governance||130|
|Item 11.||Executive Compensation||130|
|Item 12.||Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters||130|
|Item 13.||Certain Relationships and Related Transactions, and Director Independence||130|
|Item 14.||Principal Accountant Fees and Services||130|
|Item 15.||Exhibits and Financial Statement Schedules||131|
|Item 16.||Form 10-K Summary||132|
The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference. Forward-looking statements pertain to possible or assumed future results that are made using current information. These forward-looking statements are generally identified when terms such as; “believe,” “estimate,” “anticipate,” “expect,” “project,” “forecast,” and other similar wordings are used. The readers of this report should take into consideration that these forward-looking statements represent management’s expectations as to future forecasts of financial performance, or the likelihood that certain events will or will not occur. Due to the very nature of estimates or predictions, these forward-looking statements should not be construed to be indicative of actual future results. Additionally, management may change estimates of future performance, or the likelihood of future events, as additional information is obtained. This document may also address targets, guidelines, or strategic goals that management is striving to reach but may not be indicative of actual results.
Readers should note that many factors affect this forward-looking information, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference into this document. These factors include, but are not limited to, the following:
|·||Monetary and interest rate policies of the Federal Reserve Board|
|·||Volatility of the securities markets|
|·||Possible impacts of the capital and liquidity requirements of Basel III standards and other regulatory pronouncements|
|·||Effects of short- and long-term federal budget and tax negotiations and their effects on economic and business conditions|
|·||Effects of the failure of the Federal government to reach agreement to raise the debt ceiling and the negative effects on economic or business conditions as a result|
|·||Effects of weak market conditions, specifically the effect on loan customers to repay loans|
|·||Political changes and their impact on new laws and regulations|
|·||Changes in deposit flows, loan demand, or real estate and investment securities values|
|·||Changes in accounting principles, policies, or guidelines as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, and other accounting standards setters|
|·||Ineffective business strategy due to current or future market and competitive conditions|
|·||Management’s ability to manage credit risk, liquidity risk, interest rate risk, and fair value risk|
|·||Operation, legal, and reputation risk|
|·||The risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful|
|·||The impact of new laws and regulations, including the impact of the Tax Cuts and Jobs Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the regulations issued thereunder|
Readers should be aware if any of the above factors change significantly, the statements regarding future performance could also change materially. The safe harbor provision provides that ENB Financial Corp is not required to publicly update or revise forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should review any changes in risk factors in documents filed by ENB Financial Corp periodically with the Securities and Exchange Commission, including Item 1A. of this Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K.
ENB Financial Corp (“the Corporation”) is a bank holding company that was formed on July 1, 2008. The Corporation’s wholly owned subsidiary, Ephrata National Bank (“the Bank”), also referred to as ENB, is a full service commercial bank organized under the laws of the United States. Presently, no other subsidiaries exist under
the bank holding company. The Corporation and the Bank are both headquartered in Ephrata, Lancaster County, Pennsylvania. The Bank was incorporated on April 11, 1881, pursuant to The National Bank Act under a charter granted by the Office of the Comptroller of the Currency (OCC). The Federal Deposit Insurance Corporation (FDIC) insures deposit accounts to the maximum extent provided by law. The Corporation’s retail, operational, and administrative offices are predominantly located in Lancaster County, southeastern Lebanon County, and southern Berks County, Pennsylvania. Ten full service offices are located in Lancaster County with one full service office in Lebanon County and one full service office in Berks County, Pennsylvania.
The basic business of the Corporation is to provide a broad range of financial services to individuals and small-to-medium-sized businesses in Lancaster County as well as Berks and Lebanon Counties. The Corporation utilizes funds gathered through deposits from the general public to originate loans. The Corporation offers a range of demand accounts, in addition to savings and time deposits. The Corporation also offers secured and unsecured commercial, real estate, and consumer loans. Ancillary services that provide added convenience to customers include direct deposit and direct payments of funds through Electronic Funds Transfer, ATMs linked to the Star® network, telephone banking, MasterCard® debit cards, Visa® or MasterCard credit cards, and safe deposit box facilities. In addition, the Corporation offers internet banking including bill pay and wire transfer capabilities, remote deposit capture, and an ENB Bank on the Go! app for iPhones or Android phones. The Corporation also offers a full complement of trust and investment advisory services through ENB’s Money Management Group.
As of December 31, 2019, the Corporation employed 280 persons, consisting of 254 full-time and 26 part-time employees. The number of full-time employees decreased by three employees, and the number of part-time employees decreased by eleven from the previous year-end. The decrease in the number of full-time and part-time employees is attributable to organic attrition and streamlining processes across departments that has resulted in improved headcount efficiency. The Bank expects to continue reviewing and implementing opportunities to align headcount with operational efficiencies in 2020. A collective bargaining agent does not represent the employees.
The Corporation’s business is providing financial products and services. These products and services are provided through the Corporation’s wholly owned subsidiary, the Bank. The Bank is presently the only subsidiary of the Corporation, and the Bank only has one reportable operating segment, community banking, as described in Note A of the Notes to the Consolidated Financial Statements included in this Report. The segment reporting information in Note A is incorporated by reference into this Part I, Item 1.
Products and Services with Reputation Risk
The Corporation offers a diverse range of financial and banking products and services. In the event one or more customers and/or governmental agencies becomes dissatisfied with or objects to any product or service offered by the Corporation, negative publicity with respect to any such product or service, whether legally justified or not, could have a negative impact on the Corporation’s reputation. The discontinuance of any product or service, whether or not any customer or governmental agency has challenged any such product or service, could have a negative impact on the Corporation’s reputation.
Market Area and Competition
The Corporation’s primary market area is Lancaster County, Pennsylvania, where ten full service offices are located. However, the Corporation’s market area also extends into contiguous Lebanon and Berks Counties. The Corporation opened a full service office in southeastern Lebanon County in 2013 and a full service office in southern Berks County in 2016 to extend physical presence to those counties. The Corporation’s greater service area is considered to be Lancaster, Lebanon, and southern and western Berks Counties of Pennsylvania. The area served by the Corporation is a mix of rural communities and small to mid-sized towns.
The Corporation’s headquarters and main campus are located in Ephrata, Pennsylvania. The Corporation’s main office and drive-up are located in downtown Ephrata, while the Cloister office is also located within Ephrata Borough. As such, the Corporation has a very strong presence in Ephrata Borough, a community with a population of approximately 13,000. When surrounding areas that also share an Ephrata address and zip code are included, the population is over 32,000 based on 2010 census data. The Corporation ranks a commanding first in deposit market share in the Ephrata area with 40.3% of deposits as of June 30, 2019, based on data compiled annually by the
Federal Deposit Insurance Corporation (FDIC). The Corporation’s deposit market share in the Ephrata area was also 40.6% as of June 30, 2018. The Corporation’s very high market share in the Ephrata area equates to a saturation of the local market that has led to the expansion of the Corporation’s branch network.
In the past 15 years, the Corporation’s market area has expanded beyond the greater Ephrata area to encompass most of northern Lancaster County, with the exception of the most western parts of the County. The majority of this expansion has occurred in recent history with the addition of eight new branch offices since 1999, bringing the total offices to twelve. Lancaster County ranks high nationally as a favored place to reside due to its scenic and fertile farmland, low cost of living, diverse local economy, and proximity to several large metropolitan areas. As a result, the area has experienced significant population growth and development. The population growth of Lancaster County has remained above both Pennsylvania and national growth levels over the past fifty years. Additionally, the population of Lancaster County has recently eclipsed half a million, with 2010 census information showing an estimated population of 508,000. The FDIC deposit market share data ranked the Corporation 5th in deposit market share in Lancaster County, with 7.6% of deposits as of June 30, 2019. The Corporation held 7.5% of deposit market share as of June 30, 2018.
In the course of attracting and retaining deposits and originating loans, the Corporation faces considerable competition. The Corporation competes with other commercial banks, savings and loan institutions, and credit unions for traditional banking products, such as deposits and loans. Based on FDIC summary of deposit data, there were 22 banks and savings associations and 12 credit unions operating in Lancaster County as of June 30, 2019, representing the same number of banks and credit unions compared to the prior year. The Corporation competes with consumer finance companies for loans, mutual funds, and other investment alternatives for deposits. The Corporation competes for deposits based on the ability to provide a range of products, low fees, quality service, competitive rates, and convenient locations and hours. The competition for loan origination generally relates to interest rates offered, products available, quality of service, and loan origination fees charged. Several competitors within the Corporation’s primary market have substantially higher legal lending limits that enable them to service larger loans and larger commercial customers.
The Corporation continues to assess the competition and market area to determine the best way to meet the financial needs of the communities it serves. Management also continues to pursue new market opportunities based on the strategic plan to efficiently grow the Corporation, improve earnings performance, and bring the Corporation’s products and services to customers currently not being reached. Management strategically addresses growth opportunities versus competitive issues by determining the new products and services to be offered, expansion of existing footprint with new locations, as well as investing in the expertise of staffing for expansion of these services.
Concentrations and Seasonality
The Corporation does not have any portion of its businesses dependent on a single or limited number of customers, the loss of which would have a material adverse effect on its businesses. No substantial portion of loans or investments is concentrated within a single industry or group of related industries, although a significant amount of loans are secured by real estate located in northern Lancaster County, Pennsylvania. Agricultural purpose loans make up approximately 26% of the loan portfolio; however, these loans are further diversified according to type of agriculture, of which dairy is the largest component accounting for approximately 12% of the loan portfolio. Furthermore, no customer accounts for more than 2.0% of the outstanding total loans. The business activities of the Corporation are generally not seasonal in nature. The sizable agricultural portfolio has minority elements that are predominately seasonal in nature due to typical farming operations. Financial instruments with concentrations of credit risk are described in Note P of the Notes to Consolidated Financial Statements included in this Report. The concentration of credit risk information in Note P is incorporated by reference into this Part I, Item 1.
Supervision and Regulation
Bank holding companies operate in a highly regulated environment and are routinely examined by federal and state regulatory authorities. The following discussion concerns various federal and state laws and regulations and the potential impact of such laws and regulations on the Corporation and the Bank.
To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory or regulatory provisions themselves. Proposals to change laws and regulations are frequently introduced in Congress, the state legislatures, and before the various bank regulatory agencies. The Corporation cannot determine the likelihood or timing of any such proposals or legislation, or the
impact they may have on the Corporation and the Bank. A change in law, regulations, or regulatory policy may have a material effect on the Corporation and the Bank’s business.
The operations of the Bank are subject to federal and state statutes applicable to banks chartered under the banking laws of the United States, to members of the Federal Reserve System, and to banks whose deposits are insured by the FDIC. Bank operations are subject to regulations of the OCC, the Consumer Financial Protection Bureau (CFPB), the Board of Governors of the Federal Reserve System, and the FDIC.
Bank Holding Company Supervision and Regulation
The Bank Holding Company Act of 1956
The Corporation is subject to the provisions of the Bank Holding Company Act of 1956, as amended, and to supervision by the Federal Reserve Board. The following restrictions apply:
General Supervision by the Federal Reserve Board
As a bank holding company, the Corporation’s activities are limited to the business of banking and activities closely related or incidental to banking. Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve Board. The Federal Reserve Board has adopted a risk-focused supervision program for small shell bank holding companies that is tied to the examination results of the subsidiary bank. The Federal Reserve Board has issued regulations under the Bank Holding Company Act that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the Federal Reserve Board may require that the Corporation stand ready to provide adequate capital funds to the Bank during periods of financial stress or adversity.
Restrictions on Acquiring Control of Other Banks and Companies
A bank holding company may not:
|·||acquire direct or indirect control of more than 5% of the outstanding shares of any class of voting stock, or substantially all of the assets of any bank, or|
|·||merge or consolidate with another bank holding company, without prior approval of the Federal Reserve Board.|
In addition, a bank holding company may not:
|·||engage in a non-banking business, or|
|·||acquire ownership or control of more than 5% of the outstanding shares of any class of voting stock of any company engaged in a non-banking business,|
unless the Federal Reserve Board determines the business to be so closely related to banking as to be a proper incident to banking. In making this determination, the Federal Reserve Board considers whether these activities offer benefits to the public that outweigh any possible adverse effects.
A bank holding company and its subsidiaries may not engage in tie-in arrangements in connection with any extension of credit or provision of any property or services. These anti-tie-in provisions state generally that a bank may not:
|·||lease or sell property, or|
|·||furnish any service to a customer,|
on the condition that the customer provides additional credit or service to a bank or its affiliates, or on the condition that the customer not obtain other credit or service from a competitor of the bank.
Restrictions on Extensions of Credit by Banks to their Holding Companies
Subsidiary banks of a holding company are also subject to restrictions imposed by the Federal Reserve Act on:
|·||any extensions of credit to the bank holding company or any of its subsidiaries,|
|·||investments in the stock or other securities of the Corporation, and|
|·||taking these stock or securities as collateral for loans to any borrower.|
Risk-Based Capital Guidelines
Bank holding companies must comply with the Federal Reserve Board’s current risk-based capital guidelines, which are amended provisions of the Bank Holding Company Act of 1956. The required minimum ratio of total capital to risk-weighted assets, including some off-balance sheet activities, such as standby letters of credit, is 8%. At least half of the total capital is required to be Tier I Capital, consisting principally of common shareholders’ equity, less certain intangible assets. The remainder, Tier II Capital, may consist of:
|·||some types of preferred stock,|
|·||a limited amount of subordinated debt,|
|·||some hybrid capital instruments,|
|·||other debt securities, and|
|·||a limited amount of the general loan loss allowance.|
The risk-based capital guidelines are required to take adequate account of interest rate risk, concentrations of credit risk, and risks of nontraditional activities.
Capital Leverage Ratio Requirements
The Federal Reserve Board requires a bank holding company to maintain a leverage ratio of a minimum level of Tier I capital, as determined under the risk-based capital guidelines, equal to 3% of average total consolidated assets for those bank holding companies that have the highest regulatory examination rating and are not contemplating or experiencing significant growth or expansion. All other bank holding companies are required to maintain a ratio of at least 1% to 2% above the stated minimum. The Bank is subject to similar capital requirements pursuant to the Federal Deposit Insurance Act.
In 2019, the federal banking agencies issued a final rule to provide an optional simplified measure of capital adequacy for qualifying community banking organizations, including the community bank leverage ratio (“CBLR”) framework. Generally, under the CBLR framework, qualifying community banking organizations with total assets of less than $10 billion, and limited amounts of off-balance-sheet exposures and trading assets and liabilities, may elect whether to be subject to the CBLR framework if they have a CBLR of greater than 9%. Qualifying community banking organizations that elect to be subject to the CBLR framework and continue to meet all requirements under the framework would not be subject to risk-based or other leverage capital requirements and, in the case of an insured depository institution, would be considered to have met the well capitalized ratio requirements for purposes of the FDIC’s Prompt Corrective Action framework. The CBLR framework will be available for banks to use in their March 31, 2020, Call Report. The Corporation has performed a preliminary analysis of the changes to capital adequacy and reporting requirements within the quarterly Call Report and expects that it will not opt into the CBLR framework.
Restrictions on Control Changes
The Change in Bank Control Act of 1978 requires persons seeking control of a bank or bank holding company to obtain approval from the appropriate federal banking agency before completing the transaction. The law contains a presumption that the power to vote 10% or more of voting stock confers control of a bank or bank holding company. The Federal Reserve Board is responsible for reviewing changes in control of bank holding companies. In doing so, the Federal Reserve Board reviews the financial position, experience and integrity of the acquiring person, and the effect the change of control will have on the financial condition of the Corporation, relevant markets, and federal deposit insurance funds.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act (SOX), also known as the “Public Company Accounting Reform and Investor Protection Act,” was established in 2002 and introduced major changes to the regulation of financial practice. SOX was established as a reaction to the outbreak of corporate and accounting scandals, including Enron and WorldCom. SOX represents a comprehensive revision of laws affecting corporate governance, accounting obligations, and corporate reporting. SOX is applicable to all companies with equity or debt securities that are either registered, or file reports under the Securities Exchange Act of 1934.
Section 404 of SOX requires publicly held companies to document and test their internal controls that impact financial reporting and report on the findings. These requirements fall under two main sections 404a and 404b. The provisions of these sections vary according to the size and market capitalization of public companies. For those companies subject to the requirements, external auditors must test and report on the effectiveness of a company’s internal controls to ensure accurate financial reporting. The Corporation became to Section 404b of SOX when total assets exceeded $1 billion. Companies must report any deficiencies or material weaknesses in their internal controls, as well as their remediation efforts. To ensure greater investor confidence in corporate disclosures from public companies, SOX restricts the services that public accounting firms can provide to publicly traded companies. The Corporation does not engage the same professional accounting firm for external and internal auditing.
The provisions of Sections 404a and 404b of SOX vary according to the publically traded market capitalization, referred to as accelerated or non-accelerated filers. While accelerated filers had to comply with Section 404a and 404b since 2004, with their auditors required to report on the effectiveness of internal controls, the Corporation only became subject to Section 404b in 2017 after assets exceeded $1 billion. The Corporation has always been subject to Section 404a.
In 2008, the SEC expanded the definitions of smaller public companies beyond non-accelerated filers to include a new definition of a smaller reporting company (SRC). The smaller reporting company definition was more favorable to smaller businesses that qualified under certain conditions. On July 1, 2008, the Corporation came into existence as ENB Financial Corp, which succeeded Ephrata National Bank. Companies can now be both SRC and non-accelerated or accelerated filers. The Corporation continues to meet the definition of a non-accelerated filer as it has a public equity float of approximately $70.6 million as of June 30, 2019.
On July 21, 2010, when the Dodd-Frank Act was signed into law, Section 404b was permanently deferred for all smaller reporting companies. However, the Corporation remains subject to Section 404b, which requires an internal control audit, when assets exceed $1 billion.
Bank Supervision and Regulation
Safety and Soundness
The primary regulator for the Bank is the OCC. The OCC has the authority under the Financial Institutions Supervisory Act and the Federal Deposit Insurance Act to prevent a national bank from engaging in any unsafe or unsound practice in conducting business or from otherwise conducting activities in violation of the law.
Federal and state banking laws and regulations govern, but are not limited to, the following:
|·||Scope of a bank’s business|
|·||Investments a bank may make|
|·||Reserves that must be maintained against certain deposits|
|·||Loans a bank makes and collateral it takes|
|·||Merger and consolidation activities|
|·||Establishment of branches|
The Corporation is a member of the Federal Reserve System. Therefore, the policies and regulations of the Federal Reserve Board have a significant impact on many elements of the Corporation’s operations, including:
|·||Loan and deposit growth|
|·||Rate of interest earned and paid|
|·||Types of securities|
|·||Breadth of financial services provided|
|·||Levels of liquidity|
|·||Levels of required capital|
Management cannot predict the effect of changes to such policies and regulations upon the Corporation’s business model and the corresponding impact they may have on future earnings.
FDIC Insurance Assessments
The FDIC imposes a risk-related premium schedule for all insured depository institutions that results in the assessment of premiums based on the Bank’s capital and supervisory measures. Under the risk-related premium schedule, the FDIC assigns, on a semi-annual basis, each depository institution to one of three capital groups, the best of these being “Well Capitalized.” For purposes of calculating the insurance assessment, the Bank was considered “Well Capitalized” as of December 31, 2019, and December 31, 2018. This designation has benefited the Bank in the past and continues to benefit it in terms of a lower quarterly FDIC rate. The FDIC adjusts the insurance rates when necessary. FDIC insurance rates have been significantly higher in recent years compared to years prior to the financial crisis. In 2008, during the financial crisis, the FDIC insurance limit was increased from $100,000 to $250,000 along with unlimited insurance coverage on non-interest bearing deposits and interest bearing deposit balances with interest rates less than or equal to 0.50%. Significant increases in the FDIC insurance costs were assessed in 2009 to both cover the increased level of bank failures that were occurring and the higher level of coverage. Since then the number of bank failures has significantly declined and the FDIC has been able to decrease the cost of the insurance. The total FDIC assessments paid by the Bank in 2019 were $172,000, compared to $285,000 in 2018.
In addition to FDIC insurance costs, the Bank is subject to assessments to pay the interest on Financing Corporation Bonds. Congress created the Financing Corporation to issue bonds to finance the resolution of failed thrift institutions. These assessment rates are set quarterly. In 2019, the Corporation recorded a credit for Financing Corporation assessments due to credits received for prior periods in the amount of $30,000. This compared to total Financing Corporation assessments paid by the Bank in 2018 of $29,000.
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act made the temporary $250,000 FDIC insurance coverage the permanent standard maximum deposit insurance amount. Additionally, on February 7, 2011, the Board of Directors of the FDIC approved a final rule based on the Dodd-Frank Act that revises the assessment base from one based on domestic deposits to one based on assets. This change, which was effective in April 2011, saved the Corporation a significant amount of FDIC insurance premiums.
Community Reinvestment Act
Under the Community Reinvestment Act (CRA), as amended, the OCC is required to assess all financial institutions that it regulates to determine whether these institutions are meeting the credit needs of the community that they serve. The Act focuses specifically on low and moderate income neighborhoods. The OCC takes an institution’s CRA record into account in its evaluation of any application made by any of such institutions for, among other things:
|·||Approval of a new branch or other deposit facility|
|·||Closing of a branch or other deposit facility|
|·||An office relocation or a merger|
|·||Any acquisition of bank shares|
The CRA, as amended, also requires that the OCC make publicly available the evaluation of a bank’s record of meeting the credit needs of its entire community, including low and moderate income neighborhoods. This evaluation includes a descriptive rating of either outstanding, satisfactory, needs to improve, or substantial noncompliance, along with a statement describing the basis for the rating. These ratings are publicly disclosed. The Bank received a satisfactory rating on the most recent CRA Performance Evaluation completed on June 4, 2018.
The Federal Deposit Insurance Corporation Improvement Act of 1991
Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), institutions are classified in one of five defined categories as illustrated below:
|Tier I Capital||Common Equity Tier I|
|Capital Category||Total Capital Ratio||Ratio||Capital Ratio||Leverage Ratio|
|Well Capitalized||> 10.0||> 8.0||> 6.5||> 5.0|
|Adequately Capitalized||> 8.0||> 6.0||> 4.5||> 4.0*|
|Undercapitalized||< 8.0||< 6.0||< 4.5||< 4.0*|
|Significantly Undercapitalized||< 6.0||< 4.0||< 3.5||< 3.0|
|Critically Undercapitalized||< 2.0|
*3.0 for those banks having the highest available regulatory rating.
The Bank’s and Corporation’s capital ratios exceed the regulatory requirements to be considered well capitalized for Total Risk-Based Capital, Tier I Risk-Based Capital, Common Equity Tier I Capital, and Tier I Leverage Capital. The capital ratio table and Consolidated Financial Statement Note M – Regulatory Matters and Restrictions, are incorporated by reference herein, from Item 8, and made a part hereof. Note M discloses capital ratios for both the Bank and the Corporation, shown as Consolidated.
Regulatory Capital Changes
In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for community banking organizations began January 1, 2015, while larger institutions (generally those with assets of $250 billion or more) began compliance on January 1, 2014. The final rules call for the following capital requirements:
|·||A minimum ratio of common equity tier I capital to risk-weighted assets of 4.5%|
|·||A minimum ratio of tier I capital to risk-weighted assets of 6%|
|·||A minimum ratio of total capital to risk-weighted assets of 8%|
|·||A minimum leverage ratio of 4%|
In addition, the final rules established a common equity tier I capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. If a banking organization fails to hold capital above the minimum capital ratios and the capital conservation buffer, it will be subject to certain restrictions on capital distributions and discretionary bonus payments. The phase-in period for the capital conservation and countercyclical capital buffers for all banking organizations began on January 1, 2016.
Under the initially proposed rules, accumulated other comprehensive income (AOCI) would have been included in a banking organization’s common equity tier I capital. The final rules allowed community banks to make a one-time election not to include these additional components of AOCI in regulatory capital and instead use the existing treatment under the general risk-based capital rules that excludes most AOCI components from regulatory capital. The opt-out election was made by the Corporation with the filing of the first quarter Call Report as of March 31, 2015.
The final rules permanently grandfather non-qualifying capital instruments (such as trust preferred securities and cumulative perpetual preferred stock) issued before May 19, 2010 for inclusion in the tier I capital of banking organizations with total consolidated assets less than $15 billion as of December 31, 2009, and banking organizations that were mutual holding companies as of May 19, 2010. The Corporation does not have trust preferred securities or cumulative perpetual preferred stock with no plans to add these to the capital structure.
The proposed rules would have modified the risk-weight framework applicable to residential mortgage exposures to require banking organizations to divide residential mortgage exposures into two categories in order to determine the applicable risk weight. In response to commenter concerns about the burden of calculating the risk weights and the potential negative effect on credit availability, the final rules do not adopt the proposed risk weights but retain the current risk weights for mortgage exposures under the general risk-based capital rules.
Consistent with the Dodd-Frank Act, the new rules replace the ratings-based approach to securitization exposures, which is based on external credit ratings, with the simplified supervisory formula approach in order to determine the appropriate risk weights for these exposures. Alternatively, banking organizations may use the existing gross-up approach to assign securitization exposures to a risk weight category or choose to assign such exposures a 1,250 percent risk weight. The Corporation does not securitize assets and has no plans to do so.
Under the new rules, mortgage servicing assets (MSAs) and certain deferred tax assets (DTAs) are subject to stricter limitations than those applicable under the current general risk-based capital rule. The new rules also increase the risk weights for past-due loans, certain commercial real estate loans, and some equity exposures, and makes selected other changes in risk weights and credit conversion factors.
Management has evaluated the impact of the above rules on levels of the Corporation’s capital. The final rulings were highly favorable in terms of the items that would have a more significant impact to the Corporation and community banks in general. Specifically, the AOCI final ruling, which would have had the greatest impact, now provides the Corporation with an opt-out provision. The final ruling on the risk weightings of mortgages was favorable and did not have a material negative impact. The rulings as to trust preferred securities, preferred stock, and securitization of assets are not applicable to the Corporation, and presently the revised treatment of MSAs is not material to capital. The remaining changes to risk weightings on several items mentioned above such as past-due loans and certain commercial real estate loans do not have a material impact to capital presently, but could change as these levels change.
Real Estate Lending Standards
Pursuant to the FDICIA, federal banking agencies adopted real estate lending guidelines which would set loan-to-value (“LTV”) ratios for different types of real estate loans. The LTV ratio is generally defined as the total loan amount divided by the appraised value of the property at the time the loan is originated. If the institution does not hold a first lien position, the total loan amount would be combined with the amount of all junior liens when calculating the ratio. In addition to establishing the LTV ratios, the guidelines require all real estate loans to be based upon proper loan documentation and a recent appraisal or certificate of inspection of the property.
Prompt Corrective Action
In the event that an institution’s capital deteriorates to the Undercapitalized category or below, FDICIA prescribes an increasing amount of regulatory intervention, including:
|·||Implementation of a capital restoration plan and a guarantee of the plan by a parent institution|
|·||Placement of a hold on increases in assets, number of branches, or lines of business|
If capital reaches the significantly or critically undercapitalized level, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management, and (in critically undercapitalized situations) appointment of a receiver. For well-capitalized institutions, FDICIA provides authority for regulatory intervention where they deem the institution to be engaging in unsafe or unsound practices, or if the institution receives a less than satisfactory examination report rating for asset quality, management, earnings, liquidity, or sensitivity to market risk.
Other FDICIA Provisions
Each depository institution must submit audited financial statements to its primary regulator and the FDIC, whose reports are made publicly available. In addition, the audit committee of each depository institution must consist of outside directors and the audit committee at “large institutions” (as defined by FDIC regulation) must include members with banking or financial management expertise. The audit committee at “large institutions” must also have access to independent outside counsel. In addition, an institution must notify the FDIC and the institution’s primary regulator of any change in the institution’s independent auditor, and annual management letters must be provided to the FDIC and the depository institution’s primary regulator. The regulations define a “large institution” as one with over $500 million in assets, which does include the Bank. Also, under the rule, an institution's independent public accountant must examine the institution's internal controls over financial reporting and perform agreed-upon procedures to test compliance with laws and regulations concerning safety and soundness.
Under the FDICIA, each federal banking agency must prescribe certain safety and soundness standards for depository institutions and their holding companies. Three types of standards must be prescribed:
|·||asset quality and earnings|
|·||operational and managerial, and|
Such standards would include a ratio of classified assets to capital, minimum earnings, and, to the extent feasible, a minimum ratio of market value to book value for publicly traded securities of such institutions and holding companies. Operational and managerial standards must relate to:
|·||internal controls, information systems and internal audit systems|
|·||interest rate exposure|
|·||asset growth, and|
|·||compensation, fees and benefits|
The FDICIA also sets forth Truth in Savings disclosure and advertising requirements applicable to all depository institutions.
USA PATRIOT Act of 2001/Bank Secrecy Act
In October 2001, the USA Patriot Act of 2001 (Patriot Act) was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C., which occurred on September 11, 2001. The Patriot Act is intended to strengthen U.S. law enforcement’s and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.
Under the Bank Secrecy Act (BSA), banks and other financial institutions are required to report to the Internal Revenue Service currency transactions of more than $10,000 or multiple transactions of which a bank is aware in any one day that aggregate in excess of $10,000 and to report suspicious transactions under specified criteria. Civil and criminal penalties are provided under the BSA for failure to file a required report, for failure to supply information required by the BSA, or for filing a false or fraudulent report.
Loans to Insiders/Regulation O
Regulation O, also known as Loans to Insiders, governs the permissible lending relationships between a bank and its executive officers, directors, and principal shareholders and their related interests. The primary restriction of Regulation O is that loan terms and conditions, including interest rates and collateral coverage, can be no more favorable to the insider than loans made in comparable transactions to non-covered parties. Additionally, the loan may not involve more than normal risk. The regulation requires quarterly reporting to regulators of the total amount of credit extended to insiders.
Under Regulation O, a bank is not required to obtain approval from the bank’s Board of Directors prior to making a loan to an executive officer or Board of Director member as long as a first lien on the executive officer’s residence secures the loan. The Corporation’s policy requires prior Board of Director approval of any Executive Officer or Director loan that when aggregated with other outstanding extensions of credit to the Insider and their related interests exceeds $500,000. Loans to any Executive Officer or Director with aggregate exposure of under $500,000 must be reported at the next scheduled Board of Director meeting. Further amendments allow bank insiders to take advantage of preferential loan terms that are available to substantially all employees. Regulation O does permit an insider to participate in a plan that provides more favorable credit terms than the bank provides to non-employee customers provided that the plan:
|·||Is widely available to employees|
|·||Does not give preference to any insider over other employees|
The Bank has a policy in place that offers general employees more favorable loan terms than those offered to non-employee customers. The Bank’s policy on loans to insiders allows insiders to participate in the same favorable rate
and terms offered to all other employees; however, any loan to an insider that does not fall within permissible regulatory exceptions must receive the prior approval of the Bank’s Board of Directors.
Dodd-Frank Wall Street Reform and Consumer Protection Act
Dodd-Frank Act, was the culmination of the legislative efforts in response to the financial crisis of 2007 - 2008. The act reshaped Wall Street and the American banking industry by bringing the most significant changes to financial regulation in the United States since the regulatory reform that followed the Great Depression. The Act’s numerous provisions were to be implemented over a period of several years and were intended to decrease various risks in the U.S. financial system. Dodd-Frank created a new Financial Stability Oversight Council to identify systemic risks in the financial system and gave federal regulators new authority to take control of and liquidate financial firms. Dodd-Frank was expected to and did have an impact on the Corporation’s business operations as its provisions began to take effect. To date the provisions that did go into effect, or began to phase in, did at a minimum increase the Corporation’s operating and compliance costs. Some of the provisions could possibly reduce fee revenue and/or increase interest expense. It is difficult to predict at this time what additional provisions of the Dodd-Frank Act will occur or be rolled back under the Trump administration. President Trump signed an executive order on February 3, 2017 designed to scale back the Dodd-Frank Act. The order lays the groundwork for sweeping change to the current law and if successfully pushed through Congress, could eventually lead to a replacement of Dodd-Frank. As such it is difficult to predict the impact that this legislation, or replacement legislation, will have on community banks going forward. Among the provisions that have either begun to affect the Corporation, or are likely to in the future, are the following:
Holding Company Capital Requirements
Dodd-Frank requires the Federal Reserve to apply consolidated capital requirements to bank holding companies that are no less stringent than those currently applied to depository institutions. Under these standards, trust preferred securities will be excluded from Tier I capital unless such securities were issued prior to May 19, 2010, by a bank holding company with less than $15 billion in assets. Dodd-Frank additionally requires that bank regulators issue countercyclical capital requirements so that the required amount of capital increases in times of economic expansion and decreases in times of economic contraction, are consistent with safety and soundness.
Dodd-Frank requires publicly traded companies to give stockholders a non-binding vote on executive compensation at least every three years, a non-binding vote regarding the frequency of the vote on executive compensation at least every six years, and a non-binding vote on “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by shareholders. The SEC has finalized the rules implementing these requirements which took effect on January 21, 2011. The Corporation was exempt from these requirements until January 21, 2013, due to its status as a smaller reporting company. Additionally, Dodd-Frank directs the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1 billion, regardless of whether the company is publicly traded. Dodd-Frank also gives the SEC authority to prohibit broker discretionary voting on elections of directors and executive compensation matters.
Consumer Financial Protection Bureau (CFPB)
Dodd-Frank created a new, independent federal agency called the Consumer Financial Protection Bureau (CFPB), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy Provisions of the Gramm-Leach-Bliley Act, and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive, or abusive practices in connection with the offering of consumer financial products. Dodd-Frank authorized the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, Dodd-Frank allows borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. Dodd-Frank permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.
Ability-to-Repay and Qualified Mortgage Rule
Pursuant to the Dodd-Frank Act, the CFPB issued a final rule on January 10, 2013 (effective on January 10, 2014), amending Regulation Z as implemented by the Truth in Lending Act, requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Mortgage lenders are required to determine consumers’ ability to repay in one of two ways. The first alternative requires the mortgage lender to consider the following eight underwriting factors when making the credit decision: (1) current or reasonably expected income or assets; (2) current employment status; (3) the monthly payment on the covered transaction; (4) the monthly payment on any simultaneous loan; (5) the monthly payment for mortgage-related obligations; (6) current debt obligations, alimony, and child support; (7) the monthly debt-to-income ratio or residual income; and (8) credit history. Alternatively, the mortgage lender can originate “qualified mortgages,” which are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a “qualified mortgage” is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. In addition, to be a qualified mortgage the points and fees paid by a consumer cannot exceed 3% of the total loan amount. Loans which meet these criteria will be considered qualified mortgages, and as a result generally protect lenders from fines or litigation in the event of foreclosure. Qualified mortgages that are “higher-priced” (e.g. subprime loans) garner a rebuttable presumption of compliance with the ability-to-repay rules, while qualified mortgages that are not “higher-priced” (e.g. Prime loans) are given a safe harbor of compliance. The final rule, as issued, is not expected to have a material impact on the Corporation’s lending activities and on the Corporation’s Consolidated Financial Statements.
Under the Durbin Amendment to the Dodd-Frank Act, the Federal Reserve adopted rules establishing standards for assessing whether the interchange fees that may be charged with respect to certain electronic debit transactions are “reasonable and proportional” to the costs incurred by issuers for processing such transactions.
Interchange fees or “swipe” fees, are charges that merchants pay to the Corporation and other card-issuing banks for processing electronic payment transactions. The Federal Reserve Board has ruled that for financial institutions with assets of $10 billion or more the maximum permissible interchange fee for an electronic debit transaction is the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction. The Federal Reserve Board also has rules governing routing and exclusivity that require issuers to offer two unaffiliated networks for routing transactions on each debit or prepaid product. While the Corporation’s asset size is presently under $10 billion, there is concern that these requirements impacting financial institutions over $10 billion in assets will eventually be pushed down to either financial institutions over $1 billion or to all financial institutions. This would negatively impact the Corporation’s non-interest income.
TILA/RESPA Integrated Disclosure (TRID) Rules
The TRID rules were mandated by Dodd-Frank to address the problem of the sometimes duplicative and overlapping disclosures required by the Truth in Lending Act (TILA) and Real Estate Settlement Procedures Act (RESPA) involving consumer purpose, closed end loans secured by real property. The CFPB was tasked with developing the new disclosures, defining the regulatory compliance parameters, and implementation. The timing elements built around these new disclosures were established to provide the consumer with ample time to consider the credit transaction and its associated costs. The final rules were implemented by amending the Truth in Lending Act; however implementation proved to be difficult as this marked the first time in thirty years that these standard disclosures were changed. Much reliance was placed on third party providers to the financial institutions to make all the necessary changes to the disclosures. After one delay, the rules became effective October 3, 2015. The Corporation partnered with its loan document software providers to ensure timely, compliant implementation.
Department of Defense Military Lending Rule
In 2015, the U.S. Department of Defense issued a final rule which restricts pricing and terms of certain credit extended to active duty military personnel and their families. This rule, which was implemented effective October 3, 2016, caps the interest rate on certain credit extensions to an annual percentage rate of 36% and restricts other fees. The rule requires financial institutions to verify whether customers are military personnel subject to the rule. The impact of this final rule, and any subsequent amendments thereto, on the Corporation’s lending activities and the Corporation’s statements of income or condition has had little or no impact; however, management will continue to monitor the implementation of the rule for any potential side effects on the Corporation’s business.
Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act was signed into law in December 2017. Among other changes, the Tax Cuts and Jobs Act reduced the federal corporate tax rate from 35% to 21% effective January 1, 2018. This tax rate change reduced the Corporation’s income tax liability in 2018 and should continue to reduce it in future years. However, the Corporation did recognize certain effects of the tax law changes in 2017. U.S. generally accepted accounting principles require companies to re-value their deferred tax assets and liabilities as of the date of enactment, with resulting tax effects accounted for in the reporting period of enactment. Since the enactment took place in December 2017, the Corporation revalued its net deferred tax assets in the fourth quarter of 2017 resulting in an approximately $1.1 million reduction to earnings in 2017.
In March 2015, federal regulators issued two related statements regarding cybersecurity. One statement instructed financial institutions to design multiple layers of security controls to establish lines of defense and to ensure that their risk management practices cover the risk of compromised customer credentials, including security measures to reliably authenticate customers accessing internet-based services of the financial institution. The other statement indicates that a financial institution’s management is expected to maintain sufficient business continuity planning processes to ensure the rapid recovery, resumption and maintenance of the institution’s operations after a cyber-attack involving malware. Financial institutions are expected to develop appropriate processes to enable recovery of data and business operations and address the rebuilding of network capabilities and restoring data if the institution or its critical service providers are victim to a cyber-attack. The Corporation could be subject to fines or penalties if it fails to observe this regulatory guidance. See Item 1A. Risk Factors for further discussion of risks related to cybersecurity.
As a consequence of the extensive regulation of the financial services industry and specifically commercial banking activities in the United States, the Corporation’s business is particularly susceptible to changes in federal and state legislation and regulations. Over the course of time, various federal and state proposals for legislation could result in additional regulatory and legal requirements for the Corporation. Management cannot predict if any such legislation will be adopted, or if adopted, how it would affect the business of the Corporation. Past history has demonstrated that new legislation or changes to existing legislation usually results in a heavier compliance burden and generally increases the cost of doing business.
Management believes that the effect of any current legislative proposals on the liquidity, capital resources and the results of operations of the Corporation and the Bank will be minimal. It is possible that there will be regulatory proposals which, if implemented, could have a material effect upon our liquidity, capital resources and results of operations. In addition, the general cost of compliance with numerous federal and state laws does have, and in the future may have, a negative impact on our results of operations. As with other banks, the status of the financial services industry can affect the Bank. Consolidations of institutions are expected to continue as the financial services industry seeks greater efficiencies and market share. Bank management believes that such consolidations may enhance the Bank’s competitive position as a community bank. See Item 1A. Risk Factors for more information.
The statistical disclosures required by this item are incorporated by reference herein, from Item 6 on page 31 and the Consolidated Statements of Income on page 81 as found in this Form 10-K filing.
A copy of the Corporation’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, as required to be filed with the Securities and Exchange Commission pursuant to Securities Exchange Act Rule 13a-1, may be obtained, without charge, from our website: www.enbfc.com or by request via e-mail to email@example.com. This information may also be obtained via written request to Mr. Barry W. Harting, Vice President and Corporate Secretary at ENB Financial Corp, 31 East Main Street, P.O. Box 457, Ephrata, PA, 17522.
The Corporation’s reports, proxy statements, and other information are available for inspection and copying at the SEC Public Reference Room at 100 F Street, N.E., Washington, DC, 20549 at prescribed rates. The public may
obtain information on the operation of the Public Reference Room by calling the Commission at 1-800-SEC-0330. The Corporation is an electronic filer with the Commission. The Commission maintains a website that contains reports, proxy and information statements, and other information regarding registrants that file electronically with the Commission. The address of the Commission’s website is http://www.sec.gov.
An investment in the Corporation’s common stock is subject to risks inherent to the banking industry and the equity markets. The material risks and uncertainties that management believes affect the Corporation are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Corporation. Additional risks and uncertainties that management is not aware of or is not focused on, or currently deems immaterial, may also impair the Corporation’s business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Corporation’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Corporation’s common stock could decline significantly, and you could lose all or part of your investment.
Risks Related To The Corporation’s Business
The Corporation Is Subject To Interest Rate Risk
The Corporation’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest earning assets, such as loans and securities, and interest expense paid on interest bearing liabilities, such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Corporation’s control, including general economic conditions and policies of various governmental and regulatory agencies, particularly, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Corporation receives on loans and securities, but also the amount of interest it pays on deposits and borrowings. Changes in interest rates could also affect:
|·||The Corporation’s ability to originate loans and obtain deposits|
|·||The fair value of the Corporation’s financial assets and liabilities|
|·||The average duration of the Corporation’s assets and liabilities|
|·||The future liquidity of the Corporation|
If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other securities, the Corporation’s net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other securities fall more quickly than the interest rates paid on deposits and other borrowings.
Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on the Corporation’s results of operations, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation Is Subject To Lending Risk
There are inherent risks associated with the Corporation’s lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Corporation operates, as well as those across the Commonwealth of Pennsylvania and the United States. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Corporation is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Corporation to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Corporation.
As of December 31, 2019, 41.5% of the Corporation’s loan portfolio consisted of commercial, industrial, and construction loans secured by real estate. Another 12.7% of the Corporation’s loan portfolio consisted of
commercial loans not secured by real estate. These types of loans are generally viewed as having more risk of default than consumer real estate loans or other consumer loans. These types of loans are also typically larger than consumer real estate loans and other consumer loans. Because the Corporation’s loan portfolio contains a significant number of commercial and industrial, construction, and commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses, and an increase in loan charge-offs, all of which could have a material adverse effect on the Corporation’s financial condition and results of operations.
A New Accounting Standard Will Result In A Significant Change In How We Recognize Credit Losses And May Have A Material Impact On Our Financial Condition Or Results Of Operations.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments, which changes the impairment model for most financial assets. This Update is intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. The underlying premise of the Update is that financial assets measured at amortized cost should be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The allowance for credit losses should reflect management’s current estimate of credit losses that are expected to occur over the remaining life of a financial asset. The income statement will be effected for the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the period. ASU 2016-13 is effective for annual and interim periods beginning after December 15, 2019, and early adoption is permitted for annual and interim periods beginning after December 15, 2018. With certain exceptions, transition to the new requirements will be through a cumulative effect adjustment to opening retained earnings as of the beginning of the first reporting period in which the guidance is adopted. On October 16, 2019, the FASB voted to defer the effective date for ASC 326, Financial Instruments – Credit Losses, for smaller reporting companies to fiscal years beginning after December 15, 2022, and interim periods within those fiscal years. We expect to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, but cannot yet determine the magnitude of any such one-time adjustment or the overall impact of the new guidance on the consolidated financial statements.
The Corporation’s Allowance For Possible Loan Losses May Be Insufficient
The Corporation maintains an allowance for possible loan losses, which is a reserve established through a provision for loan losses, charged to expense. The allowance represents management’s best estimate of expected losses inherent in the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political, and regulatory conditions, and unidentified losses inherent in the current loan portfolio. Determining the appropriate level of the allowance for possible loan losses understandably involves a high degree of subjectivity and requires the Corporation to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of the Corporation’s control, may require an increase in the allowance for possible loan losses. In addition, bank regulatory agencies periodically review the Corporation’s allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for possible loan losses, the Corporation will need additional provisions to increase the allowance for possible loan losses. Any increases in the allowance for possible loan losses will result in a decrease in net income, and may have a material adverse effect on the Corporation’s financial condition and results of operations.
The Basel III Capital Requirements May Require Us To Maintain Higher Levels Of Capital, Which Could Reduce Our Profitability
Basel III targets higher levels of base capital, certain capital buffers, and a migration toward common equity as the key source of regulatory capital. Although the new capital requirements are phased in over the next decade, Basel III signals a growing effort by domestic and international bank regulatory agencies to require financial institutions, including depository institutions, to maintain higher levels of capital. As Basel III is implemented, regulatory viewpoints could change and require additional capital to support our business risk profile. If the Corporation and the Bank are required to maintain higher levels of capital, the Corporation and the Bank may have fewer
opportunities to invest capital into interest-earning assets, which could limit the profitable business operations available to the Corporation and the Bank and adversely impact our financial condition and results of operations.
Future Credit Downgrades Of The United States Government Due To Issues Relating To Debt And The Deficit May Adversely Affect The Corporation
As a result of past difficulties of the federal government to reach agreement over federal debt and issues connected with the debt ceiling, certain rating agencies placed the United States Government’s long-term sovereign debt rating on their equivalent of negative watch and announced the possibility of a rating downgrade. The rating agencies, due to constraints related to the rating of the United States, also placed government-sponsored enterprises in which the Corporation invests and receives lines of credit on negative watch and a downgrade of the United States credit rating would trigger a similar downgrade in the credit rating of these government-sponsored enterprises. Furthermore, the credit rating of other entities, such as state and local governments, may also be downgraded should the United States credit rating be downgraded. Credit downgrades often cause a lower valuation of the Corporation’s securities.
The Corporation Is Subject To Environmental Liability Risk Associated With Lending Activities
A significant portion of the Corporation’s loan portfolio is secured by real property. During the ordinary course of business, the Corporation may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Corporation may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Corporation to incur substantial expenses and may materially reduce the affected property’s value or limit the Corporation’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws, may increase the Corporation’s exposure to environmental liability. Although the Corporation has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Corporation’s financial condition and results of operations.
If The Corporation Concludes That The Decline In Value Of Any Of Its Investment Securities Is Other Than Temporary, The Corporation is Required To Write Down The Value Of That Security Through A Charge To Earnings
The Corporation reviews the investment securities portfolio at each quarter-end reporting period to determine whether the fair value is below the current carrying value. When the fair value of any of the investment securities has declined below its carrying value, the Corporation is required to assess whether the decline is other than temporary. If it concludes that the decline is other than temporary, it is required to write down the value of that security through a charge to earnings. Changes in the expected cash flows of these securities and/or prolonged price declines have resulted and may result in concluding in future periods that there is additional impairment of these securities that is other than temporary, which would require a charge to earnings to write down these securities to their fair value. Due to the complexity of the calculations and assumptions used in determining whether an asset is impaired, the impairment disclosed may not accurately reflect the actual impairment in the future.
The Corporation’s Profitability Depends Significantly On Economic Conditions In The Commonwealth Of Pennsylvania And Its Market Area
The Corporation’s success depends primarily on the general economic conditions of the Commonwealth of Pennsylvania, and more specifically, the local markets in which the Corporation operates. Unlike larger national or other regional banks that are more geographically diversified, the Corporation provides banking and financial services to customers primarily located in Lancaster County, as well as Berks, Chester, and Lebanon Counties. The local economic conditions in these areas have a significant impact on the demand for the Corporation’s products and services as well as the ability of the Corporation’s customers to repay loans, the value of the collateral securing loans, and the stability of the Corporation’s deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets, or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Corporation’s financial condition and results of operations.
The Earnings Of Financial Services Companies Are Significantly Affected By General Business And Economic Conditions
The Corporation’s operations and profitability are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the U.S. economy and the local economies in which the Corporation operates, all of which are beyond the Corporation’s control. Deterioration in economic conditions could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values and a decrease in demand for the Corporation’s products and services, among other things, any of which could have a material adverse impact on the Corporation’s financial condition and results of operations.
The Corporation Operates In A Highly Competitive Industry And Market Area
The Corporation faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional, and community banks within the various markets in which the Corporation operates. Additionally, various out-of-state banks have begun to enter or have announced plans to enter the market areas in which the Corporation currently operates. The Corporation also faces competition from many other types of financial institutions, including, without limitation, online banks, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes, and continued consolidation. Banks, securities firms, and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting), and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Corporation’s competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Corporation can offer.
The Corporation’s ability to compete successfully depends on a number of factors, including, among other things:
|·||The ability to develop, maintain, and build upon long-term customer relationships based on quality service, high ethical standards, and safe, sound management practices|
|·||The ability to expand the Corporation’s market position|
|·||The scope, relevance, and pricing of products and services offered to meet customer needs and demands|
|·||The rate at which the Corporation introduces new products and services relative to its competitors|
|·||Customer satisfaction with the Corporation’s level of service|
|·||Industry and general economic trends|
Failure to perform in any of these areas could significantly weaken the Corporation’s competitive position, which could adversely affect the Corporation’s growth and profitability and have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation Is Subject To Extensive Government Regulation And Supervision
The Corporation is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds, and the banking system as a whole, not shareholders. These regulations affect the Corporation’s lending practices, capital structure, investment practices, dividend policy, and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations, and policies for possible changes. Changes to statutes, regulations, or regulatory policies, including changes in interpretation or implementation of statutes, regulations, or policies, could affect the Corporation in substantial and unpredictable ways. Such changes could subject the Corporation to additional costs, limit the types of financial services and products the Corporation may offer, and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations, or policies could result in sanctions by regulatory agencies, civil money penalties, and/or reputation damage, which could have a material adverse effect on the Corporation’s business, financial condition, and results of operations. While the Corporation has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.
Future Governmental Regulation And Legislation Could Limit The Corporation’s Future Growth
The Corporation is a registered bank holding company, and its subsidiary bank is a depository institution whose deposits are insured by the FDIC. As a result, the Corporation is subject to various regulations and examinations by various regulatory authorities. In general, statutes establish the corporate governance and eligible business activities for the Corporation, certain acquisition and merger restrictions, limitations on inter-company transactions such as loans and dividends, capital adequacy requirements, requirements for anti-money laundering programs and other compliance matters, among other regulations. The Corporation is extensively regulated under federal and state banking laws and regulations that are intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole. Compliance with these statutes and regulations is important to the Corporation’s ability to engage in new activities and consummate additional acquisitions. In addition, the Corporation is subject to changes in federal and state tax laws as well as changes in banking and credit regulations, accounting principles and governmental economic and monetary policies. The Corporation cannot predict whether any of these changes may adversely and materially affect it. Federal and state banking regulators also possess broad powers to take supervisory actions as they deem appropriate. These supervisory actions may result in higher capital requirements, higher insurance premiums and limitations on the Corporation’s activities that could have a material adverse effect on its business and profitability. While these statutes are generally designed to minimize potential loss to depositors and the FDIC insurance funds, they do not eliminate risk, and compliance with such statutes increases the Corporation’s expense, requires management’s attention and can be a disadvantage from a competitive standpoint with respect to non-regulated competitors.
The Regulatory Environment For The Financial Services Industry Is Being Significantly Impacted By Financial Regulatory Reform Initiatives In The United States And Elsewhere, Including Dodd-Frank And Regulations Promulgated To Implement It
Dodd-Frank, which was signed into law on July 21, 2010, comprehensively reforms the regulation of financial institutions, products and services. Dodd-Frank requires various federal regulatory agencies to implement numerous rules and regulations. Because the federal agencies are granted broad discretion in drafting these rules and regulations, many of the details and the impact of Dodd-Frank may not be known for many months or years. While much of how the Dodd-Frank and other financial industry reforms will change our current business operations depends on the specific regulatory reforms and interpretations, many of which have yet to be released or finalized, it is clear that the reforms, both under Dodd-Frank and otherwise, will have a significant effect on our entire industry. Although Dodd-Frank and other reforms will affect a number of the areas in which we do business, it is not clear at this time the full extent of the adjustments that will be required and the extent to which we will be able to adjust our businesses in response to the requirements. Although it is difficult to predict the magnitude and extent of these effects at this stage, we believe compliance with Dodd-Frank and implementing its regulations and initiatives will negatively impact revenue and increase the cost of doing business, both in terms of transition expenses and on an ongoing basis, and it may also limit our ability to pursue certain business opportunities.
The Corporation’s Banking Subsidiary May Be Required To Pay Higher FDIC Insurance Premiums Or Special Assessments Which May Adversely Affect Its Earnings
Future bank failures may prompt the FDIC to increase its premiums above the current levels or to issue special assessments. The Corporation generally is unable to control the amount of premiums or special assessments that its subsidiary is required to pay for FDIC insurance. Any future changes in the calculation or assessment of FDIC insurance premiums may have a material adverse effect on the Corporation’s results of operations, financial condition, and the ability to continue to pay dividends on common stock at the current rate or at all.
The Corporation’s Controls And Procedures May Fail Or Be Circumvented
Management regularly reviews and updates the Corporation’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Corporation’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Corporation’s business, results of operations, and financial condition.
New Lines Of Business Or New Products And Services May Subject The Corporation To Additional Risks
From time to time, the Corporation may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services, the Corporation may invest significant time and resources. Initial timetables for the
introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Corporation’s system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Corporation’s business, results of operations, and financial condition.
The Corporation’s Ability To Pay Dividends Depends On Earnings And Is Subject To Regulatory Limits
The Corporation’s ability to pay dividends is also subject to its profitability, financial condition, capital expenditures, and other cash flow requirements. Dividend payments are subject to legal and regulatory limitations, generally based on net profits and retained earnings, imposed by the various banking regulatory agencies. There is no assurance that the Corporation will have sufficient earnings to be able to pay dividends or generate adequate cash flow to pay dividends in the future. The Corporation’s failure to pay dividends on its common stock could have a material adverse effect on the market price of its common stock.
Future Acquisitions May Disrupt The Corporation’s Business And Dilute Stockholder Value
The Corporation may use its common stock to acquire other companies or make investments in corporations and other complementary businesses. The Corporation may issue additional shares of common stock to pay for future acquisitions, which would dilute the ownership interest of current shareholders of the Corporation. Future business acquisitions could be material to the Corporation, and the degree of success achieved in acquiring and integrating these businesses into the Corporation could have a material effect on the value of the Corporation’s common stock. In addition, any acquisition could require the Corporation to use substantial cash or other liquid assets or to incur debt. In those events, the Corporation could become more susceptible to economic downturns and competitive pressures.
The Corporation May Need To Or Be Required To Raise Additional Capital In The Future, And Capital May Not Be Available When Needed And On Terms Favorable To Current Shareholders
Federal banking regulators require the Corporation and its subsidiary bank to maintain adequate levels of capital to support their operations. These capital levels are determined and dictated by law, regulation, and banking regulatory agencies. In addition, capital levels are also determined by the Corporation’s management and board of directors based on capital levels that they believe are necessary to support the Corporation’s business operations.
If the Corporation raises capital through the issuance of additional shares of its common stock or other securities, it would likely dilute the ownership interests of current investors and could dilute the per share book value and earnings per share of its common stock. Furthermore, a capital raise through issuance of additional shares may have an adverse impact on the Corporation’s stock price. New investors also may have rights, preferences and privileges senior to the Corporation’s current shareholders, which may adversely impact its current shareholders. The Corporation’s ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside of its control, and on its financial performance. Accordingly, the Corporation cannot be certain of its ability to raise additional capital on acceptable terms and acceptable time frames or to raise additional capital at all. If the Corporation cannot raise additional capital in sufficient amounts when needed, its ability to comply with regulatory capital requirements could be materially impaired. Additionally, the inability to raise capital in sufficient amounts may adversely affect the Corporation’s financial condition and results of operations.
The Corporation May Not Be Able To Attract And Retain Skilled People
The Corporation’s success highly depends on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Corporation can be intense and the Corporation may not be able to hire people or to retain them. The unexpected loss of services of one or more of the Corporation’s key personnel could have a material adverse impact on the Corporation’s business because of their skills, knowledge of the Corporation’s market, years of industry experience, and the difficulty of promptly finding qualified replacement personnel. The Corporation does not currently have employment agreements or non-competition agreements with any of its senior officers.
The Corporation’s Information Systems May Experience An Interruption Or Breach In Security
The Corporation relies heavily on communications and information systems to conduct its business. Any failure, interruption, or breach in security of these systems could result in failures or disruptions in the Corporation’s customer relationship management, general ledger, deposit, loan, and other systems. While the Corporation has policies and procedures designed to prevent or limit the effect of the failure, interruption, or security breach of its information systems, there can be no assurance that any such failures, interruptions, or security breaches will not occur or, if they do occur, that they will be adequately addressed. Further, while the Corporation maintains insurance coverage that may, subject to policy terms and conditions including significant self-insured deductibles, cover certain aspects of cyber risks, such insurance coverage may be insufficient to cover all losses. The occurrence of any failures, interruptions, or security breaches of the Corporation’s information systems could damage the Corporation’s reputation, adversely affecting customer or consumer confidence, result in a loss of customer business, subject the Corporation to additional regulatory scrutiny and possible regulatory penalties, or expose the Corporation to civil litigation and possible financial liability, any of which could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation Continually Encounters Technological Change
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Corporation’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Corporation’s operations. Many of the Corporation’s competitors have substantially greater resources to invest in technological improvements. The Corporation may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Corporation’s business, financial condition, and results of operations.
The Corporation’s Operations Of Its Business, Including Its Interaction With Customers, Are Increasingly Done Via Electronic Means, And This Has Increased Its Risks Related To Cyber Security
The Corporation is exposed to the risk of cyber-attacks in the normal course of business. In general, cyber incidents can result from deliberate attacks or unintentional events. The Corporation has observed an increased level of attention in the industry focused on cyber-attacks that include, but are not limited to, gaining unauthorized access to digital systems for purposes of misappropriating assets or sensitive information, corrupting data, or causing operational disruption. To combat against these attacks, policies and procedures are in place to prevent or limit the effect on the possible security breach of its information systems. While the Corporation maintains insurance coverage that may, subject to policy terms and conditions including significant self-insured deductibles, cover certain aspects of cyber risks, such insurance coverage may be insufficient to cover all losses. While the Corporation has not incurred any material losses related to cyber-attacks, nor is it aware of any specific or threatened cyber-incidents as of the date of this report, it may incur substantial costs and suffer other negative consequences if it falls victim to successful cyber-attacks. Such negative consequences could include remediation costs that may include liability for stolen assets or information and repairing system damage that may have been caused; deploying additional personnel and protection technologies, training employees, and engaging third party experts and consultants; lost revenues resulting from unauthorized use of proprietary information or the failure to retain or attract customers following an attack; disruption or failures of physical infrastructure, operating systems or networks that support our business and customers resulting in the loss of customers and business opportunities; additional regulatory scrutiny and possible regulatory penalties; litigation; and reputational damage adversely affecting customer or investor confidence.
The Increasing Use Of Social Media Platforms Presents New Risks And Challenges And Our Inability Or Failure To Recognize, Respond To And Effectively Manage The Accelerated Impact Of Social Media Could Materially Adversely Impact Our Business
There has been a marked increase in the use of social media platforms, including weblogs (blogs), social media websites, and other forms of Internet-based communications which allow individuals access to a broad audience of consumers and other interested persons. Social media practices in the banking industry are evolving, which creates uncertainty and risk of noncompliance with regulations applicable to our business. Consumers value readily available information concerning businesses and their goods and services and often act on such information without further investigation and without regard to its accuracy. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted.
Information posted on such platforms at any time may be adverse to our interests and/or may be inaccurate. The dissemination of information online could harm our business, prospects, financial condition, and results of operations, regardless of the information’s accuracy. The harm may be immediate without affording us an opportunity for redress or correction.
Other risks associated with the use of social media include improper disclosure of proprietary information, negative comments about our business, exposure of personally identifiable information, fraud, out-of-date information, and improper use by employees and customers. The inappropriate use of social media by our customers or employees could result in negative consequences including remediation costs including training for employees, additional regulatory scrutiny and possible regulatory penalties, litigation or negative publicity that could damage our reputation adversely affecting customer or investor confidence.
The Corporation Is Subject To Claims And Litigation Pertaining To Fiduciary Responsibility
From time to time, customers make claims and take legal action pertaining to the Corporation’s performance of its fiduciary responsibilities. Whether customer claims and legal action related to the Corporation’s performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Corporation, they may result in significant financial liability and/or adversely affect the market perception of the Corporation and its products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Corporation’s business, financial condition, and results of operations.
Financial Services Companies Depend On The Accuracy And Completeness Of Information About Customers And Counterparties
In deciding whether to extend credit or enter into other transactions, the Corporation may rely on information furnished by, or on behalf of, customers and counterparties, including financial statements, credit reports, and other financial information. The Corporation may also rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations.
Consumers May Decide Not To Use Banks To Complete Their Financial Transactions
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on the Corporation’s financial condition and results of operations.
A Change In Control Of The United States Government And Issues Relating To Debt And The Deficit May Adversely Affect The Corporation
The outcome of future elections could result in changes in control of the federal government and bring significant changes (or uncertainty) in governmental policies, regulatory environments, spending sentiment and many other factors and conditions, some of which could adversely impact the Corporation’s business, financial condition and results of operations.
Natural Disasters, Acts Of War Or Terrorism, Pandemics, and Other External Events Could Significantly Impact The Corporation’s Business
Severe weather, natural disasters, acts of war or terrorism, pandemics, and other adverse external events could have a significant impact on the Corporation’s ability to conduct business. Such events could affect the stability of the Corporation’s deposit base; impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue, and/or cause the Corporation to incur additional expenses. Severe weather or natural disasters, acts of war or terrorism, pandemics, or other adverse external events, may occur in the future. Although management has established disaster recovery policies and
procedures, the occurrence of any such event could have a material adverse effect on the Corporation’s business, financial condition, and results of operations.
Risks Associated With The Corporation’s Common Stock
The Corporation’s Stock Price Can Be Volatile
Stock price volatility may make it more difficult for shareholders to resell their shares of common stock when they desire and at prices they find attractive. The Corporation’s stock price can fluctuate significantly in response to a variety of factors including, among other things:
|•||Actual or anticipated variations in quarterly results of operations|
|•||Recommendations by securities analysts|
|•||Operating and stock price performance of other companies that investors deem comparable to the Corporation|
|•||News reports relating to trends, concerns, and other issues in the financial services industry|
|•||Perceptions in the marketplace regarding the Corporation and/or its competitors|
|•||New technology used, or services offered, by competitors|
|•||Significant acquisitions or business combinations, strategic partnerships, joint ventures, or capital commitments by, or involving, the Corporation or its competitors|
|•||Changes in government regulations|
Geopolitical conditions such as acts or threats of terrorism or military conflicts
General market fluctuations, industry factors, and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes, or credit loss trends, could also cause the Corporation’s stock price to decrease regardless of operating results.
The Trading Volume In The Corporation’s Common Stock Is Less Than That Of Other Larger Financial Services Companies
The Corporation’s common stock is listed for trading on the Over the Counter Bulletin Board (OTCBB) exchange. The trading volume in its common stock is a fraction of that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity, and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Corporation’s common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Corporation has no control. Given the lower trading volume of the Corporation’s common stock, significant sales of the Corporation’s common stock, or the expectation of these sales, could cause the Corporation’s stock price to fall.
An Investment In The Corporation’s Common Stock Is Not An Insured Deposit
The Corporation’s common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund, or by any other public or private entity. Investment in the Corporation’s common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, an investor in the Corporation’s common stock may lose some or all of their investment.
The Corporation’s Articles Of Incorporation And Bylaws, As Well As Certain Banking Laws, May Have An Anti-Takeover Effect
Provisions of the Corporation’s articles of incorporation and bylaws, federal banking laws, including regulatory approval requirements, and the Corporation’s stock purchase rights plan, could make it more difficult for a third party to acquire the Corporation, even if doing so would be perceived to be beneficial to the Corporation’s shareholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination that could adversely affect the market price of the Corporation’s common stock.
Item 1B. Unresolved Staff Comments
ENB Financial Corp’s headquarters and main office of Ephrata National Bank are located at 31 East Main Street, Ephrata, Pennsylvania.
Listed below are the office locations of properties owned or leased by the Corporation. No mortgages, liens, or encumbrances exist on any of the Corporation’s owned properties. As of December 31, 2019, the Corporation leased three properties.
|Property Location||Leased||Acreage||Sq Ftg|
|Corporate Headquarters/Main Office||Owned||0.50||42,539|
|31 East Main Street|
|ENB's Money Management Group||Owned||0.17||11,156|
|47 East Main Street|
|31 East Franklin Street|
|124 East Main Street|
|Main Street Drive-In||Owned||0.41||700|
|42 East Main Street|
|809 Martin Avenue|
|935 North Railroad Avenue|
|New Holland, Pennsylvania|
|1 Main Street|
|351 South 7th Street|
|3190 Lititz Pike|
|Blue Ball Office||Owned||2.27||5,900|
|110 Marble Avenue|
|East Earl, Pennsylvania|
|1 North Penryn Road|
|361 West Main Street|
|615 East Lincoln Avenue|
|6296 Morgantown Road|
|Georgetown Drive-Thru Office||Leased||N/A||252|
|1298 Georgetown Road|
|60 Historic Drive|
In addition to the above properties, the Corporation owns two other properties located in the Corporation’s Ephrata Main Street Campus. These properties were acquired in 2002, when a group of properties adjacent to and surrounding the Corporation’s Main Office was purchased. These two properties are being held for future use or possible sale. The other properties purchased in 2002 have been remodeled as office or operational space and are reflected in the offices shown above. The Corporation also owns a four acre parcel of land in Ephrata Borough that was converted from other real estate owned to Bank property as of December 31, 2011. The parcel is being evaluated for future expansion plans.
The nature of the Corporation’s business generates a certain amount of litigation involving matters arising in the ordinary course of business; however, in the opinion of management, there are no material proceedings pending to which the Corporation is a party to, or which would be material in relation to the Corporation’s undivided profits or financial condition. There are no proceedings pending other than ordinary routine litigation incident to the business of the Corporation. In addition, no material proceedings are pending, known to be threatened, or contemplated against the Corporation by governmental authorities.
Item 4. Mine Safety Disclosures – Not Applicable
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters, and Issuer Purchases of Equity Securities
On April 17, 2019, ENB Financial Corp announced the Board of Directors declared a two-for-one stock split of the Corporation’s issued and outstanding common stock pursuant to which one (1) additional share of common stock was issued for each share of common stock held by shareholders of record as of the close of business on May 31, 2019. The additional shares were issued on June 28, 2019. The stock split was effected pursuant to articles of amendment to the articles of incorporation to reduce the par value of the common stock from $0.20 to $0.10 and increase the authorized shares of common stock proportionately from 12,000,000 to 24,000,000. The Corporation has only one class of stock authorized, issued, and outstanding, which now consists of common stock with a par value of $0.10 per share. As of December 31, 2019, there were 24,000,000 shares of common stock authorized with 5,739,114 shares issued, and 5,640,742 shares outstanding to approximately 1,500 shareholders. The Corporation’s common stock is traded on a limited basis on the OTCQX Best Market under the symbol “ENBP.” Prices presented in the table below reflect high and low prices of actual transactions known to management. Prices and dividends per share are adjusted for stock splits. Market quotations reflect inter-dealer prices, without retail mark up, mark down, or commission and may not reflect actual transactions.
|Source - SNL Financial LC|
Since 1973, the Corporation, and before it the Bank, has paid quarterly cash dividends on or around March 15, June 15, September 15, and December 15 of each year. The Corporation currently expects to continue the practice of paying quarterly cash dividends to its shareholders for the foreseeable future. However, future dividends are dependent upon future earnings. The dividend payments reflected above amount to 30.8% and 33.6% dividend payout ratio for 2019 and 2018, respectively. The dividend payout ratio is only one element of management’s plan for managing capital. Certain laws restrict the amount of dividends that may be paid to shareholders in any given
year. In addition, under Pennsylvania corporate law, the Corporation may not pay a dividend if, after issuing the dividend (1) the Corporation would be unable to pay its debts as they become due, or (2) the Corporation’s total assets would be less than its total liabilities plus the amount needed to satisfy any preferential rights of shareholders. In addition, as declared by the Board of Directors, Ephrata National Bank’s dividend restrictions apply indirectly to ENB Financial Corp because cash available for dividend distributions will initially come from dividends Ephrata National Bank pays to ENB Financial Corp. See Note M to the consolidated financial statements in this Form 10-K filing, for information that discusses and quantifies this regulatory restriction.
ENB Financial Corp offers its shareholders the convenience of a Dividend Reinvestment Plan (DRP) and the direct deposit of cash dividends. The DRP gives shareholders registered with the Corporation the opportunity to have their quarterly dividends invested automatically in additional shares of the Corporation’s common stock. Shareholders who prefer a cash dividend may have their quarterly dividends deposited directly into a checking or savings account at their financial institution. For additional information on either program, contact the Corporation’s stock registrar and dividend paying agent, Computershare Shareholder Services, P.O. Box 505000, Louisville, KY 40233-5000.
The following table details the Corporation’s purchase of its own common stock during the three months ended December 31, 2019.
Issuer Purchase of Equity Securites
|Total Number of||Maximum Number|
|Total Number||Average||Shares Purchased||of Shares that May|
|of Shares||Price Paid||as Part of Publicly||Yet be Purchased|
|Period||Purchased||Per Share||Announced Plans *||Under the Plan *|
* On February 20, 2019, the Board of Directors of the Corporation approved a plan to repurchase, in the open market and privately renegotiated transactions, up to 200,000 shares of its outstanding common stock. This plan replaces the 2015 plan. The first purchase of common stock under this plan occurred on May 13, 2019. By December 31, 2019, a total of 77,266 shares were repurchased at a total cost of $1,567,000, for an average cost per share of $20.28.
Recent Sales of Unregistered Securities and Equity Compensation Plan
The Corporation does not have an equity compensation plan and has not sold any unregistered securities.
Shareholder Performance Graph
Set forth below is a line graph comparing the yearly change in the cumulative total shareholder return on ENB Financial Corp’s common stock against the cumulative total return of the Russell 2000 Index, the Mid-Atlantic Custom Peer Group Index, and the SNL Small Cap Bank Index for the period of five fiscal years commencing December 31, 2014, and ending December 31, 2019. The graph shows that the cumulative investment return to shareholders, based on the assumption that a $100 investment was made on December 31, 2014, in each of the following: the Corporation’s common stock, the Russell 2000 Index, the Mid-Atlantic Custom Peer Group Index, and the SNL Small Cap Bank Index and that all dividends were reinvested in those securities over the past five years, the cumulative total return on such investment would be $152.66, $148.49, $170.64, and $176.97, respectively. The shareholder return shown on the graph below is not necessarily indicative of future performance.
|ENB Financial Corp||100.00||104.95||114.83||118.13||123.09||152.66|
|SNL Small Bank||100.00||109.52||155.27||162.85||145.94||176.97|
Peer Group consists of Mid-Atlantic commercial banks with assets between $1B - $3B as of 12/31/2019
Item 6 - Selected Financial Data
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The selected financial data set forth below should be read in conjunction with the Corporation's financial statements
and their accompanying notes presented elsewhere herein.
|Year Ended December 31,|
|INCOME STATEMENT DATA|
|Net interest income||36,618||33,124||30,178||25,287||23,098|
|Provision for loan losses||770||660||940||325||150|
|Income before income taxes||13,521||11,055||8,682||8,906||8,268|
|Provision for federal income taxes||2,126||1,306||2,338||1,353||1,358|
|PER SHARE DATA|
|Net income (basic and diluted)||2.01||1.71||1.12||1.33||1.21|
|Cash dividends paid||0.620||0.575||0.560||0.545||0.540|
|Book value at year-end||20.69||36.04||35.01||33.31||33.37|
|BALANCE SHEET DATA|
|Total long-term debt||77,872||65,386||65,850||61,257||59,594|
|Return on average assets||1.01%||0.93%||0.63%||0.80%||0.79%|
|Return on average stockholders' equity||10.36%||9.94%||6.46%||7.74%||7.38%|
|Average equity to average assets ratio||9.76%||9.36%||9.79%||10.36%||10.74%|
|Dividend payout ratio||30.85%||33.63%||50.22%||41.13%||44.63%|
|Net interest margin||3.53%||3.46%||3.46%||3.12%||3.07%|
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis represents management’s view of the financial condition and results of operations of the Corporation. This discussion and analysis should be read in conjunction with the consolidated financial statements and other financial schedules included in this annual report. The financial condition and results of operations presented are not indicative of future performance.
ENB Financial Corp and its wholly owned subsidiary, Ephrata National Bank, are committed to remaining an independent community bank serving the greater communities surrounding Lancaster County, Pennsylvania. The Corporation’s roots date back to the April 11, 1881 charter granted to Ephrata National Bank by the Office of the Comptroller of the Currency. The Bank’s growth has been entirely organic over 138 years of existence. The Board and Management are committed to the principals and values that have served the company well over this long history. In order to remain an independent bank of undisputed integrity, the Board and Management’s desire is to produce strong financial results that will ensure trust from the Bank’s depositors and favorable returns to the shareholder over the long term.
Every three years Management and the Board evaluate and revise the strategic plan to ensure the continuing success of the Corporation into the future. This endeavor is designed to continually sharpen the products and services the Bank provides in a manner that best serves the customer and attains the financial performance that shareholders expect. In the most recent strategic plan that covers the years 2019 to 2021, the Board and Management laid out a five-point plan to ensure success in the next three years and beyond. Succession planning and managing leadership changes were a key element of this strategic plan. The Board and Management also set into place bold goals to further strengthen the Corporation’s financial performance ratios so the Corporation is in a position to outperform the local peer group. The most visible of those targets is to meet and exceed a return on assets of over 1.00% and to maintain a return on stockholder’s equity of over 10.0%, with a target range of 10.5% to 11.0%. Management also desired to reduce the efficiency ratio under 70% for 2019 with a three-year goal of reducing to no greater than 68.5%. Management views return on assets as the best overall indicator of a financial institution’s performance. Management and the Board believe that achieving a higher return on assets will directly correlate to improved earnings per share and dividends per share, and higher book value of common stock, which in the end will produce higher returns to the shareholder.
Results of Operations
The Corporation recorded net income of $11,395,000 for the year ended December 31, 2019, a 16.9% increase from the $9,749,000 earned during the same period in 2018. The 2018 net income was 53.7% higher than the 2017 net income of $6,344,000. Earnings per share, basic and diluted, were $2.01 in 2019, compared to $1.71 in 2018, and $1.12 in 2017.
The increase in the Corporation’s 2019 earnings was caused primarily by an increase in net interest income of $3.5 million, or 10.5%, compared to an increase of $2.9 million, or 9.8% in 2018. Net interest income accounts for 76% of the gross income stream of the Corporation. The Corporation’s net interest margin increased in 2019 to 3.53%, from 3.46% in 2018. Loan yields increased as a result of four Federal Reserve rate increases in 2018, lifting the yields on the Corporation’s variable rate loans. Even though the Federal Reserve cut rates three times in the last half of 2019, the pickup in yield throughout the first part of the year served to increase loan yield for the year. This coupled with volume growth in the loan portfolio, increased loan interest income by $5.4 million, or 19.1%.
The Corporation’s non-interest income increased by $269,000, or 2.4%, from 2018 to 2019. Earnings on bank owned life insurance declined by $907,000, or 55.4% in 2019 compared to the prior year due to a death benefit of $913,000 recorded in 2018. Gains on securities transactions were $499,000 in 2019, compared to losses of $291,000 in 2018, an increase in income of $790,000. Gains on the sale of mortgages increased by $334,000, or 20.8% in 2019 compared to 2018 due to a high volume of mortgage originations stemming from the low interest rate environment.
The financial services industry uses two primary performance measurements to gauge performance: return on average assets (ROA) and return on average equity (ROE). ROA measures how efficiently a bank generates income
based on the amount of assets or size of a company. ROE measures the efficiency of a company in generating income based on the amount of equity or capital utilized. The latter measurement typically receives more attention from shareholders. The Corporation’s 2019 ROA was 1.01%, compared to 0.93% in 2018. ROE increased from 9.94% in 2018 to 10.36% in 2019. The increase in ROA and ROE was primarily due to higher income in 2019 compared to 2018.
The below table highlights the Corporation’s key performance ratios for the years ended December 31, 2019, 2018, and 2017.
Key Performance Ratios
|Year ended December 31,|
|Return on Average Assets||1.01%||0.93%||0.63%|
|Return on Average Equity||10.36%||9.94%||6.46%|
The results of the Corporation’s operations are best explained by addressing in further detail the five major sections of the income statement, which are as follows:
|·||Net interest income|
|·||Provision for loan losses|
The following discussion analyzes each of these five components.
Net Interest Income
Net interest income (NII) represents the largest portion of the Corporation’s operating income. In 2019, NII generated 76.4% of the Corporation’s gross revenue stream, compared to 75.0% in 2018, and 74.5% in 2017. Since NII comprises a significant portion of the operating income, the direction and rate of increase or decrease will often indicate the overall performance of the Corporation.
The following table shows a summary analysis of NII on a fully taxable equivalent (FTE) basis. For analytical purposes and throughout this discussion, yields, rates, and measurements such as NII, net interest spread, and net yield on interest earning assets, are presented on an FTE basis. This differs from the NII reflected on the Corporation’s Consolidated Statements of Income, where the NII is simply the interest earned on loans and securities less the interest paid on deposits and borrowings. By calculating the NII on an FTE basis, the added benefit of having tax-free loans and securities is factored in to more accurately represent what the Corporation earns through the NII. The FTE adjustment shows the benefit these tax free loans and securities bring in a dollar amount because the Corporation does not pay tax on the income they generate. As a result, the FTE NII shown in both tables below will exceed the NII reported on the consolidated statements of income. The amount of FTE adjustment totaled $749,000 for 2019, $879,000 for 2018, and $2,341,000 for 2017. The significant decline in FTE adjustment in 2018 and 2019 was primarily due to the corporate tax rate change implemented at the end of 2017 as well as lower levels of tax-free income.
Net Interest Income
(DOLLARS IN THOUSANDS)
|Total interest income||41,737||36,498||33,117|
|Total interest expense||5,119||3,374||2,938|
|Net interest income||36,618||33,124||30,179|
|Tax equivalent adjustment||749||880||2,341|
|Net interest income|
|(fully taxable equivalent)||37,367||34,004||32,520|
NII is the difference between interest income earned on assets and interest expense incurred on liabilities. Accordingly, two factors affect NII:
|·||The rates charged on interest earning assets and paid on interest bearing liabilities|
|·||The average balance of interest earning assets and interest bearing liabilities|
The Federal funds rate, the Prime rate, the shape of the U.S. Treasury curve, and other wholesale funding curves, all affect NII. The Federal Reserve controls the Federal funds rate, which is one of a number of tools available to the Federal Reserve to conduct monetary policy. The Federal funds rate, and guidance on when the rate might be changed, is often the focal point of discussion regarding the direction of interest rates. During 2019, the Federal funds rate was decreased three times between July and October taking the rate to 1.75% by December 31, 2019. With the recent declines in the Federal funds rate, the U.S. Treasury yield curve became flatter. A flat yield curve generally signals the end of a period of economic expansion and the beginning of a recession. Long-term rates like the ten-year U.S. Treasury were 283 basis points under the 4.75% Prime rate as of December 31, 2019. Long-term Treasury rates declined steadily throughout 2019, and with the decreases in the Federal Reserve short-term rates, the yield curve remained essentially flat throughout the year. Management had not anticipated the three Fed rate decreases in the second half of 2019. With the current flat yield curve, it does make increasing asset yield much more difficult, which adds strain to NII and NIM.
The Prime rate is generally used by commercial banks to extend variable rate loans to business and commercial customers. For many years, the Prime rate has been set at 300 basis points, or 3.00% higher, than the Federal funds rate and typically moves when the Federal funds rate changes. As such, the Prime rate decreased to 4.75% on December 31, 2019, after three rate declines in 2019. The Corporation’s Prime-based loans generally reprice a day after the Federal Reserve rate movement.
As a result of the higher rates at the beginning of 2019 before the Federal Reserve began cutting rates, the Corporation’s NII on a tax equivalent basis increased in 2019 with the Corporation’s margin increasing to 3.53% for the year, compared to 3.46% in 2018. Loan yields were higher in 2019 due to the higher rates at the beginning of the year and the full effect of the Federal Reserve rate decreases not being felt until late in the year and going forward. The Corporation’s NII for 2019 increased substantially over 2018, by $3,494,000, or 10.5%. Management’s asset liability sensitivity measurements continue to show a benefit to both margin and NII given further Federal Reserve rate increases. Actual results over the past two years have confirmed the asset sensitivity of the Corporation’s balance sheet. However, in a down-rate environment, the margin and NII would suffer unless balance sheet growth is enough to offset lower asset yields.
Deposit rates were not increased throughout 2019 and some CD promotional rates were discontinued in the third quarter after nearly a full year of two odd-term CD specials. With multiple Federal Reserve rate declines in the latter part of 2019, there is some room to control deposit rates moving forward in an effort to protect margin. Borrowing rates were higher in the beginning of 2019, so new long-term advances initiated early in the year were at higher rates than the maturing borrowings. With a lower Prime rate and lower Treasury rates, asset yields may decline throughout 2020. Due to the variable rate loans in the Corporation’s loan portfolio, any Prime rate decreases have an immediate negative impact to NII and margin. The ability to improve NII in 2020 will be dependent on any
future Federal Reserve rate moves as well as the Corporation’s ability to grow interest-earning assets at a fast enough pace to offset potentially lower yields.
Security yields will generally fluctuate more rapidly than loan yields based on changes to the U.S. Treasury rates and yield curve. With lower Treasury rates in 2019 compared to 2018, security reinvestment has been occurring at lower levels as cash flows from the securities portfolio are generally being reallocated into loan portfolio growth. Because of the lower market interest rates and very flat yield curve, it is difficult to achieve substantially higher yields in the investment portfolio.
The Corporation’s loan portfolio yield has increased over prior years’ periods as the variable rate portion of the loan portfolio repriced higher with each Federal Reserve rate movement prior to the third quarter of 2019. The vast majority of the Corporation’s commercial Prime-based loans were priced at the Prime rate, which was 5.50%, throughout the first six months of 2019 and then 5.00% as of September 30, 2019, and 4.75% as of December 31, 2019. The pricing for the most typical five-year fixed rate commercial loans is currently very similar to the Prime rate. With the July, September, and October Federal Reserve 0.25% rate reductions, adding variable rate loans to the portfolio means they will immediately reprice down when the Fed lowers rates. There are elements of the Corporation’s Prime-based commercial loans priced above the Prime rate based on the level of credit risk of the borrower. Management does price a portion of consumer variable rate loans above the Prime rate, which also helps to improve loan yield. Both commercial and consumer Prime-based pricing continues to be influenced by local competition.
Mid-term and long-term interest rates on average were lower in 2019 compared to 2018. The average rate of the 10-year U.S. Treasury was 2.14% in 2019 compared to 2.91% in 2018, and it stood at 1.92% on December 31, 2019, compared to 2.77% on December 31, 2018. The slope of the yield curve has been compressed throughout 2019 and even inverted at certain points during the year. As of December 31, 2019, the 10-year U.S. Treasury rate was 17 basis points higher than the Fed funds rate compared to 27 basis points as of December 31, 2018. The slope of the yield curve has fluctuated many times in the past two years with the 10-year U.S. Treasury yield as high as 2.79% in 2019 and 3.24% in 2018, and as low as 1.47% in 2019, and 2.44% in 2018.
While the Corporation’s overall cost of funds remains low, there were increases in 2018 and 2019 due to higher interest expense on both deposits and borrowings. Core deposit interest rates are still very low and have not been increased significantly, although time deposit rates have increased for two odd-month CD specials that were initiated in the fourth quarter of 2018 and discontinued in the fourth quarter of 2019. The Corporation increased interest rates marginally on the Corporation’s interest bearing core accounts. Typically, financial institutions will make small systematic moves on core interest bearing accounts while making larger rate increases in the pricing of new or reissued time deposits. Borrowing costs, and the wholesale borrowing curves that they are based on, generally follow the direction and slope of the U.S. Treasury curve. However, these curves can be quicker to rise and slower to fall as the providers of these funds seek to protect themselves from rate movements. The Corporation refinanced the majority of borrowings at higher rates in 2018 and 2019 as lower-priced borrowings matured with no ability to refinance at lower rates, so the interest rates on borrowings increased during 2018 and 2019. With lower interest rates available at the end of 2019, management anticipates there may be room to achieve some improvements in borrowing costs as borrowings mature in 2020 and are replaced at market rates.
The following table provides an analysis of year-to-year changes in net interest income by distinguishing what changes were a result of average balance increases or decreases and what changes were a result of interest rate increases or decreases.
RATE/VOLUME ANALYSIS OF CHANGES IN NET INTEREST INCOME
(TAXABLE EQUIVALENT BASIS, DOLLARS IN THOUSANDS)
|2019 vs. 2018||2018 vs. 2017|
|Increase (Decrease)||Increase (Decrease)|
|Due To Change In||Due To Change In|
|Interest on deposits at other banks||17||(38||)||(21||)||(170||)||174||4|
|Securities available for sale:|
|Total interest income||3,576||1,533||5,109||1,789||130||1,919|
|Total interest expense||147||1,599||1,746||(67||)||502||435|
|NET INTEREST INCOME||3,429||(66||)||3,363||1,856||(372||)||1,484|
In 2019, the Corporation’s NII on an FTE basis increased by $3,363,000, a 9.9% increase over 2018. Total interest income increased $5,109,000, or 13.7%, while interest expense increased $1,746,000, or 51.7%, from 2018 to 2019. The FTE interest income from the securities portfolio decreased by $323,000, or 3.8%, while loan interest income increased $5,345,000, or 19.0%. During 2019, additional loan volume added $3,998,000 to net interest income, and higher yields primarily due to the multiple Prime rate increases throughout 2018 caused a $1,347,000 increase, resulting in a net increase of $5,345,000. Lower balances in the securities portfolio caused a decrease of $493,000 in net interest income, while slightly higher yields on securities caused a $170,000 increase, resulting in a net decrease of $323,000. Some of the reduction in municipal securities can be directly attributed to funding loan growth.
The average balance of interest bearing liabilities increased by 7.9% during 2019, driven by the growth in deposit balances. Deposit rates increased throughout 2019 and higher balances of deposits both resulted in higher interest expense. Higher interest rates contributed to $1,411,000 of interest expense increase while higher balances caused $73,000 of increased expense, resulting in total increased interest expense of $1,485,000.
Out of all the Corporation’s deposit types, interest-bearing demand deposits reprice the most rapidly, as these rates can be adjusted higher after a Federal Reserve rate increase in order for the Corporation to remain competitive. Demand deposit interest expense increased a total of $1,125,000 in 2019, with $992,000 due to higher rates and $132,000 due to higher balances. Interest expense on time deposit balances increased a total of $356,000. Higher interest rates caused an increase of $419,000, while lower balances caused a decrease of $63,000, resulting in the net increase in interest expense of $356,000.
The average balance of short-term and long-term borrowings increased by $4.2 million, or 5.8%, from December 31, 2018, to December 31, 2019. The increase in total borrowings increased interest expense by $74,000. The increase
in interest rates increased interest expense by $187,000, as long-term borrowings at lower rates matured and were replaced with new advances at higher rates. The aggregate of these amounts was an increase in interest expense of $261,000 related to total borrowings.
The following table shows a more detailed analysis of net interest income on an FTE basis shown with all the major elements of the Corporation’s balance sheet, which consists of interest earning and non-interest earning assets and interest bearing and non-interest bearing liabilities. Additionally, the analysis provides the net interest spread and the net yield on interest earning assets. The net interest spread is the difference between the yield on interest earning assets and the interest rate paid on interest bearing liabilities. The net interest spread has the deficiency of not giving credit for the non-interest bearing funds and capital used to fund a portion of the total interest earning assets. For this reason, management emphasizes the net yield on interest earning assets, also referred to as the net interest margin (NIM). The NIM is calculated by dividing net interest income on an FTE basis into total average interest earning assets. The NIM is generally the benchmark used by analysts to measure how efficiently a bank generates NII.
COMPARATIVE AVERAGE BALANCE SHEETS AND NET INTEREST INCOME
(TAXABLE EQUIVALENT BASIS, DOLLARS IN THOUSANDS)
|Interest earning assets:|
|Federal funds sold and|
|deposits at other banks||19,596||371||1.89||18,772||392||2.09||29,277||388||1.33|
|Securities available for sale:|
|Total securities (d)||304,699||8,096||2.66||319,420||8,419||2.64||323,317||10,293||3.18|
|Total interest earning assets||1,057,483||42,486||4.02||982,962||37,377||3.80||939,490||35,458||3.78|
|Non-interest earning assets (d)||69,599||64,607||63,682|
|Interest bearing liabilities:|
|Total interest bearing liabilities||673,279||5,119||0.76||623,836||3,373||0.54||614,382||2,938||0.48|
|Non-interest bearing liabilities:|
|Total liabilities & stockholders' equity||1,127,082||1,047,569||1,003,172|
|Net interest income (FTE)||37,367||34,004||32,520|
|Net interest spread (b)||3.26||3.26||3.30|
|Effect of non-interest|
|Net yield on interest earning assets (c)||3.53||3.46||3.46|
|(a)||Includes balances of non-accrual loans and the recognition of any related interest income. Average balances also include net deferred loan costs of $1,753,000 in 2019, $1,429,000 in 2018, and $1,098,000 in 2017. Such fees recognized through income and included in the interest amounts totaled ($523,000) in 2019, ($534,000) in 2018, and ($445,000) in 2017.|
|(b)||Net interest spread is the arithmetic difference between the yield on interest earning assets and the rate paid on interest bearing liabilities.|
|(c)||Net yield, also referred to as net interest margin, is computed by dividing net interest income (FTE) by total interest earning assets.|
|(d)||Securities recorded at amortized cost. Unrealized holding gains and losses are included in non-interest earning assets.|
The Corporation’s interest income increased substantially, more than compensating for the increase in interest expense, resulting in a NIM of 3.53% for 2019, an increase from the NIM of 3.46% for 2018. The yield earned on assets increased 22 basis points while the rate paid on liabilities also increased 22 basis points. The yield on total securities only increased by two basis points for the year while the loan yield increased more significantly by 20 basis points during 2019 due to the Federal Reserve increases through late 2018. The three Federal Reserve rate decreases in the second half of 2019 did not have the full impact on lowering loan yield in 2019. The full impact will be felt in 2020. Loan yields increased significantly during 2018 and throughout the first six months of 2019 with the higher Prime rate and higher yields on fixed-rate loans. However, with the recent declines in interest rates generally and the Prime rate specifically, loan yields are once again being challenged. Growth in the loan portfolio coupled with better yields prior to the third quarter of 2019 on variable rate loans caused loan interest income to increase through December 31, 2019. Loan interest income increased $5,346,000, or 19.0%, for the year ended December 31, 2019, compared to 2018.
Loan pricing was challenging in early 2018 as a result of competition resulting in fixed-rate loans being priced at very low levels and variable-rate loans priced at the Prime rate or below. Pricing improved during the last half of 2018 and into the first half of 2019 with much more significant loan growth. The Prime rate was at its recent peak of 5.50% at the beginning of 2019 and held there until July of 2019, providing a lift to loan yield. After the three Federal Reserve 0.25% rate reductions in the second half of 2019 the Prime rate ended the year at 4.75%, a rate above the typical business or commercial five-year fixed rates being extended. Commercial rates offered in the market place have declined since December 31, 2019, because U.S. Treasury rates have steadily declined. The commercial or business fixed rates do increase with longer fixed terms or lower credit quality as management looks to be compensated for this increased risk. In terms of the variable rate pricing, nearly all variable rate loans offered are Prime-based. Management is able to price loan customers with higher levels of credit risk at Prime plus pricing, such as Prime plus 0.75%, which amounted to 5.50% at December 31, 2019. However, there are relatively few of these higher rate loans in the commercial and agricultural portfolios due to the strong credit quality of the Corporation’s borrowers and market competition. Competition in the immediate market area has been pricing select shorter-term fixed-rate commercial and agricultural lending rates close to or below 4.00% for the strongest loan credits.
Earnings and yields on the Corporation’s securities increased by two basis points for the year ended December 31, 2019, compared to the same period in 2018. The Corporation’s securities portfolio consists of fixed income debt instruments as well as variable rate instruments that reprice when market rates change. The Corporation’s taxable securities experienced a ten basis-point increase in yield for 2019, compared to 2018. Most security reinvestment in 2019 had been occurring at higher rates. The yield on tax-exempt securities decreased by five basis points in 2019, compared to 2018, primarily due to a smaller and shorter tax-exempt portfolio.
The interest rate paid on deposits increased for the year ended December 31, 2019, from the same period in 2018. Management follows a disciplined pricing strategy on core deposit products that are not rate sensitive, meaning that the balances do not fluctuate significantly when interest rates change. Rates on interest-bearing checking accounts and money market accounts were increased in 2019, resulting in an increase in the cost of funds on these accounts of 39 basis points. Additionally, two time deposit specials were introduced in the fourth quarter of 2018 and lasted throughout most of 2019, resulting in the cost of funds on these instruments increasing by 30 basis points during the year. Typically, the Corporation sees increases in time deposits during periods when consumers are not confident in the stock market and economic conditions deteriorate. During these periods, there is a “flight to safety” to federally insured deposits. This trend occurred in past years, but time deposit balances declined throughout 2017, 2018, and 2019. As the rate between time deposits and core deposits narrowed, many customers chose to transfer funds from maturing time deposits into checking and savings accounts.
Since the financial crisis, depositors have been more concerned about the financial health of their financial institution. This concern affects their desire to obtain the best possible market interest rates. This trend benefits the Corporation due to its high capital levels and track record of strong and stable earnings. The Corporation’s Bauer Financial rating of 5, the highest level of their rating scale, has assisted the Bank in gaining core deposits over the past several years.
The Corporation’s average rate on borrowed funds increased by 24 basis points from 2018 to 2019, as refinancing of several long-term borrowings maturing in 2019 was completed at higher market interest rates. Throughout 2019, the new fixed borrowing rates were higher than the average rate paid on the Corporation’s existing borrowings.
Provision for Loan Losses
The allowance for loan losses provides for losses inherent in the loan portfolio as determined by a quarterly analysis and calculation of various factors related to the loan portfolio. The amount of the provision reflects the adjustment that management determines is necessary to ensure that the allowance for loan losses is adequate to cover any losses inherent in the loan portfolio. The Corporation gives special attention to the level of underperforming loans when calculating the necessary provision for loan losses. The analysis of the loan loss allowance takes into consideration, among other things, the following factors:
|·||levels and trends in delinquencies, non-accruals, and charge-offs,|
|·||levels of classified loans,|
|·||trends within the loan portfolio,|
|·||changes in lending policies and procedures,|
|·||experience of lending personnel and management oversight,|
|·||national and local economic trends,|
|·||concentrations of credit,|
|·||external factors such as legal and regulatory requirements,|
|·||changes in the quality of loan review and Board oversight, and|
|·||changes in the value of underlying collateral.|
A provision expense of $770,000 was recorded in 2019, compared to $660,000 in 2018, and $940,000 in 2017. The provision expense in 2019 was primarily due to higher levels of delinquencies, classified loans, and charge-offs during the year as well as organic loan portfolio growth. As of December 31, 2019, total delinquencies represented 0.91% of total loans, compared to 0.46% as of December 31, 2018. These ratios are extremely low compared to local and national peer groups but delinquencies did increase throughout 2019. The vast majority of the Corporation’s loan customers have remained very steadfast in making their loan payments and avoiding delinquency, even during challenging economic conditions. The delinquency ratios speak to the long-term health, conservative nature, and, importantly, the character of the Corporation’s customers and lending practices. Classified loans are primarily determined by loan-to-value and debt-to-income ratios. The level of classified loans has increased from December 31, 2018 to December 31, 2019, from 13.7% of regulatory capital to 18.9% of regulatory capital. The delinquency and classified loan information is utilized in the quarterly ALLL calculation, which directly affects the provision expense. A sharp increase or decrease in delinquencies and/or classified loans during the year would be cause for management to increase or decrease the provision expense. The allowance as a percentage of loans remained stable at 1.25% at both December 31, 2019 and December 31, 2018. It is anticipated that the Corporation will record a provision expense again in 2020 based on projected loan growth and projected delinquencies and levels of classified loans.
Management also continues to provide for estimated losses on pools of similar loans based on historical loss experience. Management employs qualitative factors every quarter in addition to historical loss experience to take into consideration the current trends in loan volume, concentrations of credit, delinquencies, changes in lending practices, and the quality of the Corporation’s underwriting, credit analysis, lending staff, and Board oversight. National and local economic trends and conditions are also considered when calculating an appropriate loan loss allowance for each loan pool. Qualitative factors only increased for the business loans and residential real estate pools in 2019 as a result of higher levels of historical delinquencies and charge-offs. Factors for six of the remaining loan pools were decreased during 2019 and one factor remained the same.
Management continues to evaluate the allowance for loan losses in relation to the growth or decline of the loan portfolio and its associated credit risk, and believes the provision and the allowance for loan losses are adequate to provide for future loan losses. For further discussion of the calculation, see the “Allowance for Loan Losses” section.
Other income for 2019 was $11,306,000, an increase of $269,000, or 2.4%, compared to the $11,037,000 earned in 2018. The following table details the categories that comprise other income.
(DOLLARS IN THOUSANDS)
|2019 vs. 2018||2018 vs. 2017|
|2019||2018||Increase (Decrease)||2018||2017||Increase (Decrease)|
|Trust and investment services||2,042||1,959||83||4.2||1,959||1,776||183||10.3|
|Service charges on deposit accounts||1,376||1,351||25||1.9||1,351||1,235||116||9.4|
|Net realized gains (losses) on sales|
|of securities available for sale||499||(291||)||790||(271.5||)||(291||)||675||(966||)||(143.1||)|
|Gains on sale of mortgages||1,936||1,602||334||20.8||1,602||1,715||(113||)||(6.6||)|
|Earnings on bank-owned life insurance||731||1,638||(907||)||(55.4||)||1,638||688||950||138.1|
|Other miscellaneous income||465||604||(139||)||(23.0||)||604||495||109||22.0|
|Total other income||11,306||11,037||269||2.4||11,037||10,321||716||6.9|
Trust and investment services income increased by $83,000, or 4.2%, from 2018 to 2019, after increasing 10.3% from 2017 to 2018. In 2019, trust and investment services revenue accounted for 4.3% of the Corporation’s gross revenue stream, including gains and losses on securities and mortgages, compared to 4.4% in 2018 and 4.4% in 2017. Trust and investment services revenue consists of income from traditional trust services and income from investment services provided through a third party. In 2019, the traditional trust business accounted for $1,235,000, or 60.5%, of total trust and investment services income, with the investment services totaling $807,000, or 39.5%. In 2019, traditional trust services income increased by $23,000, or 1.9%, from 2018 levels, while investment services income increased $60,000, or 8.0%. The amount of customer investment activity drives the investment services income. Market increases and a larger customer base primarily caused the increase in trust revenue in 2019. The trust and investment services area continues to be an area of strategic focus for the Corporation. Management believes there is a great need for retirement, estate, and small business planning in the Corporation’s service area. Management also sees these services as being a necessary part of a comprehensive line of financial solutions across the organization.
Service charges on deposit accounts for the year ended December 31, 2019, increased by $25,000, or 1.9%, compared to 2018. Overdraft service charges for 2019, which comprise 81.3% of the total deposit service charges, increased to $1,119,000, from $1,075,000 in 2018, a 4.1% increase. Several other categories of fees increased or decreased by lesser amounts.
Other fees decreased for the year ended December 31, 2019, by $210,000, or 13.3%, compared to the previous year. This decrease was primarily due to loan origination and administration fees, which decreased in total by $703,000, or 69.9%, due to amortizing additional fees over the life of the loan beginning in 2019. Partially offsetting this decrease, fees on an off-balance sheet cash management product were $413,000 in 2019, and are now being recorded in other service charges whereas in the prior year, the fees were included in interest income. Additionally, account analysis fees increased by $39,000, or 34.3% in 2019 compared to 2018, due to pricing changes as well as the addition of clients to the cash management program throughout the year. Various other fee income categories increased or decreased to lesser degrees making up the remainder of the variance compared to the prior year.
Commissions increased by $293,000, or 11.3%, for the year ended December 31, 2019, compared to the previous year. This was primarily caused by debit card interchange income, which increased by $303,000, or 13.4%. The interchange income is a direct result of the volume of debit card transactions processed and this income increases as customer accounts increase or as customers utilize their debit cards to a higher degree.
Gains/losses on security transactions were higher for the year ended December 31, 2019, with a total of $499,000 of gains recorded compared to $291,000 of losses recorded for 2018, a $790,000 increase in income. Gains or losses taken on securities fluctuate based on market conditions including:
|·||large swings in market pricing, utilizing volatility and market timing to the Corporation’s advantage,|
|·||appreciation or deterioration of securities values due to changes in interest rates, credit risk, financial performance, or market dynamics such as spread and liquidity,|
|·||sale of securities at gains or losses to fund loan growth,|
|·||opportunities to reposition the securities portfolio to improve long-term performance, or|
|·||management’s asset liability goals to improve liquidity or reduce interest rate or fair value risk.|
The gains or losses recorded depend entirely on management’s active trades based on the above. Losses can be in the form of active sales of securities, or impairment of securities, which involve writing the security down to a lower value based on anticipated credit losses. There were no impairment charges in 2017, 2018, or 2019, therefore all security gains and losses incurred during these years were active sales designed to either take gains or losses, or reposition the portfolio.
The number of securities sold in 2019 was higher because of the very low interest rate environment that presented many opportunities to sell securities at gains. Loan growth was strong in 2019 providing opportunities to both sell securities at gains and use the proceeds to fund new loans. During 2018, the rate environment was not as conducive to taking gains and Management made the decision to sell off some securities at losses to fund loan growth and to reposition the portfolio for better rates-up performance. Loan growth was strong in 2018 and 2019 and this continues to be one of the core elements of Management’s plan to increase asset yield and protect margin, by converting securities into loans and improving the Corporation’s loan-to-deposit ratio.
Gains on the sale of mortgages in 2019 increased $334,000, or 20.8%, from 2018. Because of the interest rate environment in 2019, margins received on sold loans were high and volume was high resulting in a higher level of gains compared to 2018. Management has budgeted for a small decrease in the gains on the sale of mortgages in 2020, as it was anticipated that the refinance market would slow after several strong years and margins would return to more normal levels. However, in early 2020 U.S. Treasury rates were down materially, which continues to drive higher mortgage volume. The level of gains from the sale of mortgages tends to be aided by a steady decline in interest rates, which has been the case. Should the direction of interest rates reverse in 2020 and start to steadily climb, it is likely the level of gains on the sale of mortgages would also decline. It remains to be seen whether this stronger initial mortgage volume and gains in early 2020 will continue throughout the remainder of 2020. Future mortgage volume will be driven largely by interest rates and the strength of the local economy.
Earnings on bank-owned life insurance (BOLI) decreased by $907,000, or 55.4%, for the year ended December 31, 2019, compared to the prior year. Increases and decreases in BOLI income depend on insurance cost components on the Corporation’s BOLI policies, the actual annual return of the policies, and any benefits paid upon death that exceed the policy’s cash surrender value. The large year-to-date decrease in BOLI income was caused by $913,000 of insurance proceeds received in the first quarter of 2018 due to the death of a participant with no similar proceeds received in 2019. Increases in cash surrender value are a function of the return of the policy net of all expenses.
The miscellaneous income category decreased by $139,000, or 23.0%, for the year ended December 31, 2019, compared to the same period in 2018. The primary reason for the decrease in miscellaneous income was a decrease in net mortgage servicing income of $159,000, or 77.0%. Mortgage servicing right amortization was elevated in 2019 due to the very low interest rate environment resulting in lower valuations.
The following table provides details of the Corporation’s operating expenses for the last three years along with the percentage increase or decrease compared to the previous year.
(DOLLARS IN THOUSANDS)
|2019 vs. 2018||2018 vs. 2017|
|2019||2018||Increase (Decrease)||2018||2017||Increase (Decrease)|
|Salaries and employee benefits||21,032||20,240||792||3.9||20,240||19,340||900||4.7|
|Advertising & marketing expenses||820||773||47||6.1||773||698||75||10.7|
|Computer software & data|
|Other operating expenses||2,522||2,613||(91||)||(3.5||)||2,613||2,518||95||3.8|
|Total operating expenses||33,633||32,446||1,187||3.7||32,446||30,877||1,569||5.1|
Salaries and employee benefits are the largest category of other expenses. In general, they comprise 62% of the Corporation’s total operating expenses. For the year 2019, salaries and benefits increased $792,000, or 3.9%, compared to 2018. Salaries increased by $324,000, or 2.1% for the year, while employee benefits increased by $468,000, or 9.2%. Salary expenses are growing because of staff additions on top of normal merit increases. Employee benefits expense increased for 2019 due to a combination of higher health insurance costs, which increased by $271,000, or 11.2%, higher profit sharing and 401(k) expenses, which increased by $90,000, or 9.3%, and BOLI split dollar benefit expenses which were $28,000 in 2019 with no similar expense in the prior year.
The Corporation has a 401(k) Savings Plan under which the Corporation makes an employer matching contribution, a non-elective safe harbor contribution and a discretionary non-elective profit sharing contribution. The employer matching contribution is made on the compensation of all eligible employees, up to a maximum of 2.5% of an eligible employee’s compensation, at $0.50 for every $1.00 of employee contribution up to 5% of an eligible employee’s salary. The employer non-elective safe harbor contribution is 3% of all employee compensation for the year. Based on the performance of the Corporation, the Compensation Committee determined the discretionary non-elective profit sharing contribution would be 2% of all eligible employee compensation. For the Corporation, the expense of the 401(k) matching contribution will be smaller than the non-elective safe harbor and the discretionary non-elective profit sharing expenses as the Corporation is matching a maximum of up to 2.5% of salary, depending on employee contributions, compared to contributing up to 5.0% of eligible employee’s salaries in the safe harbor and discretionary profit sharing contributions. The 401(k) matching contribution expense of the 401(k) Savings Plan increased $18,000, or 5.3% in 2019, a function of a larger workforce and greater employee participation.
Occupancy expenses consist of the following:
|·||Depreciation of bank buildings|
|·||Real estate taxes and property insurance|
|·||Building repair and maintenance|
Occupancy expenses have decreased by $43,000, or 1.7%, for 2019 compared to 2018. Utilities costs decreased by $29,000, or 3.9% in 2019 compared to 2018, primarily a result of lower electricity costs. Additionally, building repairs and maintenance costs decreased by $15,000, or 9.9%, and snow removal costs decreased by $13,000, or 15.3%, when comparing 2019 to 2018.
Equipment expenses increased by $43,000, or 3.8%, for 2019 compared to 2018. Equipment service contract expenses increased by $62,000, or 28.9%, for the year ended December 31, 2019, compared to the same period in 2018. Other equipment-related expenses increased or decreased to lesser degrees making up the remainder of the variance.
Advertising and marketing expenses for the year increased by $47,000, or 6.1%, from 2018 levels. These expenses can be further broken down into two categories, marketing expenses and public relations. The marketing expenses
alone totaled $536,000 in 2019, which was a $35,000, or 7.0% increase, over 2018. Marketing expenses support the overall business strategies of the Corporation; therefore, the timing of these expenses is dependent upon those strategies. Public relations, the smaller category of advertising and marketing expenses, totaled $284,000 for 2019, compared to $273,000 for 2018, an increase of $11,000, or 4.0%. Fairs and expos, promotional items, and sponsorships make up this category.
Computer software and data processing expenses increased by $296,000, or 12.6%, for 2019 compared to 2018. Software-related expenses were up by $83,000, or 6.0%, for the year ended December 31, 2019, compared to the prior year, primarily because of increased software maintenance agreement expenses, which support the overall strategy of the Corporation. Software expenses are likely to continue to increase in 2020, but the actual increase will be dependent on how quickly new software platforms are identified, analyzed, approved and placed into service. Data processing fees were up $213,000, or 22.5%, for the year ended December 31, 2019, compared to the same period in 2018. These fees increase with the increase in customer transactions as well as any increases in debit card related fraud/charge-off expenses. These charge-off expenses were $48,000 higher in 2019 compared to 2018.
Bank shares tax expense was $930,000 for 2019, an increase of $29,000, or 3.2%, from 2018. Two main factors determine the amount of bank shares tax: the ending value of shareholders’ equity and the ending value of tax-exempt U.S. obligations. The shares tax calculation uses a period-end balance of shareholders’ equity and a tax rate of 0.95%. The increase in 2019 can be primarily attributed to the Corporation’s growing value of shareholders’ equity.
Professional services expense increased $114,000, or 5.8%, for 2019, compared to 2018. These services include accounting and auditing fees, legal fees, and fees for other third-party services. Outside services costs increased by $122,000, or 14.3%, for 2019 compared to 2018. In addition, shareholder-related expenses increased by $22,000, or 16.5%, for the year ended December 31, 2019, compared to the prior year. Other professional services expense categories increased or decreased to lesser degrees making up the remainder of the variance.
Other operating expenses decreased by $91,000, or 3.5%, for the year ended December 31, 2019, compared to the same period in 2018. FDIC insurance costs decreased by $173,000, or 54.9% for 2019 compared to 2018, primarily a result of credits issued by the FDIC in 2019. Fraud-related charge-off fees decreased by $153,000, or 90.0% for 2019 compared to 2018. Partially offsetting these decreases, loan-related expenses increased by $109,000, or 25.2%, for the year ended December 31, 2019, compared to the prior year primarily driven by a higher provision for off balance sheet credit losses which increased by $86,000. Additionally, charitable contributions increased by $76,000, or 49.2%, and travel-related costs increased by $45,000, or 24.9%, in 2019 compared to 2018. Other operating expense categories increased or decreased by smaller amounts making up the remainder of the variance.
Management uses the efficiency ratio as one metric to evaluate the Corporation’s level of operating expenses. The efficiency ratio measures the efficiency of the Corporation in producing one dollar of revenue. For example, an efficiency ratio of 70% means it costs seventy cents to generate one dollar of revenue. A lower ratio represents better operational efficiency. The formula for calculating the efficiency ratio is total operating expenses, excluding foreclosed property and OREO expenses, divided by net interest income on an FTE basis, prior to the provision for loan losses, plus other income, excluding gain or loss on the sale of securities. A higher level of operating expenses may be justified if the Corporation is growing interest earning assets and is increasing net interest income and other income at faster levels. This was the case in 2019 as the Corporation’s efficiency ratio was 69.8%, compared to 71.6% for 2018. Management has been successful in increasing both net interest income and fee income during this period, as well as holding operating expenses to lower growth rates, resulting in improved efficiency. In 2020, management anticipates possible compression in net interest margin, which could result in lower net interest income making improvements in efficiency more difficult to achieve. While management desires a lower efficiency ratio, the desire to capture additional market share in the near future and the interest rate environment, including the timing of the Federal Reserve’s rate actions, will play a large part in determining when the Corporation’s efficiency ratio improves further and the degree to which additional improvements can be made.
Nearly all of the Corporation’s income is taxed at a corporate rate of 21% for Federal income tax purposes. The Corporation is also subject to Pennsylvania Corporate Net Income Tax; however, very limited taxable activity is conducted at the corporate level. The Corporation’s wholly owned subsidiary, Ephrata National Bank, is not subject
to state income tax, but does pay Pennsylvania Bank Shares Tax. The Bank Shares Tax expense appears on the Corporation’s Consolidated Statements of Income under operating expenses.
Certain items of income are not subject to Federal income tax, such as tax-exempt interest income on loans and securities, and increases in the cash surrender value of life insurance; therefore, the effective income tax rate for the Corporation is lower than the stated tax rate. The effective tax rate is calculated by dividing the Corporation’s provision for income tax by the pre-tax income for the applicable period.
For the year ended December 31, 2019, the Corporation recorded a tax provision of $2,126,000, compared to $1,306,000 for 2018. This increase in tax provision was caused by a combination of higher pre-tax earnings and lower tax-free income. Taxable income increased by $2.46 million, or 22.3%, while tax-free income declined by $1.44 million, or 29.7%. The sharper decrease in tax-free income was primarily caused by additional tax-free BOLI income of $913,000 received in 2018 as a result of a life insurance policy recovery on a participant. Outside of this event, management was also reducing the amount of tax-free municipal bond securities held during 2019 as part of a larger balance sheet strategy.
The effective tax rate for the Corporation was 15.7% for 2019, compared to 11.8% for 2018. The Corporation’s effective tax rate is lower than the 21% corporate rate as a result of tax-free assets that the Corporation holds on its balance sheet and was higher than 2019 due to the significant reduction in tax-free income. The majority of the Corporation’s tax-free assets are in the form of obligations of states and political subdivisions, referred to as municipal bonds. The Corporation also has a relatively small component of tax-free municipal loans.
Cash and Cash Equivalents
Cash and cash equivalents consist of the cash on hand in the Corporation’s vaults, operational transaction accounts with the Federal Reserve Bank (FRB), and deposits in other banks. The FRB requires a specified amount of cash available either in vault cash or in an FRB account. Known as cash reserves, these funds provide for the daily clearing house activity of the Corporation and fluctuate based on the volume of each day’s transactions. Beyond these requirements, the Corporation maintains additional cash levels as part of Management’s active asset liability and liquidity strategy. Management has been carrying larger cash balances to provide an immediate hedge against interest rate risk and liquidity risk. As of December 31, 2019, the Corporation had $41.1 million in cash and cash equivalents, compared to $41.4 million as of December 31, 2018.
As a result of the actions of the Board of Governors on December 16, 2008, financial institutions have been able to receive interest on balances held at the FRB. Because of this, management began to keep larger balances at the FRB and less Federal funds. This overnight rate fluctuates as the overnight Federal Funds rate fluctuates and as of December 31, 2019, it stood at 1.55%. The Corporation expects to maintain an element of total cash at the Federal Reserve as part of a diversified cash management plan as long as liquidity levels allow for this to happen. Management also invests excess cash in two money market accounts at other financial institutions. One money market account yielded a return of 1.70% at December 31, 2019, and the other money market account yielded a return of 1.85%, both more than the return received from the FRB. This diversification alters the mix of cash and cash equivalents to more interest bearing deposits in banks and less Federal funds sold. The cash and cash equivalents represent only one element of liquidity. For further discussion on liquidity management, refer to Item 7A Quantitative and Qualitative Disclosures about Market Risk.
Sources and Uses of Funds
The following table shows an overview of the Corporation’s primary sources and uses of funds. This table utilizes average balances to explain the change in the sources and uses of funding. Management uses this analysis tool to evaluate changes in each balance sheet category. For purposes of this analysis, securities available for sale are shown based on book value and not fair market value. Additionally, short-term investments only include interest-bearing funds. Trends identified from past performance assist management with decisions concerning future growth.
Some conclusions drawn from the following table are as follows:
|·||Balance sheet growth rate was 7.6% in 2019 compared to 4.6% in 2018.|
|·||Balance sheet mix changed with average balances of loans growing at a rate of 13.7%, compared to a 4.6% decrease in securities.|
|·||Interest bearing demand deposits and savings deposits grew in 2019 compared to a decline in time deposits.|
|·||Interest bearing demand deposits experienced the most growth out of all deposit segments, up 20.4%.|
|·||Savings deposits continued to grow at a very steady and slower pace, similar to 2018 at 4.0%.|
|·||Non-interest bearing deposits, the most beneficial deposits, grew at a rate of 5.4% in 2019, compared to 12.1% growth in 2018.|
|·||Time deposits continue to decline both in amount and as a percentage of total deposits with a 4.3% decrease in 2019 compared to a 8.5% decline in 2018.|
|·||Borrowings increased by 5.8% in 2019, compared to 2.4% in 2018.|
SOURCES AND USES OF FUNDS
(DOLLARS IN THOUSANDS)
|2019 vs. 2018||2018 vs. 2017|
|2019||2018||Increase (Decrease)||2018||2017||Increase (Decrease)|
|Securities available for sale||304,699||319,420||(14,721||)||(4.6||)||319,420||323,317||(3,897||)||(1.2||)|
|Interest bearing demand||256,564||213,037||43,527||20.4||213,037||201,522||11,515||5.7|
|Non-interest bearing demand||340,130||322,733||17,397||5.4||322,733||287,928||34,805||12.1|
The Corporation classifies all of its debt securities as available for sale and reports the portfolio at fair market value. As of December 31, 2019, the Corporation had $314.8 million of investment securities, which accounted for 26.9% of assets, compared to 27.3% as of December 31, 2018. The securities portfolio increased in size but decreased as a percentage of the balance sheet in 2019 due to increased loan growth resulting in sales of securities to fund higher loan balances. While the ending balance of securities increased 4.9% from December 31, 2018 to December 31, 2019, the average balance of securities decreased 4.6% for the year compared to 2018.
Each quarter management sets portfolio allocation guidelines and adjusts security portfolio strategy generally based upon the following factors:
|·||Performance of the various instruments including spreads over U.S. Treasury rates|
|·||Slope of the U.S. Treasury yield curve|
|·||Level of and projected direction of interest rates|
|·||ALCO positions as to liquidity, interest rate risk, and net portfolio value|
|·||Changes in credit risk of the various instruments|
|·||State of the economy and projected economic trends|
The securities policy of the Corporation imposes guidelines to ensure diversification within the portfolio. The diversity specifications are designed to control the level of risk presented by each security type. The amount of diversity permitted through the policy allows management to pursue security types with better total return profiles or securities with higher yields. However, those securities that can provide higher levels of return will often bring higher elements of duration or credit risk. Management’s goal is to optimize portfolio total return performance over the long term while staying within portfolio policy guidelines. The composition of the securities portfolio at year end based on fair market value is shown in the following table.
(DOLLARS IN THOUSANDS)
|U.S. government agencies||32,624||10.5||30,120||10.0||34,352||10.8|
|U.S. agency mortgage-backed securities||48,626||15.4||44,639||14.9||52,073||16.3|
|U.S. agency collateralized mortgage obligations||60,253||19.1||54,090||18.0||54,641||17.1|
|Obligations of states and political subdivisions||88,452||28.1||94,625||31.6||112,243||35.1|
|Total debt securities, available for sale||308,097||97.9||294,065||98.0||314,078||98.3|
|Marketable equity securities (a)||6,708||2.1||5,934||2.0||5,583||1.7|
The Corporation typically invests excess liquidity into securities, both fixed-rate and variable-rate bonds which account for 97.9% of all securities, with equity securities accounting for the other 2.1%. The securities portfolio provides interest and dividend income to supplement the interest income on loans. Additionally, the securities portfolio assists in the management of both liquidity risk and interest rate risk. Refer to Item 7A Quantitative and Qualitative Disclosures about Market Risk for further discussion of risk strategies. To provide maximum flexibility for management of liquidity and interest rate risks, the securities portfolio is classified as available for sale and reported at fair value. Management adjusts the value of the portfolio on a monthly basis to fair market value as determined in accordance with U.S. generally accepted accounting principles. Management has the ability and intent to hold all debt securities until maturity, and does not generally record impairment on the bonds that are currently valued below book value.
The Corporation’s marketable equity securities include an investment in qualified Community Reinvestment Act (CRA) mutual funds and a small portfolio of bank stocks held at the holding company level. A total of $6,071,000 has been invested into one qualified CRA fund that carried an AAA credit rating as of December 31, 2019. The fund is a Small Business Administration (SBA) CRA fund with a $6,071,000 book value and market value as it has a stable dollar price. The current guideline used by management for the minimum amount to be invested in CRA-approved investments is approximately 0.5% of assets. The current $6,071,000 of CRA investments is equivalent to 0.5% of assets. The small portfolio of bank stocks included in marketable equity securities had a book value of $614,000 and a fair market value of $637,000 as of December 31, 2019.
Overall, the tax equivalent yield on all of the Corporation’s securities increased only slightly from 2.64% for 2018, to 2.66% for 2019. On the taxable segment of the portfolio, Treasury rates were lower in 2019 compared to 2018, so the majority of securities that matured or were sold had slightly lower or similar yields compared to the securities purchased to replace them. The Corporation’s securities portfolio underwent a number of changes during 2019 including an increase in investments in asset-backed securities and a decrease in obligations of states and political subdivisions. The fair market value of the Corporation’s securities portfolio increased by $14.8 million, or 4.9%, from December 31, 2018 to December 31, 2019, but the portfolio accounted for a smaller amount of the Corporation’s assets at 26.9% as of December 31, 2019, compared to 27.3% as of December 31, 2018.
Management invested in asset-backed securities in 2018 in the form of student loan floaters in an effort to provide an instrument that will perform well in a rates-up environment and offset the interest rate risk of the longer fixed-rate municipal bonds. The investment in this segment grew throughout 2019 and continues to be a good defensive structure to balance rates-up risk.
Management views the U.S. government agency sector as foundational to the building of the securities portfolio. U.S. agencies have very low risk and high liquidity, and depending on structure, are fairly predictable in terms of their performance. Non-callable agencies have a set maturity date with no principal payments until maturity. Callable agencies offer a higher yield but carry option risk, the risk that the agency could call the issue after it reaches the call date. This typically occurs if interest rates decline. The non-callable structures have lower yield but a better total return profile when considering all rate scenarios, however given a slow progression of higher rates the callable structure would outperform given the higher yield. As a result, management uses a blend of non-callable and callable instruments
to enhance yield performance but ensure a predictable cash flow ladder is built out into the future. Management prefers to use corporate bonds to supplement U.S. agencies in building a ladder of steady maturities in the one-year to five-year time frame. Corporate bonds provide better return than U.S. agencies, especially in this shorter time frame, since they provide better yields and are generally not callable. While corporate bonds do carry substantially more credit risk than U.S. agencies, the credit risk of corporate bonds is greatly mitigated by maintaining shorter maturities and investing in A-rated Fortune 500 companies.
Investments in MBS and CMOs assist management in adding to and maintaining a stable five-year ladder of cash flows, which is important in providing stable liquidity and interest rate risk positions. Unlike U.S. agency bonds, corporate bonds, and obligations of states and political subdivisions, which only pay principal at final maturity, the U.S. agency MBS and CMO securities pay monthly principal and interest. The combined effect of all of these instruments paying monthly principal and interest provides the Corporation with a significant and reasonably stable cash flow. Cash flows coming off of MBS and CMOs do slow down and speed up as interest rates increase or decrease. During the majority of 2019, cash flows from these securities were higher than the prior year as a result of lower Treasury rates. Management desires and pursues those MBS and CMO securities that do not experience significant changes in prepayment speeds given changes in interest rates. Since nearly all of these securities are purchased at a premium, management is most concerned with how quickly that premium will be amortized based on the average life of the security. Therefore, management attempts to guard against those securities with fast or volatile prepayment speeds in favor of those that demonstrate more consistent principal payments.
Obligations of states and political subdivisions, often referred to as municipal bonds, are tax-free securities that generally provide the highest yield in the securities portfolio on a tax-equivalent basis. In the continued prolonged period of historically low interest rates and with a lower Corporate tax rate, the municipal bond sector has lost some of its benefit compared to other segments of the portfolio. Municipal tax-equivalent yields generally start above other taxable bonds; however, they generally carry the longest duration and highest interest rate risk exposure out of all the Corporation’s securities. Due to the lower tax rate in 2018 and 2019, municipal bonds do not provide yields as high as previous years, but they still are an important component of the Corporation’s portfolio. The municipal bond portfolio had an unrealized gain position of $2,236,000 as of December 31, 2019, compared to an unrealized loss position of $1,532,000 as of December 31, 2018.
The vast majority of the municipal bonds held by the Corporation on December 31, 2019 carried between an A and an AA credit rating, with 8.2% carrying the highest AAA rating. These are stronger ratings on average than the ratings on the corporate bonds held by the Corporation. These ratings reflect the final rating or the rating with any insurance backing or credit enhancements. The Corporation’s securities policy requires that municipal bonds not carrying insurance have a minimum S&P credit rating of A- or a minimum Moody’s credit rating of A3 at the time of purchase. It is possible that municipalities have an underlying rating of S&P BBB+ or Moody’s Baa1 rating prior to insurance or credit enhancement while having a final rating of S&P A- or Moody’s A3 with the insurance and/or credit enhancement. In the current environment, the major rating services have tightened their credit underwriting procedures and are more apt to downgrade municipalities. Additionally, the weaker economy has reduced revenue streams for many municipalities and has called into question the basic premise that municipalities have unlimited power to tax, i.e. the ability to raise taxes to compensate for revenue shortfalls. Therefore, management closely monitors any municipal bonds that have their credit ratings downgraded below initial purchase guidelines. The Corporation has not experienced any losses due to defaults or bankruptcies of states or political subdivisions. As of December 31, 2019, all of the municipal bonds carried credit ratings within the Corporation’s initial purchase policy requirements.
As of December 31, 2019, the Corporation held corporate bonds with a total book value of $54.6 million and fair market value of $54.9 million. Corporate bonds, consisting of bonds issued by public companies as unsecured credit, carry a 100% risk weighting for capital purposes and therefore are viewed as a higher risk security. Because of the higher risk posed by corporate bonds, the Corporation has a policy that limits corporates to 20% of the portfolio book value. As of December 31, 2019, this $54.6 million book value of corporate debt amounted to 17.5% of the portfolio book value, compared to $61.1 million book value, or 19.9% of portfolio book value as of December 31, 2018.
Like any security, corporate bonds have both positive and negative qualities and management must evaluate these securities on a risk versus reward basis. Corporate bonds add diversity to the portfolio and provide strong relative yields for short maturities; however, by their very nature, corporate bonds carry a high level of credit risk should the entity experience financial difficulties. Management stands to possibly lose the entire principal amount if the entity that issued the corporate paper fails. As a result of the higher level of credit risk taken on by purchasing a corporate bond, management has in place certain minimal credit ratings that must be met in order for management to purchase a
corporate bond. The financial performance of any corporate bond being considered for purchase is analyzed both prior to and after purchase. Management conducts periodic monitoring throughout the year including an internal financial analysis. An independent credit review is conducted at least annually in addition to management’s periodic monitoring. Additionally, the Corporation’s securities policy calls for corporate bonds purchased to not have maturities greater than six years with the preferred maturity range of two to five years. Credit risk grows exponentially with length. The shorter the maturity the more assurance the company’s financial position will remain sufficiently strong to ensure full payment of the bond at maturity. The longer the time horizon the more difficult it is to project the financial health of the company.
Management closely monitors the unrealized gain or loss positions of all the corporate bonds to identify any potential weakness. The trading levels of these securities are closely linked to the financial performance and health of the entity. Significant declines in the valuations of these securities, beyond what can be attributed to movement in interest rates, are generally an indication of higher credit risk. Management reviews all securities with unrealized losses approaching 10% or those carrying unrealized losses for prolonged periods of time, for possible impairment. As of December 31, 2019, the highest percentage of unrealized losses for any corporate bond was 0.9%. Most Corporate bonds had unrealized gains as of December 31, 2019. All but two of the corporate bonds had at least an A credit rating by one of the major credit rating services, with all corporate bonds considered investment grade. Currently, there are no indications that any of these bonds would discontinue contractual payments.
The entire securities portfolio is reviewed monthly for credit risk and evaluated quarterly for possible impairment. Corporate bonds have the most potential credit risk out of the Corporation’s debt instruments. Due to the rapidly changing credit environment and improving but sluggish economic conditions, management is closely monitoring all corporate bonds. For further information on impairment see Note B. For further details regarding credit risk see Note P.
The following table shows the weighted-average life and yield on the Corporation’s securities by maturity intervals as of December 31, 2019, based on amortized cost. All of the Corporation’s securities are classified as available for sale and are reported at fair value; however, for purposes of this schedule they are shown at amortized cost.
SECURITIES PORTFOLIO MATURITY ANALYSIS
(DOLLARS IN THOUSANDS)
|Within||1 - 5||5 - 10||Over 10|
|U.S. government agencies||4,161||2.42||26,245||1.85||2,215||2.45||—||—||32,621||1.97|
|U.S. agency mortgage-backed securities||9,323||2.09||23,074||2.16||11,828||2.36||4,634||2.54||48,859||2.23|
|U.S. agency collateralized mortgage obligations||9,330||2.16||37,261||2.18||10,424||2.47||3,109||2.27||60,124||2.23|
|Obligations of states and political subdivisions||—||—||1,369||2.65||3,628||2.63||81,219||2.97||86,216||2.95|
|Marketable equity securities||—||—||—||—||—||—||6,685||2.93||6,685||2.93|
|Total securities available for sale||25,341||2.18||140,027||2.24||31,996||2.46||115,392||2.83||312,756||2.48|
Securities are assigned to categories based on stated contractual maturity except for MBS and CMOs, which are based on anticipated payment periods.
The yield on the securities portfolio, including equity securities, was 2.48% as of December 31, 2019, compared to 2.64% as of December 31, 2018. The reduction in yield was primarily due to the decline in market interest rates throughout 2019. Management also reduced municipal bonds throughout 2019 which carry the highest yield in the portfolio. This reduction in balance caused a reduction in overall security yield. As of December 31, 2019, the effective duration of the Corporation’s fixed income security portfolio was 2.2 years for the base case or rates unchanged scenario, compared to 3.0 years as of December 31, 2018. Effective duration is the estimated duration or length of a security or portfolio, which is implied by the price volatility. Effective duration is calculated by converting price volatility to a standard measurement representing length, expressed in years. It is a measurement of price sensitivity,
with lower durations being advantageous in periods of rising rates and longer durations benefiting the holder in periods of declining rates. An effective duration of 3.0 years would approximate the duration of a three-year U.S. Treasury, a security that has no option risk or call provisions. Management receives effective duration and price volatility information quarterly on an individual security basis. Management’s target base case, or rates unchanged effective duration, is 3.0 years. The Corporation manages duration, along with interest rate sensitivity and fair value risk, across the entire balance sheet. Currently, assets are repricing quicker than liabilities, meaning the Corporation is asset sensitive and benefits by higher interest rates. Regardless of the Corporation’s asset sensitive balance sheet position, management still desires for the securities portfolio’s effective duration to increase toward the 3.0 target throughout 2020.
Effective duration is only one measurement of the length of the securities portfolio. Management receives and monitors a number of other measurements. In general, a shorter portfolio will adjust more quickly in a rising interest rate environment, whereas a longer portfolio will tend to generate more return over the long-term and will outperform a shorter portfolio when interest rates decline. Because the Corporation’s securities portfolio is now shorter than it has been historically and shorter than the average peer bank, it will generally outperform the average peer bank given static rates or an increase in interest rates, and will generally underperform given lower interest rates. Additionally, with fixed rate instruments, the longer the term of the security, generally the more fair value risk there is when interest rates rise. The converse is true when interest rates decline. The securities portfolio is a significant piece of the Corporation’s assets, but there are other crucial elements that management also uses to manage the Corporation’s asset liability position such as cash and cash equivalents and borrowings. Beyond these, management also utilizes other elements of the Corporation’s balance sheet to reduce exposure to higher interest rates. Prime-based loans account for approximately 20% of the Corporation’s total loans which results in this segment of the portfolio having very minimal exposure to interest rate risk because these loans reprice to the new Prime rate whenever there is a Federal Reserve rate movement. The unusually extended period of historically low rates also caused the Corporation’s deposits to undergo major changes in consistency with non-interest bearing accounts and savings accounts responsible for a larger percentage of deposits while time deposits have declined markedly. This has benefited the Corporation’s asset liability position with more core deposits which model with longer lives causing liabilities to extend. The combination of Prime-based loans and longer core deposits has allowed management to historically take on more duration in the securities portfolio. See Item 7A Quantitative and Qualitative Disclosures about Market Risk for further discussion on the Corporation’s management of asset liability risks including interest rate risk and fair value risk.
The majority of the Corporation’s securities are held at the bank level with only a very small portfolio of bank stocks held at the holding company level. With only $614,000 of book value as of December 31, 2019, the non-maturity nature of the Corporation’s bank stock portfolio is not material to the duration of the Corporation’s securities portfolio or assets. The decision to purchase these equity securities at the holding company level took into account tax strategies, market conditions, and other strategic decisions.
Net loans outstanding increased $58.8 million, or 8.6%, from $685.4 million at December 31, 2018, to $744.2 million at December 31, 2019. The following table shows the composition of the loan portfolio as of December 31 for each of the past five years.
LOANS BY MAJOR CATEGORY
(DOLLARS IN THOUSANDS)
|Commercial real estate|
|Total commercial real estate||311,788||41.5||285,437||41.2||260,792||43.7||275,067||48.3||260,900||50.2|
|Consumer real estate (a)|
|1-4 family residential mortgages||258,676||34.4||219,037||31.6||176,971||29.7||150,253||26.3||133,538||25.7|
|Home equity loans||9,770||1.3||10,271||1.5||11,181||1.9||10,391||1.8||10,288||2.0|
|Home equity lines of credit||70,809||9.4||64,413||9.3||61,104||10.2||53,127||9.3||37,374||7.2|
|Total consumer real estate||339,255||45.1||293,721||42.4||249,256||41.8||213,771||37.4||181,200||34.9|
|Commercial and industrial|
|Commercial and industrial||58,019||7.7||61,043||8.8||41,426||6.9||42,471||7.4||36,189||7.0|
|Total commercial and industrial||95,211||12.7||104,122||15.1||80,942||13.6||77,192||13.5||73,577||14.2|
|Deferred loan costs, net||(1,948||)||(1,596||)||(1,243||)||(1,000||)||(714||)|
|Allowance for loan losses||9,447||8,666||8,240||7,562||7,078|
|Total net loans||744,171||685,407||589,313||564,005||513,205|
|(a)||Residential real estate loans do not include mortgage loans serviced for others. These loans totaled $154,577,000 as of December 31, 2019, $126,916,000 as of December 31, 2018, $98,262,000 as of December 31, 2017, $66,767,000 as of December 31, 2016, and $38,024,000 as of December 31, 2015.|
The composition of the loan portfolio has remained relatively stable in recent years, with the one major trend being the growth in 1-4 family residential lending. The total of all categories of real estate loans comprised 86.6% of total loans as of December 31, 2019, compared to 83.6% of total loans as of December 31, 2018. Consumer real estate has been the largest category of the loan portfolio for the past two years, with commercial real estate being the second largest category.
Commercial real estate consists of 41.5% of total loans as of December 31, 2019, compared to 41.2% of total loans as of December 31, 2018. Within the commercial real estate segment there has been an increase in agricultural mortgages and commercial mortgages over the past year, with construction based mortgages then declining slightly in 2019. Agricultural purpose loans have averaged approximately 26% of the Corporation’s total loans over the past five-year period, and had experienced a period of slow growth in 2016 followed by declines in 2017, and then growth again in 2018 and 2019. In 2016 the growth rate slowed as economic conditions, namely weaker commodity prices, became more difficult and changes occurred in the Corporation’s agricultural lending team. The reduction in agricultural mortgages in 2017 was caused by a general slowing of the growth rate in the local agricultural industry, a more challenging year for dairy farmers, which account for approximately half the Corporation’s agricultural loans, and a reduction in the pipeline of new agricultural loans caused by the prior changes in the agricultural lending staff. The Corporation has a history of an agricultural focus, which coincides with the market area and type of customers that we serve. In 2018 and 2019, agricultural loan growth picked up due to the Corporation’s renewed commitment to and more agricultural relationships proceeding with projects. Management believes the agricultural loan portfolio will continue to grow in 2020, but is also closely tracking the impact of weaker commodity prices on the Corporation’s farmers.
Commercial real estate loans increased to $311.8 million at December 31, 2019, from $285.4 million at December 31, 2018, a 9.3% increase. The increase in commercial real estate occurred in the agriculture and commercial mortgages. Agriculture mortgages increased by $9.4 million, or 5.7%, and commercial mortgages increased by $18.8 million, or 18.5%, from December 31, 2018, to December 31, 2019. The agricultural mortgages, along with agricultural loans not secured by real estate, accounted for 26.1% of the entire loan portfolio as of December 31, 2019, compared to 26.9% as of December 31, 2018. Management expects agricultural and commercial loans to increase in 2020. Management believes as economic conditions stabilize in 2020, other elements of the local diversified economy outside of the agriculture industry will expand and cause commercial mortgages to continue to grow as well.
The other area of commercial lending is non-real estate secured commercial lending, referred to as commercial and industrial lending. Commercial and industrial loans not secured by real estate accounted for 12.7% of total loans as of December 31, 2019, compared to 15.1% as of December 31, 2018. In scope, the commercial and industrial loan sector, at 12.7% of total loans, is significantly smaller than the commercial real estate sector at 41.5% of total loans. This is consistent with management’s credit preference for obtaining real estate collateral when making commercial loans. The balance of total commercial and industrial loans decreased from $104.1 million at December 31, 2018, to $95.2 million at December 31, 2019, a 8.5% decrease. This category of loans generally includes unsecured lines of credit, truck, equipment, and receivable and inventory loans, in addition to tax-free loans to municipalities. Based on current levels of demand for these types of loans and the higher level of commercial and industrial expertise that the Corporation now has, management anticipates that these loans will experience moderate growth in 2020.
The Corporation provides credit to many small and medium-sized businesses. Much of this credit is in the form of Prime-based lines of credit to local businesses where the line may not be secured by real estate, but is based on the health of the borrower with other security interests on accounts receivable, inventory, equipment, or through personal guarantees. Commercial and industrial loans decreased to $58.0 million at December 31, 2019, a $3.0 million, or 4.9% decrease, from the $61.0 million at December 31, 2018.
As a result of the regulatory concerns regarding commercial real estate (CRE) lending that arose out of the financial crisis of 2008, there has been a renewed focus on the amount of CRE loans as a percentage of total risk-based capital. The CRE loans are viewed as having more risk due to the specific types of commercial loans that fall into this category and their heavy reliance on the value of real estate that is used as collateral. During the financial crisis and years immediately after, many financial institutions had CRE loans in excess of 400% of total risk-based capital. Regulators were warning banks of concentrations in CRE loans and the increased risk that they could potentially bring. The Corporation’s level of CRE loans has been low relative to other community banks and the CRE profile has not materially changed over the past several years. The Corporation remains well below the CRE guidelines of 100% of total risk-based capital for construction and development loans, and 300% of risk-based capital for total CRE loans. There are nine categories of CRE loans by definition; however the Corporation only has seven of those types.
The following chart details the Corporation’s CRE loans as of December 31, 2019 and December 31, 2018.
|CRE SUMMARY BY CATEGORY|
|(DOLLARS IN THOUSANDS)||December 31,|
|Loan Amount||Capital||Loan Amount||Capital|
|Land Development Loans||2,074||1.7||3,280||2.8|
|1-4 Family Residential Construction Loans||1,731||1.4||1,046||0.9|
|Commercial Construction Loans||19,550||15.6||11,560||9.8|
|Other Land Loans||—||—||61||0.1|
|Nonfarm, Nonresidential Property||22,021||17.6||17,696||15.1|
|Unsecured Loans to Developers||853||0.7||884||0.7|
|Corporation's Risk-Based Capital||124,970||117,479|
The Corporation’s level of CRE loans is low relative to other financial institutions in its peer group and as a percentage of risk-based capital, with 43.7% as of December 31, 2019. Management does not believe the Corporation’s CRE profile will change significantly during 2020. Management is closely monitoring all CRE loan types to be able to determine any negative trends that may occur. Management does internally monitor the delinquencies and risk ratings of these loans on a monthly basis and has established internal policy guidelines to restrict the amount of each of the above seven types of CRE loans as a percentage of capital. As of December 31, 2019, the Corporation was well under internal guidelines for all of the above CRE loan types.
The consumer residential real estate category represents the largest group of loans for the Corporation. The consumer residential real estate category of total loans increased from $293.7 million on December 31, 2018, to $339.3 million on December 31, 2019, a 15.5% increase. This category includes closed-end fixed rate or adjustable rate residential real estate loans secured by 1-4 family residential properties, including first and junior liens, and floating rate home equity loans. The 1-4 family residential mortgages account for the vast majority of residential real estate loans with fixed and floating home equity loans making up the remainder. Historically, the entire consumer residential real estate component of the loan portfolio has averaged close to 40% of total loans. In 2018, this percentage was 42.4%, and in 2019 it increased to 45.1%. Management expects the consumer residential real estate category to increase at a similar pace in 2020 due to a continued effort to increase mortgage volume.
The first lien 1-4 family mortgages increased by $39.6 million, or 18.1%, from December 31, 2018, to December 31, 2019. These first lien 1-4 family loans made up 76% of the residential real estate total as of December 31, 2019, and 75% as of December 31, 2018. The vast majority of the first lien 1-4 family closed end loans consist of single family personal first lien residential mortgages and home equity loans, with the remainder consisting of 1-4 family residential non-owner-occupied mortgages. During 2019, mortgage production increased 8.9% over the prior year. The Corporation experienced increases in both portfolio and secondary market production. The percentage of mortgage originations going in the Corporation’s held for investment mortgage portfolio remained the same at 61% year over year. Market conditions were favorable throughout the year, in combination with an increase in held for sale mortgage production. Gains on the sale of mortgages increased by 21% in 2019 compared to 2018. The low interest rate environment did lead to an incremental increase in refinance activity; 51% of volume in 2019 was purchase, 22% was residential construction lending, and 27% was refinance activity. The volume of mortgage production in 2019 led to a 19% increase in growth of the overall residential loan portfolio, with a continuing shift from fixed rate loans to interim adjustable rate mortgages (ARMs), climbing from 44% of the residential loan portfolio at the end of 2018, to 49% at the end of 2019. This shift in production has decreased the bank’s interest rate risk profile and this trend is expected to continue in 2020.
As of December 31, 2019, the remainder of the residential real estate loans consisted of $9.8 million of fixed rate junior lien home equity loans, and $70.8 million of variable rate home equity lines of credit (HELOCs). This compares to $10.3 million of fixed rate junior lien home equity loans, and $64.4 million of HELOCs as of December 31, 2018. Therefore, combined, these two types of home equity loans increased from $74.7 million to $80.6 million, an increase of 7.9%. After remaining at 3.25% for seven (7) years, the Prime rate was increased by 25 basis points to 3.50% in December of 2015 and another 25 basis points to 3.75% in December of 2016 before increasing three more times in 2017 and 4 times in 2018 ending the year at a rate of 5.50%. During 2019, the Prime rate decreased three times, ending the year at 4.75%. The majority of borrowers chose variable-rate HELOC products throughout 2018 and 2019 instead of fixed-rate home equity loans. Management believes consumers may continue to choose variable-rate products in 2020 if the interest rate environment remains low. Only if the Prime rate would begin to increase, would consumers be more likely to choose to fix their loan for a specified term as opposed to allowing the interest rate to remain variable.
Consumer loans not secured by real estate represent a very small portion of the Corporation’s loan portfolio, accounting for 0.7% of total loans as of December 31, 2019, and 1.3% of loans at December 31, 2018. In recent years, homeowners have turned to equity in their homes to finance cars and education rather than traditional consumer loans for those expenditures. Due to the credit crisis that occurred in 2008 and 2009, specialized lenders began pulling back on the availability of credit and more favorable credit terms. The underwriting standards of major financing and credit card companies began to strengthen in the past few years after years of lower credit standards. This led consumers to seek unsecured credit away from national finance companies and back to their bank of choice. Management has seen the need for additional unsecured credit increase; however, this increased need for credit has only resulted in low levels of additional consumer loans for the Corporation. Slightly higher demand for unsecured credit is being offset by principal payments on existing loans.
Management anticipates that the Corporation’s level of consumer loans will likely be relatively unchanged in the near future, as the need for additional unsecured credit in an environment of slow economic growth is generally being offset by those borrowers wishing to reduce debt levels and move away from the higher cost of unsecured financing relative to other forms of real estate secured financing.
Management anticipates that the loan portfolio composition will remain largely the same in 2020 outside of the recent trend of consumer real estate loans slowly increasing as a percentage of the loan portfolio while the commercial real estate loan segment slightly declines. These two segments consistently are the largest two segments of the portfolio with each accounting for over 40% of the portfolio over the last three years. The consumer real estate segment grew faster than the commercial real estate segment in 2019 and is expected to do the same in 2020. The economic conditions that prevailed in 2019, were more favorable to originating consumer real estate loans than commercial real estate loans. In 2019 management expanded the Corporation’s geographic outreach in terms of marketing 1 to 4 family residential mortgages, which allowed these loans to grow despite an overall slowing of economic activity. Additionally, the three Federal Reserve rate decreases in the second half of 2019 elevated the amount of mortgage activity. Economic conditions appeared to be weakening in late 2019, which began to impact the growth rate of commercial real estate loans. This impact is expected to continue into 2019, with further slowing of commercial loan growth. Outside of these two large loan segments, the Corporation’s commercial and industrial segment declined moderately in 2019 and would be expected to hold as a lower percentage of the total loan portfolio in 2020. The Corporation’s small unsecured consumer loan portfolio is expected to remain under 1% of the total loan portfolio in 2020. Management is still aggressively pursuing loan growth with a focus on residential and commercial real estate, and agriculture lending. Management is well positioned for 2020 with a very strong brand image and history of expertise in these areas along with having reached a higher complement of lending staff in 2019, however the growth obtained will be highly dependent on economic conditions and competitive forces.
The following tables show the maturities for the loan portfolio as of December 31, 2019, by time frame for the major categories, and also the loans, which are floating or fixed, maturing after one year.
(DOLLARS IN THOUSANDS)
|Due in One||Through||Due After|
|Year or Less||Five Years||Five Years||Total|
|Commercial real estate|
|Total commercial real estate||19,197||13,367||279,224||311,788|
|Consumer real estate|
|1-4 family residential mortgages||12,379||7,452||238,845||258,676|
|Home equity loans||5,540||1,280||2,950||9,770|
|Home equity lines of credit||22||2,835||67,952||70,809|
|Total consumer real estate||17,941||11,567||309,747||339,255|
|Commercial and industrial|
|Commercial and industrial||21,884||30,335||5,800||58,019|
|Total commercial and industrial||33,992||39,096||22,123||95,211|
|Total amount due||72,779||67,611||611,280||751,670|
FIXED AND FLOATING RATE LOANS DUE AFTER ONE YEAR
(DOLLARS IN THOUSANDS)
|Fixed Rates||Adjustable Rates||Total|
|Commercial real estate|
|Total commercial real estate||15,043||277,548||292,591|
|Consumer real estate|
|1-4 family residential mortgages||78,514||167,782||246,296|
|Home equity loans||2,001||2,229||4,230|
|Home equity lines of credit||14,009||56,779||70,788|
|Total consumer real estate||94,524||226,790||321,314|
|Commercial and industrial|
|Commercial and industrial||29,208||6,927||36,135|
|Total commercial and industrial||47,089||14,130||61,219|
|Total amount due||160,423||518,468||678,891|
The majority of the Corporation’s fixed-rate loans have a maturity date longer than five years. The primary reason for the longevity of the portfolio is the high percentage of real estate loans, which typically have maturities of 15 or 20 years. Fixed-rate commercial mortgages have maturities that range from 3 years to 25 years. The most popular commercial mortgage term is a 20-year amortization with a 5-year reset period. In this case, the loan matures in twenty
years but after five years either the loan rate resets to the Prime rate plus 0.75%, or a fixed rate for another reset period. The original maturity date does not change. Customers will generally opt for another fixed reset period within the original term.
Out of all the loans due after one year, 23.6% are fixed-rate loans as of December 31, 2019. These loans will not reprice to a higher or lower interest rate unless they mature or are refinanced by the borrower. Floating or adjustable rate loans reflect different types of repricing. Approximately 24% of the $518.5 million of loans due after one year are true floating loans. These loans are tied to the Prime rate and will reprice when the Prime rate changes. For commercial customers, generally all pass credits have been granted access to the Prime rate since 2011. However, a number of the Corporation’s business and commercial Prime-based loans have been priced at levels above the Prime rate due to the credit standing of the borrower. In terms of consumer real estate loans utilizing the Prime rate for pricing, the most common rate is Prime; however, the Corporation now utilizes risk-based pricing which causes HELOCs to be priced at various multiples of the Prime rate. Outside of a six-month introductory rate, the majority of the Corporation’s HELOCs were priced at 4.75%, 5.00%, and 5.25% as of December 31, 2019. The other 76% of the Corporation’s floating or adjustable loans due after one year are adjustable in nature and will reprice at a predetermined time in the amortization of the loan. These loans are mostly real estate commercial loans.
As of December 31, 2018, 29% of the $446.1 million of floating or adjustable loans due after one year were true floating rate loans that could reprice immediately, with the other 71% being adjustable after an initial fixed rate period. The percentage of loans that can reprice immediately decreased from 29% as of December 31, 2018, to 24% as of December 31, 2019. This decrease was a function of more consumers fixing their loans during 2019. True floating rate loans that would immediately reprice according to changes in the Prime rate are favorable in reducing the Corporation’s total exposure to interest rate risk and fair value risk should interest rates increase. It is likely the borrowing habits of commercial borrowers will change if the Fed raises rates in the near term. More commercial customers will desire to lock into an initial fixed interest rate period to avoid future rate increases. However, if the customer perceives rates will remain low for an extended period of time or even decrease further, there is a greater likelihood that borrowers will opt for variable rate loans in order to get the best available pricing.
For more details regarding how the length of the loan portfolio and its repricing affects interest rate risk, please see Item 7A Quantitative and Qualitative Disclosures about Market Risk.
Non-performing assets include:
|·||Loans past due 90 days or more and still accruing|
|·||Troubled debt restructurings|
|·||Other real estate owned|
(DOLLARS IN THOUSANDS)
|Loans past due 90 days or more and still accruing||821||397||440||384||378|
|Troubled debt restructurings, non-performing||1,157||—||245||—||—|
|Total non-performing loans||3,962||2,230||1,078||1,105||758|
|Other real estate owned||—||—||—||—||—|
|Total non-performing assets||3,962||2,230||1,078||1,105||758|
|Non-performing assets to loans||0.53%||0.32%||0.18%||0.20%||0.15%|
Non-performing assets increased by $1,732,000, or 77.7%, from December 31, 2018, to December 31, 2019, primarily as a result of increases in loans past due 90 days or more and still accruing, and troubled debt restructurings. The increase in loans past due 90 days or more and still accruing was caused by higher delinquencies in the Corporation’s residential real estate portfolio. At the end of 2019, $807,000 of residential real estate loans were more than 90 days past due and still accruing, compared to $396,000 at the end of 2018. There were also two non-performing TDR loans as of December 31, 2019. The first, an agricultural mortgage of $718,000 had cash flow difficulties and a modification in payment terms was made to allow annual interest and principal payments. The second TDR loan was a $439,000 real estate secured loan with a payment modification made in the form of granting a nine-month interest-only payment. This second TDR loan was both non-accrual and TDR. For this above non-performing chart the $439,000 real estate loan is listed under TDR loans. There were no non-performing TDR loans as of December 31, 2018. The TDR loan as of December 31, 2017, was an agriculture loan restructured in the second quarter of 2017. This loan was paid off in full in July of 2018. A TDR is a loan where management has granted a concession to the borrower from the original terms. A concession is generally granted in order to improve the financial position of the borrower and improve the likelihood of full collection by the lender.
Management continues to monitor delinquency trends and the level of non-performing loans as a leading indicator of future credit risk. At this time, management believes that the potential for material losses related to non-performing loans remains low but is likely to trend higher. This is more of a function of the Corporation’s non-performing assets already being at very low historical levels. It is far more likely the level of non-performing assets would increase than decline to lower levels. The level of the Corporation’s non-performing loans remains very low relative to the size of the portfolio and relative to peers.
As of December 31, 2019, there were seven loans to four unrelated borrowers totaling $1,984,000 on non-accrual compared to eight loans to four unrelated borrowers totaling $1,833,000 as of December 31, 2018. The largest non-accrual relationship at December 31, 2019, was three loans to a single borrower with a combined balance of $1,070,000 to an agricultural borrower.
The Corporation’s diverse customer base, with many small businesses and industry types represented, has helped to avoid large concentrations in industries where significant non-performance is more likely. See Note P for further discussion on concentrations of credit risk. Severe economic conditions naturally will impact nearly all industries to some extent; however, the impact can vary greatly. Some businesses simply are not as successful in negotiating more difficult times, or may be impacted by non-economic matters like succession planning and poor business practice. Based on present economic conditions, management does not anticipate any significant new trends or the emergence of more severe trends beyond those already discussed.
As of December 31, 2019 and 2018, the Corporation had no properties classified as other real estate owned (OREO). Expenses related to OREO are included in other operating expenses and gains or losses on the sale of OREO are included in other income on the Consolidated Statements of Income.
Total delinquencies include loans 30 to 59 days past due, loans 60 to 89 days past due, loans 90 days or more past due and still accruing, and non-accrual loans. Total delinquencies as a percentage of total loans increased from 0.40% as of December 31, 2018, to 0.91% as of December 31, 2019. Although this represents an increase year-over-year, the level of non-performing loans in total still remains low compared to the Corporation’s peer group. The potential for significant losses related to delinquent loans is difficult to predict as actual charge-offs are dependent on more than the level of delinquency. Management does view that the levels of delinquency, as well as net charge-offs, could increase going forward if economic conditions worsen for borrowers or as the Corporation’s loan portfolio continues to grow. However, management currently does not expect the overall level of delinquencies to change materially in 2020.
Allowance for Loan Losses
The allowance for loan losses is established to cover any losses inherent in the loan portfolio. Management reviews the adequacy of the allowance each quarter based upon a detailed analysis and calculation of the allowance for loan losses. This calculation is based upon a systematic methodology for determining the allowance for loan losses in accordance with U.S. generally accepted accounting principles. The calculation includes estimates and is based upon losses inherent in the loan portfolio. The calculation, and detailed analysis supporting it, emphasizes the level of delinquent, non-performing and classified loans. The allowance calculation includes specific provisions for non-performing loans and general allocations to cover anticipated losses on all loan types based on historical losses. Based on the quarterly loan
loss calculation, management will adjust the allowance for loan losses through the provision as necessary. Changes to the allowance for loan losses during the year are primarily affected by three events:
|·||Charge off of loans considered not recoverable|
|·||Recovery of loans previously charged off|
|·||Provision or credit for loan losses|
The Corporation’s strong credit and collateral policies have been instrumental in producing a favorable history of loan losses. While many financial institutions experienced a pattern of an escalation of allowance for loan losses after the financial crisis, then followed with reductions to the allowance in the form of credit provisions, the Corporation generally lagged this trend. This was due to a steady decline of the Corporation’s classified assets, delinquencies and non-performing loans. It took a longer period to bring the allowance back down to levels supported by the quarterly allowance for loan loss calculation. However, in recent years, the Corporation has recorded more normal levels of provision expenses in order to account for the growth in the loan portfolio as well as make adjustments for increasing levels of delinquencies and classified loans.
The Allowance for Loan Losses table below shows the activity in the allowance for loan losses for each of the past five years. At the bottom of the table, two benchmark percentages are shown. The first is net charge-offs as a percentage of average loans outstanding for the year. The second is the total allowance for loan losses as a percentage of total loans.
ALLOWANCE FOR LOAN LOSSES
(DOLLARS IN THOUSANDS)
|Balance at January 1,||8,666||8,240||7,562||7,078||7,141|
|Loans charged off:|
|Commercial real estate||(122||)||(223||)||(200||)||—||(272||)|
|Consumer real estate||—||(20||)||—||—||(28||)|
|Commercial and industrial||(63||)||(110||)||(89||)||(23||)||(44||)|