CITIZENS FINANCIAL SERVICES, INC. CAUTIONARY STATEMENT We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Company, the Bank,First Citizens Insurance , Realty or the Company on a consolidated basis. When we use words such as "believes," "expects," "anticipates," or similar expressions, we are making forward-looking statements. Forward-looking statements may prove inaccurate. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements:
· Interest rates could change more rapidly or more significantly than we expect.
· The economy could change significantly in an unexpected way, which would cause
the demand for new loans and the ability of borrowers to repay outstanding
loans to change in ways that our models do not anticipate.
· The financial markets could suffer a significant disruption, which may have a
negative effect on our financial condition and that of our borrowers, and on
our ability to raise money by issuing new securities.
· It could take us longer than we anticipate implementing strategic initiatives,
including expansions, designed to increase revenues or manage expenses, or we
may be unable to implement those initiatives at all.
· Acquisitions and dispositions of assets could affect us in ways that management
has not anticipated.
· We may become subject to new legal obligations or the resolution of litigation
may have a negative effect on our financial condition or operating results.
· We may become subject to new and unanticipated accounting, tax, regulatory or
compliance practices or requirements. Failure to comply with any one or more of
these requirements could have an adverse effect on our operations.
· We could experience greater loan delinquencies than anticipated, adversely
affecting our earnings and financial condition.
· We could experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
· We could lose the services of some or all of our key personnel, which would
negatively impact our business because of their business development skills,
financial expertise, lending experience, technical expertise and market area
knowledge.
· The agricultural economy is subject to extreme swings in both the costs of
resources and the prices received from the sale of products, as a result of
weather, government regulations, international trade agreements and consumer
tastes, which could negatively impact certain of our customers.
· Loan concentrations in certain industries could negatively impact our results,
if financial results or economic conditions deteriorate.
· A budget impasse in the
values, liquidity and profitability as a result of either delayed or reduced
funding to school districts and municipalities who are customers of the bank.
· Companies providing support services related to the exploration and drilling of
the natural gas reserves in our market area may be affected by federal, state
and local laws and regulations such as restrictions on production, permitting,
changes in taxes and environmental protection, which could negatively impact
our customers and, as a result, negatively impact our loan and deposit volume
and loan quality. Additionally, the activities the companies providing support
services related to the exploration and drilling of the natural gas reserves
may be dependent on the market price of natural gas. As a result, decreases in
the market price of natural gas could also negatively impact these companies,
our customers.
Additional factors are discussed in this Annual Report on Form 10-K under "Item
1A. Risk Factors." These risks and uncertainties should be considered in
evaluating forward-looking statements and undue reliance should not be placed on
such statements. Forward-looking statements speak only as of the date they are
made and the Company does not undertake to update forward-looking statements to
reflect circumstances or events that occur after the date of the forward-looking
statements or to reflect the occurrence of unanticipated events. Accordingly,
past results and trends should not be used by investors to anticipate future
results or trends.
21--------------------------------------------------------------------------------
INTRODUCTION
The following is management's discussion and analysis of the significant changes in financial condition, the results of operations, capital resources and liquidity presented in the accompanying consolidated financial statements for the Company. The Company's consolidated financial condition and results of operations consist almost entirely of the Bank's financial condition and results of operations. Management's discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes. Except as noted, tabular information is presented in thousands of dollars. The Company currently engages in the general business of banking throughout its service area ofBradford ,Tioga ,Clinton ,Potter andCentre counties in north centralPennsylvania ,Lebanon ,Berks ,Schuylkill andLancaster counties in south centralPennsylvania and Allegany County in southernNew York . We also have a limited branch office inUnion county ,Pennsylvania , which primarily serves agricultural customers in the centralPennsylvania market. We maintain our main office inMansfield, Pennsylvania . Presently we operate 28 banking facilities, 27 of which operate as bank branches after closing a facility in the first quarter of 2020. InPennsylvania , the Company has full service offices located inMansfield ,Blossburg ,Ulysses ,Genesee ,Wellsboro ,Troy ,Sayre ,Canton ,Gillett ,Millerton ,LeRaysville ,Towanda ,Rome , the Mansfield Wal-Mart SuperCenter ,Mill Hall ,Schuylkill Haven ,Friedensburg ,Mt. Aetna ,Fredericksburg ,Mount Joy , Fivepointville,State College and two branches near the city ofLebanon, Pennsylvania after closing a third branch inJanuary 2020 . We also have a limited branch office inWinfield, Pennsylvania . InNew York , our office is inWellsville . Risk identification and management are essential elements for the successful management of the Company. In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity, reputational and regulatory risk. Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates. Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company. The Company uses its asset/liability and funds management policies to control and manage interest rate risk. Credit risk represents the possibility that a customer may not perform in accordance with contractual terms. Credit risk results from loans with customers and the purchasing of securities. The Company's primary credit risk is in the loan portfolio. The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses. Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio. Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors. The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk. These guidelines include, among other things, contingent funding alternatives. Reputational risk, or the risk to our business, earnings, liquidity, and capital from negative public opinion, could result from our actual or alleged conduct in a variety of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, ethical issues, or inadequate protection of customer information, which could include identify theft, or theft of customer information through third parties. We expend significant resources to comply with regulatory requirements. Failure to comply could result in reputational harm or significant legal or remedial costs. Damage to our reputation could adversely affect our ability to retain and attract new customers, and adversely impact our earnings and liquidity. Regulatory risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company and its subsidiary. We cannot predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations. 22 -------------------------------------------------------------------------------- Readers should carefully review the risk factors described in other documents the Company files with theSEC , including the annual reports on Form 10-K, the quarterly reports on Form 10-Q and any current reports on Form 8-K filed by us. TRUST AND INVESTMENT SERVICES; OIL AND GAS SERVICES Our Investment and Trust Division is committed to helping our customers meet their financial goals. The Trust Division offers professional trust administration, investment management services, estate planning and administration, custody of securities and individual retirement accounts. In addition to traditional trust and investment services offered, we assist our customers through various oil and gas specific leasing matters from lease negotiations to establishing a successful approach to personal wealth management. Assets held by the Bank in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Bank. As ofDecember 31, 2019 and 2018, assets owned and invested by customers of the Bank through the Bank's investment representatives totaled$215.4 million and$178.5 million , respectively. Additionally, as summarized in the table below, the Trust Department had assets under management as ofDecember 31, 2019 and 2018 of$134.3 million and$117.6 million , respectively. During the year endedDecember 31, 2019 ,$16.5 million of new trust accounts were opened,$7.7 million of additional contributions to trust accounts,$23.3 million distributed from trust accounts, and$3.4 million of accounts were closed. A portion of this distributions related to the FNB pension plan that was terminated in 2019. As a result of market fluctuations, the market value of the trust accounts increased approximately$19.9 million during the year endedDecember 31, 2019 . The following table reflects trust accounts by investment type and structure: (market values - in thousands) 2019 2018 INVESTMENTS: Bonds$ 17,349 $ 17,559 Stock 18,632 16,372 Savings and Money Market Funds 16,085 16,100 Mutual Funds 75,158 60,847 Mineral interests 1,045 4,500 Mortgages 696 1,082 Real Estate 4,982 839 Miscellaneous 351 279 Cash - 9 TOTAL$ 134,298 $ 117,587 ACCOUNTS: Trusts 34,975 30,736 Guardianships 5,929 2,347 Employee Benefits 51,870 51,907 Investment Management 41,520 32,595 Custodial 4 2 TOTAL$ 134,298 $ 117,587 Our financial consultants offer full service brokerage and financial planning services throughout the Bank's market areas. Appointments can be made at any Bank branch. Products such as mutual funds, annuities, health and life insurance are made available through our insurance subsidiary,First Citizens Insurance Agency, Inc. RESULTS OF OPERATIONS Net income for the year endedDecember 31, 2019 was$19,490,000 , which represents an increase of$1,456,000 , or 8.1%, when compared to 2018. Net income for the year endedDecember 31, 2018 was$18,034,000 , which represents an increase of$5,009,000 , or 38.5%, when compared to 2017. Basic and diluted earnings per share were$5.54 ,$5.09 and$3.67 for 2019, 2018 and 2017, respectively. Net income is influenced by five key components: net interest income, provision for loan losses, non-interest income, non-interest expenses, and the provision for income taxes. 23 -------------------------------------------------------------------------------- Net Interest Income The most significant source of revenue is net interest income; the amount by which interest earned on interest-earning assets exceeds interest paid on interest-bearing liabilities. Factors that influence net interest income are changes in volume of interest-earning assets and interest-bearing liabilities as well as changes in the associated interest rates. The following table sets forth the Company's average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders' equity, the related rates, net interest income and rate "spread" created. The acquisition of theState College branch, which closed onDecember 8, 2017 , impacted the average balances and rates for 2018 when compared to 2017: 24 -------------------------------------------------------------------------------- Analysis
of Average Balances and Interest Rates
2019 2018 2017
Average Interest Average Average Interest Average Average Interest Average
Balance(1) (3) Rate Balance(1) (3) Rate Balance(1) (3) Rate (dollars in thousands) $ $ % $ $ % $ $ % ASSETS Short-term investments: Interest-bearing deposits at banks 9,693 23 0.24 8,929 20 0.22 8,790 15 0.17 Total short-term investments 9,693 23 0.24 8,929 20 0.22 8,790 15 0.17 Interest bearing time deposits at banks 15,085 384 2.55 12,734 299 2.35 8,346 171 2.05 Investment securities: Taxable 188,697 5,170 2.74 191,991 4,237 2.21 194,716 3,366 1.73 Tax-exempt (3) 58,637 1,889 3.22 64,728 2,208 3.41 84,235 3,657 4.34 Total investment securities 247,334 7,059 2.85 256,719 6,445 2.51 278,951 7,023 2.52
Loans:
Residential mortgage loans 215,749 11,473 5.32 214,458 11,205 5.22 206,321 10,660 5.17 Construction loans 19,085 984 5.16 25,698 1,235 4.80 24,299 1,040 4.28 Commercial Loans 415,681 22,741 5.47 388,037 20,611 5.31 329,767 17,525 5.31 Agricultural Loans 344,586 15,879 4.61 305,003 13,638 4.47 214,200 9,251 4.32 Loans to state & political subdivisions 97,780 3,845 3.93 101,496 3,759 3.70 98,427 4,146 4.21 Other loans 9,684 740 7.64 9,558 737 7.71 10,341 823 7.96 Loans, net of discount (2)(3)(4) 1,102,565 55,662 5.05 1,044,250 51,185 4.90 883,355 43,445 4.92 Total interest-earning assets 1,374,677 63,128 4.59 1,322,632 57,949 4.38 1,179,442 50,654 4.29 Cash and due from banks 6,168 6,807 6,774 Bank premises and equipment 16,074 16,338 16,799 Other assets 57,038 54,722 55,910 Total non-interest earning assets 79,280 77,867 79,483 Total assets 1,453,957 1,400,499
1,258,925
LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities: NOW accounts 331,906 2,282 0.69 326,040 1,642 0.50 323,105 1,139 0.35 Savings accounts 218,240 814 0.37 192,727 323 0.17 179,557 191 0.11 Money market accounts 164,872 1,978 1.20 164,916 1,618 0.98 127,888 650 0.51 Certificates of deposit 277,946 4,145 1.49 276,213 3,327 1.20 261,758 2,645 1.01 Total interest-bearing deposits 992,964 9,219 0.93 959,896 6,910 0.72 892,308 4,625 0.52 Other borrowed funds 109,041 2,821 2.59 117,912 2,664 2.26 68,536 1,214 1.77 Total interest-bearing liabilities 1,102,005 12,040 1.09 1,077,808 9,574 0.89 960,844 5,839 0.61 Demand deposits 187,991 171,353 153,523 Other liabilities 14,074 12,647 14,802 Total non-interest-bearing liabilities 202,065 184,000 168,325 Stockholders' equity 149,887 138,691 129,756 Total liabilities & stockholders' equity 1,453,957 1,400,499 1,258,925 Net interest income 51,088 48,375 44,815 Net interest spread (5) 3.50 % 3.49 % 3.68 % Net interest income as a percentage of average interest-earning assets 3.72 % 3.66 % 3.80 %
Ratio of interest-earning assets
to interest-bearing liabilities 1.25 1.23 1.23 (1) Averages are based on daily averages. (2) Includes loan origination and commitment fees. (3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 21% for 2019 and 2018 and 34% for 2017. Tax equivalent income is considered a non-gaap measure. See reconciliation to equivalent GAAP measure on page 25. (4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets. (5) Interest rate spread represents the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities. For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Federal statutory rate for the corresponding year. Accordingly, tax equivalent adjustments for investments and loans have been made accordingly to the previous table for the years endedDecember 31, 2019 , 2018 and 2017, respectively (in thousands): 25 -------------------------------------------------------------------------------- 2019 2018
2017
Interest and dividend income from investment securities, interest bearing time deposits and short-term investments (non-tax adjusted) (GAAP)$ 7,069 $ 6,300 $ 5,966 Tax equivalent adjustment 397 464 1,243 Interest and dividend income from investment securities,
interest bearing time deposits and short-term
investments (tax equivalent basis) (Non-GAAP)
2019 2018 2017
Interest and fees on loans (non-tax adjusted)
(GAAP) $ 54,911 $ 50,458 $ 42,127
Tax equivalent adjustment 751 727 1,318
Interest and fees on loans (tax equivalent basis)
(Non-GAAP) $ 55,662 $ 51,185 $ 43,445
2019 2018 2017
Total interest income $ 61,980 $ 56,758 $ 48,093
Total interest expense 12,040 9,574 5,839
Net interest income (GAAP) 49,940 47,184 42,254
Total tax equivalent adjustment 1,148 1,191 2,561
Net interest income (tax equivalent basis)
(Non-GAAP) $ 51,088 $ 48,375 $ 44,815 The following table shows the tax-equivalent effect of changes in volume and rates on interest income and expense (in thousands):
Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis
2019 vs. 2018 (1) 2018 vs. 2017 (1)
Change in Change Total Change in Change Total
Volume in Rate Change Volume in Rate Change
Interest Income:
Short-term
investments:
Interest-bearing
deposits at banks $ 2 $ 1 $ 3 $ - $ 5 $ 5
Interest bearing time
deposits at banks 58 27 85 100 28 128
Investment
securities:
Taxable (71 ) 1,004 933 (46 ) 917 871
Tax-exempt (200 ) (119 ) (319 ) (752 ) (697 ) (1,449 )
Total investment
securities (271 ) 885 614 (798 ) 220 (578 )
Total investment
income (211 ) 913 702 (698 ) 253 (445 )
Loans:
Residential mortgage
loans 68 200 268 424 121 545
Construction loans (350 ) 99 (251 ) 63 132 195
Commercial Loans 1,500 630 2,130 3,095 (9 ) 3,086
Agricultural Loans 1,814 427 2,241 4,049 338 4,387
Loans to state &
political
subdivisions (124 ) 210 86 136 (523 ) (387 )
Other loans 9 (6 ) 3 (62 ) (24 ) (86 )
Total loans, net of
discount 2,917 1,560 4,477 7,705 35 7,740
Total Interest Income 2,706 2,473 5,179 7,007 288 7,295
Interest Expense:
Interest-bearing
deposits:
NOW accounts 30 610 640 11 492 503
Savings accounts 48 443 491 15 117 132
Money Market
accounts (1 ) 361 360 229 739 968
Certificates of
deposit 21 797 818 152 530 682
Total
interest-bearing
deposits 98 2,211 2,309 407 1,878 2,285
Other borrowed funds (170 ) 327 157 1,049 401 1,450
Total interest
expense (72 ) 2,538 2,466 1,456 2,279 3,735
Net interest income $ 2,778 $ (65 ) $ 2,713
(1) The portion of the total change attributable to both volume and rate changes during the year has been
allocated
to volume and rate components based upon the absolute dollar amount of the change in each component prior to
allocation.
26-------------------------------------------------------------------------------- 2019 vs. 2018 Tax equivalent net interest income for 2019 was$51,088,000 compared to$48,375,000 for 2018, an increase of$2,713,000 or 5.6%. Total interest income increased$5,179,000 , as loan interest income increased$4,477,000 , and total investment income increased$614,000 . Interest expense increased$2,466,000 from 2018. Total tax equivalent interest income from investment securities increased$614,000 in 2019 from 2018. The average balance of investment securities decreased$9.4 million , which had an effect of decreasing interest income by$271,000 due to volume. The majority of the decrease in volume was in tax-exempt securities, which experienced a decrease in the average balance of$6.1 million . The average tax-effected yield on our investment portfolio increased from 2.51% in 2018 to 2.85% in 2019. The increase in the tax-effected yield is attributable to purchases made in a higher rate environment and calls in 2019 of securities purchased at a discount. As a result of yield on taxable securities increasing 53 basis points (bps) to 2.74%, interest income on investment securities increased$885,000 . The investment strategy for 2019 has been to utilize cashflows from the investment portfolio to purchase agency and state and political securities to maintain a consistent level of investments. Investment purchases have been focused on securities with short fixed maturities for agency securities, high coupon callable municipal securities that are highly likely to be called and agency mortgage backed securities with consistent cashflows. We continually monitor interest rate trading ranges and focus purchases to times when rates are in the top third of the trading range. The Bank believes its investment strategy has appropriately mitigated its interest rate risk exposure to both rising and falling rate scenarios, while providing sufficient cashflows. In total, loan interest income increased$4,477,000 in 2019 from 2018. The average balance of our loan portfolio increased by$58.3 million in 2019 compared to 2018, which resulted in an increase in interest income of$2,917,000 due to volume. The increase in the average balance of loans was driven by growth in our central and south centralPennsylvania markets. The average tax-effected yield on our loan portfolio increased 15 basis points to 5.05% in 2019, resulting in an increase in loan interest income of$1,560,000 . The increase in the tax-effected yield was due to the higher rate environment promoted by theFederal Reserve in 2018 through the four rate increases made in 2018, which were partially offset by two rate decreases in 2019. • Interest income on residential mortgage loans increased$268,000 . The average
balance of residential mortgage loans increased
increase of
2018 to 5.32% in 2019 as a result of a higher rate environment during the year
as a result of rate increases in 2018.
• The average balance of construction loans decreased
2019 as projects were completed, which resulted in a decrease of
interest income. The average yield on construction loans increased from 4.80%
to 5.16%, which correlated to a
• Interest income on commercial loans increased
The increase in the average balance of commercial loans of
attributable organic growth in the central and south central markets as well as
completed construction projects. The increase in the average balance of these
loans resulted in an increase in interest income due to volume of
Our lenders have been able to attract and retain loan relationships in their
markets by providing excellent customer service and having attractive
products. We believe our lenders are adept at customizing and structuring
loans to customers that meet their needs and satisfy our commitment to credit
quality. In many cases, the Bank works with the
(SBA) guaranteed loan programs to offset risk and to further promote economic
growth in our market area. The average yield on commercial loans increased 16
basis points to 5.47% in 2019, resulting in an increase in interest income due
to rate of
• Interest income on agricultural loans increased
The increase in the average balance of agricultural loans of
primarily attributable to the central and south central markets as well as
completed construction projects. The increase in the average balance of these
loans resulted in an increase in interest income due to volume of
The average yield on agricultural loans increased from 4.47% in 2018 to 4.61%
in 2019 due to a general increase in rates, resulting in an increase in
interest income due to rate of
customizing, understanding and have the expertise to structure loans for
customers that meet their needs and satisfy our commitment to credit quality.
In many cases, the Bank works with the
Agriculture's (USDA) guaranteed loan programs to offset risk and to further
promote economic growth in our market area.
27--------------------------------------------------------------------------------
• The average balance of loans to state and political subdivisions decreased
million from 2018 to 2019 which had a negative impact of
interest income due to volume. The average tax equivalent yield on loans to
state and political subdivisions increased from 3.70% in 2018 to 3.93% in 2019,
increasing interest income by
Total interest expense increased$2,466,000 in 2019 compared to 2018. The majority of the increase was due to an increase in the average rate paid on interest bearing liabilities of 20 basis points to 1.09%. This increase resulted in an increase in interest expense of$2,538,000 . The rise in rates was driven by theFederal Reserve raising short term rates in 2018, which increased pressure on the Bank to raise rates on deposit pricing and to pay higher rates for short-term and overnight borrowings. While theFederal Reserve cut rates in 2019, the cuts were less than the increases in 2018, but did have an impact in lowering rates in the second half of 2019. The average rate on certificates of deposit increased from 1.20% to 1.49% resulting in an increase in interest expense of$797,000 . The average rate paid on other borrowed funds increased from 2.26% to 2.59% resulting in an increase in interest expense of$327,000 . The average rate paid on money market accounts increased from 0.98% to 1.20% resulting in an increase in interest expense of$361,000 . Increases in rates paid on NOW accounts and savings accounts were less than 20 basis points, and resulted in a cumulative increase in interest expense of$1,053,000 . Average interest bearing liabilities increased$24.2 million in 2019, with average interest bearing deposits increasing$33.1 million and average other borrowings decreasing$8.9 million . As a result of the decrease in average borrowings, interest expense decreased$72,000 as result of the change in volume. Increases in average deposits included NOW accounts of$5.7 million , savings accounts of$25.5 million and certificates of deposits of$1.7 million . The combined impact to interest expense of these increases was$98,000 . The average balance of other borrowed funds decreased$8.9 million , which corresponds to a decrease in interest expense of$170,000 . Our tax equivalent net interest margin for 2019 was 3.72% compared to 3.66% for 2018, with the change attributable to higher tax-effected yields as a result of the higher rate environment. The interest rate environment for 2019 was a further flattening of the yield curve with longer term decreasing more than short term rates decreased. During periods of 2019, portions of the yield curve were inverted. Should short or long-term interest rates move in such a way that results in a further flattening or inversion, we would anticipate additional pressure on our margin. 2018 vs. 2017 Tax equivalent net interest income for 2018 was$48,375,000 compared to$44,815,000 for 2017, an increase of$3,560,000 or 7.9%. Total interest income increased$7,295,000 , as loan interest income increased$7,740,000 , while total investment income decreased$445,000 . Interest expense increased$3,735,000 from 2017. Total tax equivalent interest income from investment securities decreased$578,000 in 2018 from 2017. The average balance of investment securities decreased$22.2 million , which had an effect of decreasing interest income by$798,000 due to volume. The majority of the decrease in volume was in tax-exempt securities, which experienced a decrease in the average balance of$19.5 million . The average tax-effected yield on our investment portfolio decreased from 2.52% in 2017 to 2.51% in 2018. The decrease in the tax-effected yield is attributable to change in tax rates between 2017 and 2018. If the same tax rate was utilized for both 2017 and 2018, the tax-effected yields in 2018 would have exceeded 2017. As a result of yield on taxable securities increasing 48 bps to 2.21%, interest income on investment securities increased$220,000 . The primary driver of the decrease in the average balance of investments securities is attributable to the decision to fund a portion of our loan growth through the cashflows of the investment portfolio. As a result of the change in tax rates, yields on municipal securities were not as attractive as yields on taxable securities and as such, the tax exempt portfolio was utilized to fund the loan growth. The increase in yield on taxable securities is attributable to theFederal Reserve raising interest rates during 2017 and 2018. Investment purchases in 2018 focused on adding additional duration through longer term bonds to improve the portfolio performance. 28 -------------------------------------------------------------------------------- In total, loan interest income increased$7,740,000 in 2018 from 2017. The average balance of our loan portfolio increased by$160.9 million in 2018 compared to 2017, which resulted in an increase in interest income of$7,705,000 due to volume. The increase in the average balance of loans was driven by the acquisition of theState College branch in December of 2017 and growth in our central and south centralPennsylvania markets as a result of our lending teams hired in 2016. • Interest income on residential mortgage loans increased$545,000 . The average
balance of residential mortgage loans increased
the
to volume. The change due to rate was an increase of
yield on residential mortgages increased from 5.17% in 2017 to 5.22% in 2018.
• The average balance of construction loans increased
2018, which resulted in an increase of
Additionally, the average yield on construction loans increased from 4.28% to
4.80% in 2018, which correlated to a
• Interest income on commercial loans increased
The increase in the average balance of commercial loans of
attributable to the acquisition of the
in the central and south central markets. The acquisition of the
branch provided us with a new expanding market. Our lenders benefited from the
market disruption created by several bank mergers in the
markets. The increase in the average balance of these loans resulted in an
increase in interest income due to volume of
• Interest income on agricultural loans increased
The increase in the average balance of agricultural loans of
primarily attributable to the lenders hired to serve the central and south
central markets. The increase in the average balance of these loans resulted in
an increase in interest income due to volume of
on agricultural loans increased from 4.32% in 2017 to 4.47% in 2018 due to a
general increase in rates, resulting in an increase in interest income due to
rate of
• The average balance of loans to state and political subdivisions increased
million from 2017 to 2018 which had a positive impact of
interest income due to volume. The average tax equivalent yield on loans to
state and political subdivisions decreased from 4.21% in 2017 to 3.70% in 2018,
decreasing interest income by
yield is primarily due to the change in tax rates from 34% in 2017 to 21% in
2018.
Total interest expense increased$3,735,000 in 2018 compared to 2017. A portion of the increase is attributable to a change in volume as the average balance of interest bearing liabilities increased$117.0 million in 2018, which had the effect of increasing interest expense by$1,456,000 . This increase was attributable to the acquisition of theState College branch and increases to fund the loan growth experienced by the Bank. Increases in average deposits included NOW accounts of$2.9 million , savings accounts of$13.2 million , money markets accounts of$37.0 and certificates of deposits of$14.5 million . The combined impact to interest expense of these increases was$407,000 . The average balance of other borrowed funds increased$49.4 million as a result of funding loan growth, which corresponds to an increase in interest expense of$1,049,000 . The average interest rate paid on interest bearing liabilities increased from 0.61% in 2017 to 0.89% in 2018, which resulted in an increase in interest expense of$2,279,000 . The average rate on certificates of deposit increased from 1.01% to 1.20% resulting in an increase in interest expense of$530,000 . The average rate paid on other borrowed funds increased from 1.77% to 2.26% resulting in an increase in interest expense of$401,000 . The average rate paid on money market accounts increased from 0.51% to 0.98% resulting in an increase in interest expense of$739,000 . Increases in rates paid on NOW accounts and savings accounts were less than 15 basis points, and resulted in a cumulative increase in interest expense of$609,000 . The rise in rates was driven by theFederal Reserve raising short term rates in 2018, which increased pressure on the Bank to raise rates on deposit pricing and to pay higher rates for the overnight borrowings. 29 -------------------------------------------------------------------------------- Our net interest margin for 2018 was 3.66% compared to 3.80% for 2017, with a large majority of the change attributable to a lower tax-effected yield as a result of the change in tax rates for 2017 and 2018. PROVISION FOR LOAN LOSSES For the year endedDecember 31, 2019 , we recorded a provision for loan losses of$1,675,000 . The provision for 2019 was$250,000 , or 13.0%, lower than the provision in 2018. The decrease in the provision for loan losses was primarily the result of organic loan growth in 2019 being less than the organic loan growth experienced in 2018 (see also "Financial Condition - Allowance for Loan Losses and Credit Quality Risk"). For the year endedDecember 31, 2018 , we recorded a provision for loan losses of$1,925,000 . The provision for 2018 was$615,000 , or 24.2% lower than the provision in 2017. The decrease in the provision for loan losses was primarily the result of the organic loan growth experienced in 2018 being less than the organic loan growth experienced in 2017 (see also "Financial Condition - Allowance for Loan Losses and Credit Quality Risk"). NON-INTEREST INCOME The following table reflects non-interest income by major category for the years endedDecember 31 (dollars in thousands): NON-INTEREST INCOME 2019 2018 2017 Service charges$ 4,687 $ 4,667 $ 4,456 Trust 750 705 755 Brokerage and insurance 1,141 790 635 Equity security gains, net 120 -
-
Available for sale security gains (losses), net 24 (19 ) 1,035 Gains on loans sold
473 382 578
Earnings on bank owned life insurance 623 622 660 Other 568 588 537 Total$ 8,386 $ 7,735 $ 8,656 2019/2018 2018/2017 Change Change Amount % Amount % Service charges$ 20 0.4$ 211 4.7 Trust 45 6.4 (50 ) (6.6 ) Brokerage and insurance 351 44.4 155 24.4 Equity security gains, net 120 NA - NA Available for sale security gains (losses), net 43 (226.3 ) (1,054 ) (101.8 ) Gains on loans sold 91 23.8 (196 ) (33.9 ) Earnings on bank owned life insurance 1 0.2 (38 ) (5.8 ) Other (20 ) (3.4 ) 51 9.5 Total$ 651 8.4$ (921 ) (10.6 ) 2019 vs. 2018 Non-interest income increased$651,000 in 2019 from 2018, or 8.4%. We experienced a$24,000 net gain on available for sale securities in 2019 compared to a net loss totaling$19,000 in 2018. During 2019, we sold 3 agency securities for a net gain of$1,000 and 4US Treasury securities for a gain of$23,000 to fund loan growth and to restructure the investment portfolio to improve performance in the current rate environment. During 2018, we sold 7 agency securities for a net loss of$179,000 and 14 municipal securities for a gain of$160,000 to fund loan growth. As a result of market conditions, the equity portfolio increased$120,000 during 2019, while remaining flat in 2018. 30 -------------------------------------------------------------------------------- Gains on loans sold increased$91,000 compared to last year. During 2019, the Bank generated$21.8 million of residential mortgage loan sale proceeds, which was$2.1 million , or 10.6% more than the proceeds received in 2018. The increase in brokerage and insurance commissions was primarily attributable to growth in our south central market. The increase in Trust revenues is due to estate settlement fees being higher in 2019 than 2018. 2018 vs. 2017 Non-interest income decreased$921,000 in 2018 from 2017, or 10.6%. We experienced a$19,000 net loss on available for sale securities in 2018 compared to a net gain totaling$1,035,000 in 2017. During 2018, we sold 7 agency securities for a net loss of$179,000 and 14 municipal securities for a gain of$160,000 to fund loan growth. During 2017, we sold 24 agency securities for a net loss of$147,000 to fund loan growth and to restructure the investment portfolio for expected future market interest rate increases. We also sold one Agency MBS security for a gain of$20,000 . In anticipation of the adoption of accounting standard ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which required the change in the market value of equity securities to be recorded in income beginning in 2018, the Company chose to sell a significant portion of its equity securities portfolio that resulted in a gain of$1,149,000 . We also sold several interest bearing time deposits during 2017 for a gain of$13,000 . Gains on loans sold decreased$196,000 compared to last year. During 2018, the Bank generated$19.7 million of residential mortgage loan sale proceeds, which was$5.4 million , or 21.5% less than the proceeds received in 2017. During 2017, we also sold the credit card portfolio for$1.0 million generating a gain on the sale of approximately$39,000 . The increase in service charges is attributable to the acquisition of theState College branch and customers generating additional interchange and ATM revenue for the Company. The increase in brokerage revenues is due to growth in sales in our south centralPennsylvania market. The decrease in trust revenues was due to estates fees decreasing in 2018 compared to 2017. Non-interest Expenses The following tables reflect the breakdown of non-interest expense by major category for the years endedDecember 31 (dollars in thousands): 2019 2018 2017 Salaries and employee benefits$ 20,456 $ 19,094 $ 17,655 Occupancy 2,174 2,126 1,988 Furniture and equipment 674 536 603 Professional fees 1,423 1,925 1,299 FDIC insurance 75 417 385 Pennsylvania shares tax 808 835 705 Amortization of intangibles 259 296 297 Merger and acquisition 466 - 165 ORE expenses 376 158 395 Software expenses 948 876 795 Other 5,682 5,294 5,027 Total$ 33,341 $ 31,557 $ 29,314 31
--------------------------------------------------------------------------------
2019/2018 2018/2017
Change Change
Amount % Amount %
Salaries and employee benefits $ 1,362 7.1 $ 1,439 8.2
Occupancy 48 2.3 138 6.9
Furniture and equipment 138 25.7 (67 ) (11.1 )
Professional fees (502 ) (26.1 ) 626 48.2
FDIC insurance (342 ) (82.0 ) 32 8.3
Pennsylvania shares tax (27 ) (3.2 ) 130 18.4
Amortization of intangibles (37 ) (12.5 ) (1 ) (0.3 )
Merger and acquisition 466 N/A (165 ) (100.0 )
ORE expenses 218 138.0 (237 ) (60.0 )
Software expenses 72 8.2 81 10.2
Other 388 7.3 267 5.3
Total $ 1,784 5.7 $ 2,243 7.7
2019 vs. 2018
Non-interest expenses for 2019 totaled $33,341,000 , which represents an increase
of $1,784,000 , compared to 2018 expenses of $31,557,000 . The primary cause of
the total increase was salaries and benefits. Salary and benefit costs increased
$1,362,000 , or 7.1%. Base salaries and related payroll taxes increased $200,000
as a result of merit increases. Full time equivalent staffing was 259 and 261
employees for 2019 and 2018, respectively. As a result of actual claims
utilization, health insurance related expenses increased $395,000 . Retirement
and profit sharing expenses increased $539,000 compared to 2018, as a result of
the employee mix and increased profitability.
The increase in furniture and fixtures was due to computer upgrades made during
2019. The increase in merger and acquisition expenses is due to the pending
merger with MidCoast Community Bancorp, Inc. and no corresponding activity in
2018. The increase in ORE expenses is the result of having additional ORE
properties in 2019 than 2018 that were acquired as part of the customer
bankruptcy settlement that resulted in the decreased professional fees. The
largest drivers of the increase in other expenses was operational charge-offs
associated with fraudulent activity, ATM and data processing expenses as a
result of fraud prevention and advertising and promotion expenses. The decrease
in professional and legal fees is due to a decrease in legal fees associated
with a customer's bankruptcy litigation that was settled in the first quarter of
2019. The decrease in FDIC insurance was due to credits received in 2019 from
the FDIC as the Deposit Insurance Fund exceeded 1.38%.
2018 vs. 2017
Non-interest expenses for 2018 totaled $31,557,000 , which represents an increase
of $2,243,000 , compared to 2017 expenses of $29,314,000 . The primary cause of
the total increase was salaries and benefits. Salary and benefit costs increased
$1,439,000 , or 8.2%. Base salaries and related payroll taxes increased
$1,089,000 as a result of additional headcount, primarily due to the State
College branch acquisition, 2018 merit increases and staffing mix changes. Full
time equivalent staffing was 261 and 253 employees for 2018 and 2017,
respectively. As a result of actual claims utilization, health insurance related
expenses decreased $145,000 . Retirement and profit sharing expenses increased
$389,000 compared to 2017, also as a result of a change in the number of
employees, the employee mix and increased profitability.
The increase in occupancy expenses in 2018 was due to the State College branch
acquisition. The increase in professional and legal fees was due to an increase
in legal fees associated with a customer's bankruptcy litigation. The decrease
in ORE expenses was the result of having fewer ORE properties in 2018 than 2017.
The decrease in merger and acquisition expenses is due to the acquisition of the
State College branch in 2017 and no corresponding activity in 2018. The largest
drivers of the increase in other expenses was ATM operating expenses and
directors fees.
32
--------------------------------------------------------------------------------
Provision for Income Taxes
The provision for income taxes was $3,820,000 , $3,403,000 and $6,031,000 for
2019, 2018 and 2017, respectively. The effective tax rates for 2019, 2018 and
2017 were 16.4%, 15.9% and 31.7%, respectively.
The increase in income tax expense of $417,000 in 2019 was due to the increase
of $1,873,000 in income before the provision for income taxes, which accounts
for an increase in tax expense of $393,000 at a 21% tax rate. The remaining
increase was due to a lower amount of tax exempt income in 2019 compared to
2018.
The decrease in income tax expense of $2,628,000 in 2018 has two primary
drivers. The first was a change in the Company's Federal statutory income tax
rate from 35% in 2017 to 21% in 2018. While income before the provision for
income taxes increased $2,381,000 to $21,437,000 , the decrease in the federal
statutory income tax rate corresponds to a reduction in income tax expenses of
approximately $1,668,000 . The second driver was a $1,531,000 increase in tax
expense in 2017 due to the Tax Cuts and Jobs Act, enacted on December 22, 2017 ,
which lowered the federal corporate income tax rate from 35% to 21% effective
January 1, 2018 . As a result of the lowered tax rate, the carrying value of the
Company's net deferred tax asset was reduced by $1,531,000 , which was charged to
income tax expense in 2017. The remaining change was due to a lower amount of
tax exempt income in 2018 compared to 2017.
We are involved in four limited partnership agreements that operate low-income
housing projects in our market area. During 2019, 2018 and 2017, we recognized
tax credits related to one of the four partnerships. Tax credits associated with
one project became fully utilized in December 2016 . The tax credits for the
other two projects were fully utilized by December 31, 2012 . We anticipate
recognizing an aggregate of $423,000 of tax credits over the next three years.
FINANCIAL CONDITION
The following table presents ending balances (dollars in millions), the dollar
amount of change and the percentage change during the past two years:
2019 % 2018 % 2017
Balance Increase Change Balance Increase Change Balance
Total assets$ 1,466.3 $ 35.6 2.5$ 1,430.7 $ 68.8 5.1$ 1,361.9 Total investments 240.7 (0.3 ) (0.1 ) 241.0 (13.8 ) (5.4 ) 254.8 Total loans, net 1,101.7 32.7 3.1 1,069.0 79.7 8.1 989.3 Total deposits 1,211.1 25.9 2.2 1,185.2 80.3 7.3 1,104.9 Total borrowings 85.1 (6.1 ) (6.7 ) 91.2 (23.5 ) (20.5 ) 114.7 Total stockholders' equity 154.8 15.6 11.2 139.2 10.2 7.9 129.0 Cash and Cash Equivalents Cash and cash equivalents totaled$18.5 million atDecember 31, 2019 compared to$16.8 million atDecember 31, 2018 . Management actively measures and evaluates its liquidity through our Asset - Liability committee and believes its liquidity needs are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources,Federal Home Loan Bank financing, federal funds lines with correspondent banks, brokered certificates of deposit and the portion of the investment and loan portfolios that mature within one year. Management expects that these sources of funds will permit us to meet cash obligations and off-balance sheet commitments as they come due. Investments The following table shows the year-end composition of the investment portfolio, at fair value, for the five years endedDecember 31 (dollars in thousands): 33 --------------------------------------------------------------------------------
2019 % of 2018 % of 2017 % of 2016 % of 2015 % of
Amount Total Amount Total Amount Total Amount Total Amount Total
Available-for-sale:
U. S. Agency
securities $ 84,863 35.1 $ 106,385 44.0 $ 98,887 38.8 $ 170,414 54.3 $ 199,591 55.5
U.S. Treasuries 27,661 11.5 33,358 13.8 28,604 11.2 3,000 0.9 10,082 2.8
Obligations of state
& political
subdivisions 61,455 25.5 52,047 21.5 79,090 31.0 96,926 30.9 102,863 28.6
Corporate
obligations 3,328 1.4 3,034 1.3 3,083 1.2 3,050 1.0 14,565 4.0
Mortgage-backed
securities 63,399 26.2 46,186 19.1 45,027 17.7 37,728 12.0 30,204 8.4
Equity securities (a) 701 0.3 516 0.3 91 0.1 2,899 0.9 2,432 0.7
Total $ 241,407 100.0 $ 241,526 100.0 $ 254,782 100.0 $ 314,017 100.0 $ 359,737 100.0
(a) As of
reclassification of equity securities from available for sale securities to
equity securities in the Consolidated Balance Sheet.
2019
The Company's investment portfolio remained stable during 2019 as the Company maintained investment levels for pledging against public deposits and liquidity needs. During 2019, we purchased$14.1 million ofU.S. agencies,$26.2 million of mortgage backed securities,$28.4 million of state and local obligations,$250,000 of corporate obligations and$65,000 of equity securities, which helped to offset the$9.8 million of principal repayments and$52.8 million of calls and maturities that occurred during the year. We also sold$10.5 million of bonds at a net gain of$24,000 . The market value of our investment portfolio increased approximately$4.2 million in 2019 due to interest rate fluctuations and equity market gains. Excluding our short term investments consisting of monies held primarily at theFederal Reserve , the effective yield on our investment portfolio for 2019 was 2.85% compared to 2.51% for 2018 on a tax equivalent basis. During 2019, rates on the short end of theTreasury yield curve decreased as a result of the decrease in the federal funds rate and the potential for additional future decreases in the federal funds rate. The rates on the long end of the curve also decreased in 2019 primarily as a result of continued low inflation. This resulted in yield curve remaining very flat and during parts of 2019, portions of the yield curve were inverted. The investment strategy in 2019 was to maintain a consistent balance to meet public deposit pledging needs as well as to meet the Company's liquidity needs. Investment purchases during the year focused on securities with short fixed maturities for agency securities, high coupon callable municipal securities that are highly likely to be called and mortgage backed securities with consistent cashflows. We continually monitor interest rate trading ranges and try to focus purchases to times when rates are in the top third of the trading range. The Company believes its investment strategy has appropriately mitigated its interest rate risk exposure if rates rise while providing sufficient cashflows for the Company's liquidity needs. AtDecember 31, 2019 , the Company did not own any securities, other than government-sponsored and government-guaranteed mortgage-backed securities, that had an aggregate book value in excess of 10% of its consolidated stockholders' equity at that date. The expected principal repayments at amortized cost and average weighted yields for the investment portfolio (excluding equity securities) as ofDecember 31, 2019 , are shown below (dollars in thousands). Expected principal repayments, which include prepayment speed assumptions for mortgage-backed securities, are significantly different than the contractual maturities detailed in Note 4 of the consolidated financial statements. Yields on tax-exempt securities are presented on a fully taxable equivalent basis, assuming a 21% tax rate, which was the rate in effect atDecember 31, 2019 . 34 -------------------------------------------------------------------------------- After One Year After Five Years One Year or Less to Five Years to Ten Years After Ten Years Total Amortized Yield Amortized Yield Amortized Yield Amortized Yield Amortized Yield Cost % Cost % Cost % Cost % Cost % Available-for-sale securities: U.S. agency securities$ 28,650 1.7$ 52,387 2.6$ 2,373 3.1 $ - -$ 83,410 2.3 U.S. treasuries - - 27,394 2.1 - - - - 27,394 2.1 Obligations of state & political Subdivisions 13,598 2.5 28,602 2.9 15,192 3.2 3,275 3.2 60,667 2.9 Corporate obligations - - - - 3,250 5.8 - - 3,250 5.8 Mortgage-backed securities 17,171 2.3 19,489 2.4 17,624 2.5 8,802 2.8 63,086 2.5 Total available-for-sale$ 59,419 2.1$ 127,872 2.5$ 38,439 3.1$ 12,077 2.9$ 237,807 2.5 AtDecember 31, 2019 , approximately 78.8% of the amortized cost of debt securities is expected to mature, call or pre-pay within five years or less. The Company expects that earnings from operations, the levels of cash held at theFederal Reserve and other correspondent banks, the high liquidity level of the available-for-sale securities, growth of deposits and the availability of borrowings from theFederal Home Loan Bank and other third party banks will be sufficient to meet future liquidity needs.
2018
The Company's investment portfolio decreased by$13.3 million , or 5.2%, during the past year primarily due to investment cash flows being utilized to fund loan growth in 2018. During 2018, we purchased$5.0 million ofU.S. Treasury securities,$52.1 million ofU.S. agencies,$10.1 million of mortgage backed securities,$2.2 million of state and local obligations and$425,000 of equity securities in financial corporations, which helped to offset the$8.4 million of principal repayments and$45.6 million of calls and maturities that occurred during the year. We also sold$27.1 million of bonds at a net loss of$19,000 . The market value of our investment portfolio decreased approximately$894,000 in 2018 due to interest rate fluctuations and sales of securities during 2018. Excluding our short term investments consisting of monies held primarily at theFederal Reserve , the effective yield on our investment portfolio for 2018 was 2.51% compared to 2.52% for 2017 on a tax equivalent basis. During 2018, rates on the short end of theTreasury yield curve increased as a result of the increase in the federal funds rate and the potential for additional future increases in the federal funds rate. This resulted in a further flattening of the yield curve and inversion on parts of the yield curve as long-term rates did not increase in a similar manner. The investment strategy in 2018 was to utilize cashflows from the investment portfolio to fund a portion of the strong loan growth the Company experienced, while maintaining a portfolio sufficient to support our various pledging requirements for deposits, borrowings and liquidity. Investment purchases during the year focused on adding additional duration to the portfolio, without exceeding policy limits. During 2018, we executed a strategy to sell pre-refunded municipal securities, which means that the securities would be called at their next call date, to maximize our investment return. We reinvested the proceeds into higher yielding securities thus improving the portfolio profile. AtDecember 31, 2018 , the Company did not own any securities, other than government-sponsored and government-guaranteed mortgage-backed securities, that had an aggregate book value in excess of 10% of its consolidated stockholders' equity at that date. Loans The Bank's lending efforts have historically focused on north centralPennsylvania and southernNew York . With the acquisition of FNB and the opening of offices inLancaster County , this focus has grown to includeLebanon ,Schuylkill ,Berks andLancaster County markets of south central,Pennsylvania . We have a limited branch office inUnion County that is staffed by a lending team to primarily support agricultural opportunities in centralPennsylvania . InDecember 2017 , we completed a branch acquisition inState College , which provides us with opportunities inCentre County, Pennsylvania . We originate loans primarily through direct loans to our existing customer base, with new customers generated through the strong relationships that our lending teams have with their customers, as well as by referrals from real estate brokers, building contractors, attorneys, accountants, corporate and advisory board members, existing customers and the Bank's website. The Bank offers a variety of loans, although historically most of our lending has focused on real estate loans including residential, commercial, agricultural, and construction loans. As ofDecember 31, 2019 , approximately 79.4% of our loan portfolio consisted of real estate loans. All lending is governed by a lending policy that is developed and administered by management and approved by the Board of Directors. 35 -------------------------------------------------------------------------------- The Bank primarily offers fixed rate residential mortgage loans with terms of up to 25 years and adjustable rate mortgage loans (with amortization schedules up to 30 years) with interest rates and payments that adjust based on one, three, five and 15 year fixed periods. Loan to value ratios are usually 80% or less with exceptions for individuals with excellent credit and low debt to income and/or high net worth. Adjustable rate mortgages are tied to a margin above the comparableFederal Home Loan Bank of Pittsburgh borrowing rate. Home equity loans are written with terms of up to 15 years at fixed rates. Home equity lines of credit are variable rate loans tied to the Prime Rate generally with a ten year draw period followed by a ten year repayment period. Home equity loans are typically written with a maximum 80% loan to value. Commercial real estate loan terms are generally 20 years or less, with one to five year adjustable interest rates. The adjustable rates are typically tied to a margin above the comparableFederal Home Loan Bank of Pittsburgh borrowing rate with a maximum loan to value ratio of 80%. Where feasible, the Bank participates in theUnited States Department of Agriculture's (USDA) andSmall Business Administration (SBA) guaranteed loan programs to offset risk and to further promote economic growth in our market area. During 2019, we originated$1.6 million inUSDA and SBA guaranteed real estate loans. Agriculture is an important industry throughout our market areas. Therefore, the Bank has not only developed an agriculture lending team with significant experience that has a thorough understanding of this industry, but also continually looks for additional employees with a thorough understanding of agriculture. We have an agricultural loan policy to assist in underwriting agricultural loans. Agricultural loans are made to a diversified customer base that include dairy, swine and poultry farmers and their support businesses. Agricultural loans focus on character, cash flow and collateral, while also taking into account the particular risks of the industry. Loan terms are generally 20 years or less, with one to five year adjustable interest rates. The adjustable rates are typically tied to a margin above the comparableFederal Home Loan Bank of Pittsburgh borrowing rate with a typical loan to value of less than 80%. We evaluate the financial strength of the integrators we have exposure to with our poultry and swine agricultural customers. The Bank is a preferred lender under theUSDA's Farm Service Agency (FSA) and participates in the FSA guaranteed loan program. The Bank, as part of its commitment to the communities it serves, is an active lender for projects by our local municipalities and school districts. These loans range from short term bridge financing to 20 year term loans for specific projects. These loans are typically written at rates that adjust at least every five years. Due to the size of certain municipal loans, we have developed participation lending relationships with other community banks that allow us to meet regulatory compliance issues, while meeting the needs of the customer. AtDecember 31, 2019 , the aggregate balance of our participation loans, in which a portion was sold to other lender's totaled$85.1 million , of which$53.3 million was sold. Activity associated with exploration for natural gas in 2019 was similar to 2018. Certain entities drilled new wells and created new pad sites and pipelines, while other companies only maintained their existing wells. Natural gas prices remained relatively low in 2019. While the Bank has loaned to companies that service the exploration activities, the Bank did not originate any loans to companies performing the actual drilling and exploration activities. Loans made by the Company were to service industry customers which included trucking companies, stone quarries and other support businesses. We also originated loans to businesses and individuals for restaurants, hotels and apartment rentals that were developed and expanded to meet the housing and living needs of the gas workers. Due to our understanding of the industry and its cyclical nature, the loans made for natural gas-related activities were originated in a prudent and cautious manner and were subject to specific policies and procedures for lending to these entities, which included lower loan to value thresholds, shortened amortization periods, and expansion of our monitoring of loan concentrations associated with this activity. 36
--------------------------------------------------------------------------------
The following table shows the year-end composition of the loan portfolio for the
five years ended
2019 2018 2017 2016 2015
Amount % Amount % Amount % Amount % Amount %
Real estate:
Residential $ 217,088 19.4 $ 215,305 19.9 $ 214,479 21.4 $ 207,423 25.9 $ 203,407 29.3
Commercial 342,023 30.7 319,265 29.5 308,084 30.8 252,577 31.6 237,542 34.2
Agricultural 311,464 27.9 284,520 26.3 239,957 24.0 123,624 15.5 57,822 8.3
Construction 15,519 1.4 33,913 3.1 13,502 1.3 25,441 3.2 15,011 2.2
Consumer 9,947 0.9 9,858 0.9 9,944 1.0 11,005 1.4 11,543 1.7
Other commercial
loans 69,970 6.3 74,118 6.9 72,013 7.2 58,639 7.3 57,549 8.2
Other agricultural
loans 55,112 4.9 42,186 3.9 37,809 3.8 23,388 2.9 13,657 2.0
State & political
subdivision loans 94,446 8.5 102,718 9.5 104,737 10.5 97,514 12.2 98,500 14.1
Total loans 1,115,569 100.0 1,081,883 100.0 1,000,525 100.0 799,611 100.0 695,031 100.0
Less allowance for
loan losses 13,845 12,884 1,190 8,886 7,106
Net loans $ 1,101,724 $ 1,068,999 $ 989,335 $ 790,725 $ 687,925
2019/2018 2018/2017
Change Change
Amount % Amount %
Real estate:
Residential $ 1,783 0.8 $ 826 0.4
Commercial 22,758 7.1 11,181 3.6
Agricultural 26,944 9.5 44,563 18.6
Construction (18,394 ) (54.2 ) 20,411 151.2
Consumer 89 0.9 (86 ) (0.9 )
Other commercial loans (4,148 ) (5.6 ) 2,105 2.9
Other agricultural loans 12,926 30.6 4,377 11.6
State & political subdivision loans (8,272 ) (8.1 ) (2,019 )
(1.9 )
Total loans $ 33,686 3.1 $ 81,358 8.1
2019
Total loans grew $33.7 million in 2019 and total $1.12 billion at the end of
2019. During 2019, the Company experienced growth in agricultural real estate
loans of $26.9 million , commercial real estate loans of $22.8 million and other
agricultural loans of $12.9 million . A portion of the growth in agricultural and
commercial loan categories was due to transfers from construction as projects
were completed in 2019. The remaining growth was again in our southcentral and
central Pennsylvania markets.
Residential real estate loans increased $1.8 million . Demand for non-conforming
loans was slightly higher than previous years but remains highly competitive,
especially in the north central Pennsylvania market. During 2019, $21.2 million
of residential real estate loans were originated for sale on the secondary
market, which compares to $19.5 million for 2018. For loans sold on the
secondary market, the Company recognizes fee income for servicing these sold
loans, which is included in non-interest income.
2018
Total loans grew$81.4 million in 2018 from$1.00 billion at the end of 2017 to$1.08 billion at the end of 2018. During 2018, the Company experienced growth in agricultural real estate loans of$44.6 million , commercial real estate loans of$11.2 million , other agricultural loans of$4.4 million , other commercial loans of$2.1 million and construction loans of$20.4 million , which will convert primarily to agricultural and commercial real estate upon completion. The growth in agricultural and commercial loan categories was primarily in our southcentral and centralPennsylvania markets and is a result of entering the south central and centralPennsylvania markets with the FNB acquisition andState College branch acquisitions and the hiring of additional agricultural and commercial lenders. 37 -------------------------------------------------------------------------------- Residential real estate loans increased$826,000 . Demand for non-conforming loans was consistent with previous years and remains highly competitive, especially in the north centralPennsylvania market. During 2018,$19.5 million of residential real estate loans were originated for sale on the secondary market, which compares to$24.3 million for 2017. For loans sold on the secondary market, the Company recognizes fee income for servicing these sold loans, which is included in non-interest income. The following table shows the maturity of commercial business and agricultural, state and political subdivision loans, commercial real estate loans, and construction loans as ofDecember 31, 2019 , classified according to the sensitivity to changes in interest rates within various time intervals (in thousands). The table does not include any estimate of prepayments which significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less. Commercial, municipal, Real estate agricultural construction Total Maturity of loans: One year or less$ 21,040 $ 400$ 21,440 Over one year through five years 98,245 5,536 103,781 Over five years 753,730 9,583 763,313 Total$ 873,015 $ 15,519 $ 888,534 Sensitivity of loans to changes in interest rates - loans due after December 31, 2020: Fixed interest rate$ 91,200 $ 7,233
Floating or adjustable interest rate 760,775 7,886 768,661 Total$ 851,975 $ 15,119 $ 867,094 Allowance for Loan Losses and Credit Quality Risk The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb probable future loan losses inherent in the loan portfolio. The provision for loan losses is charged against current income. Loans deemed not collectable are charged-off against the allowance while subsequent recoveries increase the allowance. The following table presents an analysis of the change in the allowance for loan losses and a summary of our non-performing assets for the years endedDecember 31, 2019 , 2018, 2017, 2016 and 2015. All non-accruing troubled debt restructurings (TDRs) are also included the non-accruing loans totals. 38 -------------------------------------------------------------------------------- December 31, 2019 2018 2017 2016 2015 Balance at beginning of period$ 12,884 $ 11,190 $ 8,886 $ 7,106 $ 6,815 Charge-offs: Real estate: Residential 32 118 107 85 66 Commercial 578 66 41 100 84 Agricultural - - 30 - - Consumer 49 40 130 100 47 Other commercial loans 38 91 - 55 41 Other agricultural loans 60 50 5 - - Total loans charged-off 757 365 313 340 238 Recoveries: Real estate: Residential - 69 - - - Commercial - 3 11 479 14 Agricultural - - - - - Consumer 33 31 49 88 33 Other commercial loans 10 30 16 33 2 Other agricultural loans - 1 1 - - Total loans recovered 43 134 77 600 49 Net loans charged-off (recovered) 714 231 236 (260 ) 189 Provision charged to expense 1,675 1,925 2,540 1,520 480 Balance at end of year$ 13,845 $ 12,884 $
11,190
Loans outstanding at end of period$ 1,115,569 $ 1,081,883 $ 1,000,525 $ 799,611 $ 695,031 Average loans outstanding, net$ 1,102,565 $ 1,044,250 $ 883,355 $ 725,881 $ 577,992 Non-performing assets: Non-accruing loans$ 11,536 $ 13,724 $
10,171
Accrual loans - 90 days or more past due 487 68 555 405 623
Total non-performing loans
Foreclosed assets held for sale 3,404 601
1,119 1,036 1,354
Total non-performing assets
Troubled debt restructurings (TDR) Non-accruing TDRs$ 6,223 $ 10,621 $ 6,798 $ 6,758 $ 3,397 Accrual TDRs 7,341 8,333 13,056 6,095 2,243 Total troubled debt restructurings$ 13,564 $ 18,954 $ 19,854 $ 12,853 $ 5,640 Net charge-offs (recoveries) to average loans 0.06 % 0.02 % 0.03 % (0.04 %) 0.03 % Allowance to total loans 1.24 % 1.19 % 1.12 % 1.11 % 1.02 % Allowance to total non-performing loans 115.15 % 93.42 % 104.33 % 74.93 % 99.33 % Non-performing loans as a percent of loans net of unearned income 1.08 % 1.27 % 1.07 % 1.48 % 1.03 % Non-performing assets as a percent of loans net of unearned income 1.38 % 1.33 % 1.18 % 1.61 % 1.22 % The Company believes it utilizes a disciplined and thorough loan review process based upon its internal loan policy approved by the Company's Board of Directors. The purpose of the review is to assess loan quality, analyze delinquencies, identify problem loans, evaluate potential charge-offs and recoveries, and assess general overall economic conditions in the markets served. An external independent loan review is performed on our commercial portfolio at least semi-annually for the Company. The external consultant is engaged to 1) review a minimum of 50% (55% for loans in 2016 and 2015) of the dollar volume of the commercial loan portfolio on an annual basis, 2) new loans originated for over$1.0 million in the last year, 3) a majority of borrowers with commitments greater than or equal to$1.0 million , 4) selected loan relationships over$750,000 which are over 30 days past due, or classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate. As part of this review, our underwriting process and loan grading system is evaluated. 39 -------------------------------------------------------------------------------- Management believes it uses the best information available to make such determinations and that the allowance for loan losses is adequate as ofDecember 31, 2019 . However, future adjustments could be required if circumstances differ substantially from assumptions and estimates used in making the initial determination. A prolonged downturn in the economy, changes in the economies of various segments of our agricultural and commercial portfolios, high unemployment rates, significant changes in the value of collateral and delays in receiving financial information from borrowers could result in increased levels of non-performing assets, charge-offs, loan loss provisions and reduction in income. Additionally, bank regulatory agencies periodically examine the Bank's allowance for loan losses. The banking agencies could require the recognition of additions to the allowance for loan losses based upon their judgment of information available to them at the time of their examination. On a monthly basis, problem loans are identified and updated primarily using internally prepared past due reports. Based on data surrounding the collection process of each identified loan, the loan may be added or deleted from the monthly watch list. The watch list includes loans graded special mention, substandard, doubtful, and loss, as well as additional loans that management may choose to include. Watch list loans are continually monitored going forward until satisfactory conditions exist that allow management to upgrade and remove the loan from the watchlist. In certain cases, loans may be placed on non-accrual status or charged-off based upon management's evaluation of the borrower's ability to pay. All commercial loans, which include commercial real estate, agricultural real estate, state and political subdivision loans, other commercial loans and other agricultural loans, on non-accrual are evaluated quarterly for impairment. The adequacy of the allowance for loan losses is subject to a formal, quarterly analysis by management of the Company. In order to better analyze the risks associated with the loan portfolio, the entire portfolio is divided into several categories. As stated above, loans on non-accrual status are specifically reviewed for impairment and given a specific reserve, if appropriate. Loans evaluated and not found to be impaired are included with other performing loans, by category, by their respective homogenous pools. Three year average historical loss factors were calculated for each pool and applied to the performing portion of the loan category for each year presented. The historical loss factors for both reviewed and homogeneous pools are adjusted based upon the following qualitative factors: • Level of and trends in delinquencies, impaired/classified loans
? Change in volume and severity of past due loans
? Volume of non-accrual loans
? Volume and severity of classified, adversely or graded loans
• Level of and trends in charge-offs and recoveries
• Trends in volume, terms and nature of the loan portfolio
• Effects of any changes in risk selection and underwriting standards and any
other changes in lending and recovery policies, procedures and practices
• Changes in the quality of the Bank's loan review system
• Experience, ability and depth of lending management and other relevant staff
• National, state, regional and local economic trends and business conditions
? General economic conditions
? Unemployment rates ? Inflation / CPI
? Changes in values of underlying collateral for collateral-dependent loans
• Industry conditions including the effects of external factors such as
competition, legal, and regulatory requirements on the level of estimated
credit losses.
• Existence and effect of any credit concentrations, and changes in the level of
such concentrations
40--------------------------------------------------------------------------------
• Any change in the level of board oversight
See also "Note 5 - Loans and Related Allowance for Loan Losses" to the consolidated financial statements. The allowance for loan losses was$13,845,000 or 1.24% of total loans as ofDecember 31, 2019 as compared to$12,884,000 or 1.19% of loans as ofDecember 31, 2018 . The$961,000 increase is a result of a$1,675,000 provision for loan losses less net charge-offs of$714,000 . During 2019, we had two customers that had charge-offs of approximately$200,000 each, and if they were excluded the net charge-off amount would be similar to prior years. The following table shows the distribution of the allowance for loan losses and the percentage of loans compared to total loans by loan category (dollars in thousands) as ofDecember 31 : 2019 2018 2017 2016 2015 Amount % Amount % Amount % Amount % Amount % Real estate loans: Residential$ 1,114 19.4$ 1,105 19.9$ 1,049 21.4$ 1,064 25.9$ 905 29.3 Commercial 4,549 30.7 4,115 29.5 3,867 30.8 3,589 31.6 3,376 34.2 Agricultural 5,022 27.9 4,264 26.3 3,143 24.0 1,494 15.5 409 8.3 Construction 43 1.4 58 3.1 23 1.3 47 3.2 24 2.2 Consumer 112 0.9 120 0.9 124 1.0 122 1.4 102 1.7 Other commercial loans 1,255 6.3 1,354 6.9 1,272 7.2 1,327 7.3 1,183 8.2 Other agricultural loans 961 4.9 752 3.9 492 3.8 312 2.9 122 2.0 State & political subdivision loans 536 8.5 762 9.5 816 10.5 833 12.2 593 14.1 Unallocated 253 N/A 354 N/A 404 N/A 98 N/A 392 N/A Total allowance for loan losses$ 13,845 100.0$ 12,884 100.0$ 11,190 100.0$ 8,886 100.0$ 7,106 100.0 As a result of previous loss experiences and other risk factors utilized in determining the allowance, the Bank's allocation of the allowance does not directly correspond to the actual balances of the loan portfolio. While commercial and agricultural real estate loans total 58.6% of the loan portfolio, 69.1% of the allowance is assigned to these portions of the loan portfolio as these loans have more inherent risks than residential real estate or loans to state and political subdivisions. Residential real estate loans comprise 19.4% of the loan portfolio as ofDecember 31, 2019 and 8.1% of the allowance is assigned to this segment as generally there are less inherent risks then commercial and agricultural loans. The following table identifies amounts of loans contractually past due 30 to 90 days and non-performing loans by loan category, as well as the change fromDecember 31, 2018 toDecember 31, 2019 in non-performing loans (in thousands). Non-performing loans include those accruing loans that are contractually past due 90 days or more and non-accrual loans. Interest does not accrue on non-accrual loans. Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest. December 31, 2019 December 31, 2018 Non-Performing Loans Non-Performing Loans 30 - 89 Days 90 Days Past Non- Total Non- 30 - 89 Days 90 Days Past Non- Total Non- Past Due Due Accruing accrual Performing Past Due Due Accruing accrual Performing Real estate: Residential $ 933 $ 2$ 962 $ 964 $ 1,624 $ 20$ 1,161 $ 1,181 Commercial 1,225 - 5,080 5,080 1,444 36 5,957 5,993 Agricultural 118 299 2,578 2,877 121 - 3,206 3,206 Consumer 123 2 6 8 37 12 14 26 Other commercial loans 283 184 1,837 2,021 73 - 2,185 2,185 Other agricultural loans 29 - 1,073 1,073 9 - 1,201 1,201 Total nonperforming loans$ 2,711 $ 487$ 11,536 $ 12,023 $ 3,308 $ 68$ 13,724 $ 13,792 41
--------------------------------------------------------------------------------
Change in Non-Performing Loans
2019/2018
Amount %
Real estate:
Residential $ (217 ) (18.4 )
Commercial (913 ) (15.2 )
Agricultural (329 ) (10.3 )
Construction - -
Consumer (18 ) (69.2 )
Other commercial loans (164 ) (7.5 )
Other agricultural loans (128 ) (10.7 )
Total nonperforming loans $ (1,769 ) (12.8 )
The following table shows the distribution of non-performing loans by loan
category (in thousands) for the past five years as of
Non-Performing Loans
2019 2018 2017 2016 2015
Real estate:
Residential $ 964 $ 1,181 $ 1,604 $ 1,903 $ 1,402
Commercial 5,080 5,993 5,354 4,445 4,482
Agricultural 2,877 3,206 205 1,340 34
Construction - - 133 - -
Consumer 8 26 49 109 64
Other commercial loans 2,021 2,185 2,669 4,057 1,172
Other agricultural loans 1,073 1,201 712 5 -
State & political subdivision loans - - - - -
Total nonperforming loans 12,023 13,792 10,726 11,859 7,154
For the year ended December 31, 2019 , we recorded a provision for loan losses of
$1,675,000 which compares to $1,925,000 for the same period in 2018, a decrease
of $250,000 . The decrease is primarily attributable to the decrease in organic
loan growth in 2019 compared to the growth in 2018. Non-performing loans
decreased $1,769,000 from December 31, 2018 to December 31, 2019 with the
decrease being primarily due to three customer relationships, one of which was
settled in the first quarter of 2019 and resulted in a $3.1 million increase in
OREO, a second relationship that made payments totaling approximately $1.0
million , which were partially offset by the third relationship of $1.7 million
being placed on non-accrual status. At December 31, 2019 , approximately 57.4% of
the Bank's non-performing loans are associated with the following three customer
relationships:
• A commercial loan relationship with $2.5 million outstanding, and additional
letters of credit of
quarries and equipment, was on non-accrual status as of
slowdown in the exploration for natural gas has significantly impacted the cash
flows of the customer, who provides excavation services and stone for pad
construction related to these activities. During 2019, the Company had the
underlying equipment collateral appraised. The 2019 appraisal indicated a
decrease in collateral values compared to the appraisal ordered for the loan
origination and an appraisal performed in 2017, however, the loan is still
considered well secured on a loan to value basis. Management determined that no
specific reserve was required as of
• An agricultural customer with a total loan relationship of
secured by real estate, equipment and cattle, was on non-accrual status as of
of 2018 and developed a workout plan that was approved in the fourth quarter of
2019 and resulted in two monthly payments being made in the fourth quarter.
Included within these loans to this customer are
subject to
cash flow difficulties for this customer. Absent a sizable and sustained
increase in milk prices, which is not assured, we will need to rely upon the
collateral for repayment of interest and principal. As of
there was a specific reserve of
• A commercial customer with a loan relationship of
commercial real estate, business assets and vehicles, was on non-accrual status
as of
grown as originally expected and has created cashflow issues. Management
reviewed the collateral and determined that no specific reserve was required as
ofDecember 31, 2019 . 42
--------------------------------------------------------------------------------
Management believes that the allowance for loan losses at
which has approximately
• The Company has a history of low charge-offs, and while higher in 2019 than the
Bank's historical average were still only 0.06% of average loans and primarily
related to two relationships.
Bank Owned Life Insurance The Company holds bank owned life insurance policies to offset current and future employee benefit costs. These policies provide the Bank with an asset that generates earnings to partially offset the current costs of benefits, and eventually (at the death of the insureds) provide partial recovery of cash outflows associated with the benefits. As ofDecember 31, 2019 and 2018, the cash surrender value of the life insurance was$28.1 million and$27.5 million , respectively. The change in cash surrender value, net of purchases and amounts acquired through acquisitions, is recognized in the results of operations. The amounts recorded as non-interest income totaled$623,000 ,$622,000 and$660,000 in 2019, 2018 and 2017, respectively. The Company evaluates annually the risks associated with the life insurance policies, including limits on the amount of coverage and an evaluation of the various carriers' credit ratings. EffectiveJanuary 1, 2015 , the Company restructured its agreements so that any death benefits received from a policy while the insured person is an active employee of the Bank will be split with the beneficiary of the policy. Under the restructured agreements, the employee's beneficiary will be entitled to receive 50% of the net amount at risk from the proceeds. The net amount at risk is the total death benefit payable less the cash surrender value of the policy as of the date of death. The policies acquired as part of the acquisition of FNB, provide a fixed dollar benefit for the beneficiarys' estate, which is dependent on several factors including whether the covered individual was a Director of FNB or an employee of FNB and their salary level. As ofDecember 31, 2019 and 2018, included in other liabilities on the Consolidated Balance sheet is a liability of$684,000 and$648,000 , respectively, for the obligation under the split-dollar benefit agreements. Other Assets 2019 Other assets increased$2.7 million in 2019 to$16.4 million from$13.6 million in 2018. As a result of settling a lawsuit with a bankrupt customer, OREO increased$2.8 million . The deferred tax asset decreased$1.2 million as a result of an increase in unrealized gains on available for sale investments. As a result of the adoption of ASU 2016-02, the Company recorded a right of use asset for facilities leased that was$1.2 million as ofDecember 31, 2019 . As a result of an increase in FHLB borrowings and letters of credit, regulatory stock increased$739,000 . 2018 Other assets decreased$1.1 million in 2018 to$13.6 million from$14.7 million in 2017. As a result of a decrease in FHLB borrowings, regulatory stock decreased$672,000 . As a result of selling several OREO properties, OREO decreased$518,000 during 2018. The deferred tax asset increased$574,000 . Deposits The following table shows the breakdown of deposits by deposit type (dollars in thousands) atDecember 31 : 43 --------------------------------------------------------------------------------
2019 2018 2017
Amount % Amount % Amount %
Non-interest-bearing
deposits $ 203,793 16.9 $ 179,971 15.2 $ 171,840 15.6
NOW accounts 340,273 28.1 336,756 28.4 337,307 30.5
Savings deposits 224,456 18.5 205,334 17.3 184,057 16.7
Money market deposit
accounts 169,865 14.0 164,625 13.9 145,287 13.1
Certificates of
deposit 272,731 22.5 298,470 25.2 266,452 24.1
Total $ 1,211,118 100.0 $ 1,185,156 100.0 $ 1,104,943 100.0
2019/2018 2018/2017
Change Change
Amount % Amount %
Non-interest-bearing deposits $ 23,822 13.2 $ 8,131 4.7
NOW accounts 3,517 1.0 (551 ) (0.2 )
Savings deposits 19,122 9.3 21,277 11.6
Money market deposit accounts 5,240 3.2 19,338 13.3
Certificates of deposit (25,739 ) (8.6 ) 32,018 12.0
Total $ 25,962 2.2 $ 80,213 7.3
2019
Total deposits increased $26.0 million in 2019, or 2.2%. The growth in
non-interest bearing deposits was driven by new customers in our south central
and central Pennsylvania markets. As a percentage of total deposits,
non-interest bearing deposits totaled 16.9% as of the end of 2019, which
compares to 15.2% at the end of 2018. In order to manage our overall cost of
funds, the Company continues to focus on adding low cost deposits by having
several checking products available for retail customers as well as being the
primary checking account for commercial customers who also have loans with the
Company. The increase in savings deposits is attributable to growth in the
central and south central markets and the acquisition of new customers in these
markets.
As a result of market conditions, we had $15.0 million of brokered CD's
outstanding as of December 31, 2019 compared to $20.0 million as of December 31,
2018 , which accounts for a portion of the decrease in CDs. In addition, we had a
municipal customer utilizes maturing CDs to fund an infrastructure project in
their community, which resulted in $9.0 million decrease in CD's. The rates paid
on certificates of deposit by the Company remain competitive with rates paid by
our competition.
2018
Total deposits increased $80.2 million in 2018, or 7.3%. The increase in savings
deposits is attributable to growth in the central and south central markets and
the acquisition of new customers. The growth in money markets was due to
municipal entities, which included the acquisition of new customers as well as
gathering additional deposits from existing customers. As a result of market
conditions and to better manage interest rate risk, we issued $20.0 million of
brokered certificates of deposit (CDs). In addition to the brokered CD's, we
also obtained a $9.0 million CD relationship with a Trust administrator in our
State College office. With the increases in the fed funds rate during 2018, the
Bank increased interest rates on both certificates of deposits and certain
transactional deposit accounts during 2018.
The growth in non-interest bearing deposits was across all customer types. As a
percentage of total deposits, non-interest bearing deposits totaled 15.2% as of
the end of 2018, which compares to 15.6% at the end of 2017.
Remaining maturities of certificates of deposit of
44
--------------------------------------------------------------------------------
2019 2018 2017
3 months or less $ 10,245 $ 29,574 $ 15,118
Over 3 months through 6 months 14,463 10,880 12,461
Over 6 months through 12 months 35,604 26,778 23,775
Over 12 months 80,589 85,719 82,572
Total $ 140,901 $ 152,951 $ 133,926
As a percent of total
certificates of deposit 51.66 % 51.25 % 50.26 %
Interest expense on certificates of deposit of $100,000 or more amounted to
$2,728,000 , $2,052,000 and $1,504,000 for the years ended December 31, 2019 ,
2018, and 2017, respectively.
Deposits by type of depositor are as follows (dollars in thousands) at December
31 :
2019 2018 2017
Amount % Amount % Amount %
Individuals $ 664,065 54.8 $ 666,255 56.2 $ 651,845 59.0
Businesses and other
organizations 306,873 25.3 276,248 23.3 229,425 20.8
State & political
subdivisions 240,180 19.9 242,653 20.5 223,673 20.2
Total $ 1,211,118 100.0 $ 1,185,156 100.0 $ 1,104,943 100.0
Borrowed Funds
2019
Borrowed funds decreased $6.1 million during 2019 as a result of our deposit
growth and net income exceeding the loan growth experienced in 2019. The
decrease was associated with a decrease of $7.4 million of short term borrowings
from the FHLB. We experienced a $6.7 million decrease in repurchase agreements.
Term loans totaled $21.5 million and $13.5 million as of December 31, 2019 and
2018, respectively. The change in term loans was due to borrowing $10.0 million
on a long-term basis and a $2.0 million maturity in 2019 (see Note 10 of the
consolidated financial statements for additional information). Management
continually monitors interest rates in order to minimize interest rate risk in
future years and as part of this may extend some of the short term borrowings
via term notes. Short term borrowings from the FHLB were $44.5 million as of
December 21, 2019 compared to $52.2 million as of December 31, 2018 .
2018
Borrowed funds decreased $23.5 million during 2018 as a result of our deposit
growth and usage of investment cashflow exceeding the loan growth experienced in
2018. The decrease was associated with a decrease of $25.5 million of short term
borrowings from the FHLB. We experienced a $3.0 million increase in repurchase
agreements. Term loans totaled $13.5 million and $14.5 million as of December
31, 2018 and 2017, respectively. The change in term loans was due to a $1.0
million maturity in 2018 (see Note 10 of the consolidated financial statements
for additional information). Management continually monitors interest rates in
order to minimize interest rate risk in future years and as part of this may
extend some of the short term borrowings via term notes. Short term borrowings
from the FHLB were $52.2 million as of December 21, 2018 compared to $77.7
million as of December 31, 2017 .
Other Liabilities
2019
Other liabilities increased slightly to $14.2 million during 2019. The primary
driver of the increase was the recording of a right of use liability for the
Company's operating leases during 2019 that totaled $1.2 million as of December
31, 2019 and an increase in employee benefit accruals of $863,000 . These
increases were offset by a decrease associated with an available for sale
security purchase of $1.5 million that did not settle by December 31, 2018 that
subsequently settled in 2019.
45--------------------------------------------------------------------------------
2018
Other liabilities increased$1.7 million during 2018, or 13.6%. The primary driver of the increase was an available for sale security purchase of$1.5 million that did not settle byDecember 31, 2018 . Stockholders' Equity We evaluate stockholders' equity in relation to total assets and the risk associated with those assets. The greater our capital resources, the greater the likelihood of meeting our cash obligations and absorbing unforeseen losses.
For
these reasons, capital adequacy has been, and will continue to be, of paramount importance. Due to its importance, we develop a capital plan and stress test capital levels using various techniques and assumptions annually to ensure that in the event of unforeseen circumstances, we would remain in compliance with our capital plan approved by the Board of Directors and regulatory requirement levels. Our Board of Directors determines our cash dividend rate after considering our capital requirements, current and projected net income, and other factors. In 2019 and 2018, the Company paid out 32.40% and 34.08% of net income in cash dividends, respectively. As ofDecember 31, 2019 , the total number of common shares outstanding was 3,525,061. For comparative purposes, outstanding shares for prior periods were adjusted for theJune 2019 stock dividend in computing earnings and cash dividends per share as detailed in Note 1 of the consolidated financial statements. During 2019, we purchased 21,551 shares of treasury stock at a weighted average cost of$59.92 per share. The Company awarded 6,371 shares of restricted stock to employees at a weighted average cost per share of$60.02 under an equity incentive plan. The Board of Directors was awarded 1,800 shares at a cost of$60.11 per share under an incentive plan. There are currently four federal regulatory measures of capital adequacy. The Bank's ratios meet the regulatory standards for well capitalized for 2019 and 2018, as detailed in Note 15 of the consolidated financial statements. 2019 Stockholders' equity increased 11.2% in 2019 to$154.8 million . Excluding accumulated other comprehensive income, which is the after-tax effect of unrealized holding gains and losses on available-for-sale securities and additional pension obligation, stockholders' equity increased$12.3 million , or 8.6%. This increase is due to net income of$19,490,000 , offset by net cash dividends of$6,315,000 and net treasury stock activity of$845,000 . All of the Company's debt investment securities are classified as available-for-sale, making this portion of the Company's balance sheet more sensitive to the changing market value of investments. Accumulated other comprehensive income increased$3,292,000 fromDecember 31, 2018 , primarily as result of the increase in the fair market value of the investment portfolio. Total stockholders' equity was approximately 10.56% of total assets as ofDecember 31, 2019 , compared to 9.73% of total assets as ofDecember 31, 2018 . 2018 Stockholders' equity increased 7.9% in 2018 to$139.2 million . Excluding accumulated other comprehensive income, , stockholders' equity increased$10.7 million , or 8.1%. This increase is due to net income of$18,034,000 , offset by net cash dividends of$6,116,000 and net treasury stock activity of$1,029,000 . All of the Company's debt investment securities were classified as available-for-sale. Accumulated other comprehensive income decreased$524,000 fromDecember 31, 2017 , primarily as result of the decrease in the fair market value of the investment portfolio. Total stockholders' equity was approximately 9.73% of total assets as ofDecember 31, 2018 , compared to 9.47% of total assets as ofDecember 31, 2017 . 46
--------------------------------------------------------------------------------
LIQUIDITY
Liquidity is a measure of the Company's ability to efficiently meet normal cash flow requirements of both borrowers and depositors. Liquidity is needed to meet depositors' withdrawal demands, extend credit to meet borrowers' needs, provide funds for normal operating expenses and cash dividends, and fund future capital expenditures. To maintain proper liquidity, we use funds management policies along with our investment and asset liability policies to assure we can meet our financial obligations to depositors, credit customers and stockholders. Management monitors liquidity by reviewing loan demand, investment opportunities, deposit pricing and the cost and availability of borrowing funds. Additionally, the bank has established various limits and ratios to monitor liquidity. On a quarterly basis, we stress test our liquidity position to ensure that the Bank has the capability of meeting its cash flow requirements in the event of unforeseen circumstances. The Company's historical activity in this area can be seen in the Consolidated Statement of Cash Flows from investing and financing activities. Cash generated by operating activities, investing activities and financing activities influences liquidity management. The most important source of funds is the deposits that are primarily core deposits (deposits from customers with other relationships). Short-term debt from theFederal Home Loan Bank supplements the Company's availability of funds as well as a line of credit arrangement with a corresponding bank. Other sources of short-term funds include brokered CDs and the sale of loans, if needed. The Company's use of funds is shown in the investing activity section of the Consolidated Statement of Cash Flows, where the net loan activity is detailed. Other significant uses of funds are capital expenditures, purchase of loans and acquisition premiums. Surplus funds are then invested in investment securities. Capital expenditures in 2019 totaled$483,000 , which included: ? Leasehold improvements and certain equipment for an office opened in 2019
totaling
? Building and ground improvements totaling
? Company vehicle purchased totaling
? Generator totaling
? Computer, network and copier upgrades totaling
Capital expenditures in 2018 totaled
totaling
? Building and ground improvements totaling
? Company vehicle purchased totaling
? Generator project totaling
? Computer and copier upgrades totaling
We expect these expenditures will support our initiatives and will create operating efficiencies, while providing quality customer service. In addition to the Bank's cash balances, the Bank achieves additional liquidity primarily from its investment in the FHLB ofPittsburgh and the resulting borrowing capacity obtained through this investment, investments that mature in less than one year and expected principal repayments from mortgage backed securities. The Bank has a maximum borrowing capacity at the Federal Home Loan Bank of approximately$547.2 million , inclusive of any outstanding amounts, as a source of liquidity. The Bank also two federal funds line with third party providers in the total amount of$34.0 million as ofDecember 31, 2019 , which is unsecured and a borrower in custody agreement was established with the FRB in the amount of$10.9 million , which is collateralized by$26.9 million of municipal loans. 47 -------------------------------------------------------------------------------- The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders. The Company also has repurchased shares of its common stock. The Company's primary source of income is dividends received from the Bank. The Bank may not declare a dividend without approval of the FRB, unless the dividend to be declared by the Bank's Board of Directors does not exceed the total of: (i) the Bank's net profits for the current year to date, plus (ii) its retained net profits for the preceding two current years, less any required transfers to surplus. In addition, the Bank can only pay dividends to the extent that its retained net profits (including the portion transferred to surplus) exceed its bad debts. The FRB, the OCC, the PDB and theFDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions. The Prompt Corrective Action Rules, described above, further limit the ability of banks to pay dividends, because banks which are not classified as well capitalized or adequately capitalized may not pay dividends and no dividend may be paid which would make the Bank undercapitalized after the dividend. AtDecember 31, 2019 , the Company (unconsolidated basis) had liquid assets of$7.2 million . CONTRACTUAL OBLIGATIONS The Company has various financial obligations, including contractual obligations which may require cash payments. The following table (in thousands) presents as ofDecember 31, 2019 , significant fixed and determinable contractual obligations to third parties by payment date. Further discussion of the obligations can be found in Notes 9, 10 and 17 to the Consolidated Financial Statements. One year One to Three to Over Five Contractual Obligations or Less Three Years Five Years Years Total Deposits without a stated maturity$ 938,387 $ - $ - $ -$ 938,387 Time deposits 119,834 118,616 29,722 4,559 272,731 FHLB Advances 24,794 - - - 24,794 Term borrowings - FHLB 20,000 11,525 10,000 - 41,525 Note Payable 7,500 - - - 7,500 Repurchase agreements 11,298 - - 11,298 Operating leases 279 468 247 291 1,285 Total$ 1,122,092 $ 130,609 $ 39,969 $ 4,850 $ 1,297,520 OFF-BALANCE SHEET ARRANGEMENTS In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers' requests for funding and take the form of loan commitments, unused lines of credit and letters of credit. For information about our loan commitments, unused lines of credit and letters of credit, see Note 16 of the notes to consolidated financial statements. For the year endedDecember 31, 2019 , we did not engage in any off-balance sheet transactions reasonably likely to have a material effect on our financial condition, results of operations or cash flows. INTEREST RATE AND MARKET RISK MANAGEMENT The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances and the market value risk of assets and liabilities. Because of the nature of our operations, we are not subject to foreign currency exchange or commodity price risk and, since the Company has no trading portfolio, it is not subject to trading risk. 48 -------------------------------------------------------------------------------- AtDecember 31, 2019 , the Company had equity securities that represent only 0.3% of our investment portfolio, and therefore equity risk is not significant. The primary factors that make assets interest-sensitive include adjustable-rate features on loans and investments, loan repayments, investment maturities and money market investments. The primary components of interest-sensitive liabilities include maturing certificates of deposit, IRA certificates of deposit, repurchase agreements and short-term borrowings. Savings deposits, NOW accounts and money market investor accounts, with the exception of top interest tier money market and NOW accounts, are considered core deposits and are not short-term interest sensitive and therefore are included in the table below in the over five year column. Top interest tier money market and NOW accounts are included in the table below in the within three month column. The following table shows the cumulative static gap (at amortized cost) for various time intervals (dollars in thousands): Maturity or Re-pricing of Company Assets and
Liabilities as of
Within Four to One to Two to Three to Over
Three Twelve Two Three Five Five
Months Months Years Years Years Years Total
Interest-earning
assets:
Interest-bearing
deposits at
banks $ 793 $ 598 $ 2,982 $ 7,944 $ 2,732 $ - $ 15,049
Investment
securities 41,499 29,847 40,188 44,546 49,637 32,090 237,807 Residential mortgage loans
40,932 49,136 49,478 33,784 33,233 10,525 217,088
Construction
loans 4,201 5,539 5,779 - - - 15,519
Commercial and
farm loans 178,919 105,703 165,599 165,726 139,979 22,643 778,569
Loans to state &
political
subdivisions 21,129 18,357 10,375 2,945 7,732 33,908 94,446
Other loans 3,037 2,134 2,038 1,243 993 502 9,947
Total
interest-earning
assets $ 290,510 $ 211,314 $ 276,439 $ 256,188 $ 234,306 $ 99,668 $ 1,368,425
Interest-bearing
liabilities:
NOW accounts $ 205,531 $ - $ - $ - $ - $ 134,742 $ 340,273
Savings accounts - - - - - 224,456 224,456
Money Market
accounts 151,940 - - - - 17,925 169,865
Certificates of
deposit 37,408 82,426 68,690 49,926 29,722 4,559 272,731
Short-term
borrowing 56,092 - - - - - 56,092
Long-term
borrowing 7,500 - 6,800 4,725 10,000 - 29,025
Total
interest-bearing
liabilities
assets
(liabilities)$ (167,961 ) $ 128,888 $ 200,949 $ 201,537 $ 194,584 $ (282,014 ) Cumulative interest-earning assets$ 290,510 $ 501,824 $ 778,263 $ 1,034,451 $ 1,268,757 $ 1,368,425 Cumulative interest-bearing liabilities 458,471 540,897 616,387 671,038 710,760 1,092,442 Cumulative gap$ (167,961 ) $ (39,073 ) $ 161,876 $ 363,413 $ 557,997 $ 275,983 Cumulative interest rate sensitivity ratio (1) 0.63 0.93 1.26 1.54 1.79 1.25 (1) Cumulative interest-earning assets divided by interest-bearing liabilities. The previous table and the simulation models discussed below are presented assuming money market investment accounts and NOW accounts in the top interest rate tier are re-priced within the first three months. The loan amounts reflect the principal balances expected to be re-priced as a result of contractual amortization and anticipated early payoffs. Gap analysis, one of the methods used by us to analyze interest rate risk, does not necessarily show the precise impact of specific interest rate movements on the Bank's net interest income because the re-pricing of certain assets and liabilities is discretionary and is subject to competition and other pressures. In addition, assets and liabilities within the same period may, in fact, be repaid at different times and at different rate levels. We have not experienced the kind of earnings volatility that might be indicated from gap analysis. 49 -------------------------------------------------------------------------------- The Bank currently uses a computer simulation model to better measure the impact of interest rate changes on net interest income. We use the model as part of our risk management and asset liability management processes that we believe will effectively identify, measure, and monitor the Bank's risk exposure. In this analysis, the Bank examines the results of movements in interest rates with additional assumptions made concerning the timing of interest rate changes, prepayment speeds on mortgage loans and mortgage securities and deposit pricing movements. Shock scenarios, which assume a parallel shift in interest rates and is instantaneous, typically have the greatest impact on net interest income. The following is a rate shock analysis and the impact on net interest income as ofDecember 31, 2019 (dollars in thousands): Change In % Change In Prospective Prospective Prospective One-Year Changes Net Interest Net Interest Income Net Interest in Rates Income Income -100 Shock$ 50,418 $ (146 ) (0.29 ) Base 50,564 - - +100 Shock 49,572 (992 ) (1.96 ) +200 Shock 48,508 (2,056 ) (4.07 ) +300 Shock 47,389 (3,175 ) (6.28 ) +400 Shock 46,152 (4,412 ) (8.73 ) The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage backed securities, call activity of other investment securities, and deposit selection, re-pricing and maturity structure. Because of these assumptions, actual results could differ significantly from these estimates which would result in significant differences in the calculated projected change on net interest income. Additionally, the changes above do not necessarily represent the level of change under which management would undertake specific measures to realign its portfolio in order to reduce the projected level of change. The projections above utilize a static balance sheet and do not include any changes that may result from the growth of the Bank. Management has developed policy limits for acceptable changes in net interest income for multiple scenarios, including shock scenarios. As ofDecember 31, 2019 , changes in net interest income projected for all scenarios, including the shock scenarios noted above are in line with Bank policy limits for interest rate risk. CRITICAL ACCOUNTING POLICIES The Company's accounting policies are integral to understanding the results reported. The accounting policies are described in detail in Note 1 of the consolidated financial statements. Our most complex accounting policies require management's judgment to ascertain the valuation of assets, liabilities, commitments and contingencies. We have established detailed policies and control procedures that are intended to ensure valuation methods are well controlled and applied consistently from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. The following is a brief description of our current accounting policies involving significant management valuation judgments. Other than Temporary Impairment All securities are evaluated periodically to determine whether a decline in their value is other than temporary and is a matter of judgment. For debt securities, management considers whether the present value of cash flows expected to be collected are less than the security's amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company's intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the Company does not intend to sell the security, and it is more-likely-than-not that it will not be required to sell the security, before recovery of the security's amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. 50 -------------------------------------------------------------------------------- Allowance for Loan Losses Arriving at an adequate level of allowance for loan losses involves a high degree of judgment. The Company's allowance for loan losses provides for probable losses based upon evaluations of known and inherent risks in the loan portfolio. Management uses historical information to assess the adequacy of the allowance for loan losses as well as the prevailing business environment; as it is affected by changing economic conditions and various external factors, which may impact the portfolio in ways currently unforeseen. This evaluation is inherently subjective as it requires significant estimates that may be susceptible to significant change, subjecting the Bank to volatility of earnings. The allowance is increased by provisions for loan losses and by recoveries of loans previously charged-off and reduced by loans charged-off. For a full discussion of the Company's methodology of assessing the adequacy of the allowance for loan losses, refer to Note 1 of the consolidated financial statements.Goodwill and Other Intangible Assets As discussed in Note 1 of the consolidated financial statements, the Company performs an evaluation of goodwill for impairment on an annual basis, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company performed a qualitative assessment to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying value. Based on the fair value of the reporting unit, no impairment of goodwill was recognized in 2019, 2018 or 2017. Pension Benefits Pension costs and liabilities are dependent on assumptions used in calculating such amounts. These assumptions include discount rates, benefits earned, interest costs, expected return on plan assets, mortality rates, and other factors. In accordance with GAAP, actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, generally affect recognized expense and the recorded obligation of future periods. While management believes that the assumptions used are appropriate, differences in actual experience or changes in assumptions may affect the Company's pension obligations and future expense. Our pension benefits are described further in Note 11 of the "Notes to Consolidated Financial Statements." Deferred Tax Assets We use an estimate of future earnings to support our position that the benefit of our deferred tax assets will be realized. If future income should prove non-existent or less than the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and our net income will be reduced. Management also evaluates deferred tax assets to determine if it is more likely than not that the deferred tax benefit will be utilized in future periods. If not, a valuation allowance is recorded. Our deferred tax assets are described further in Note 12 of the consolidated financial statements. ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. This information is included under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate and Market Risk Management", appearing in this Annual Report on Form 10-K. 51
--------------------------------------------------------------------------------
© Edgar Online, source
