FIRST NATIONAL CORPORATION Cautionary Statement Regarding Forward-Looking Statements
First National Corporation (the Company) makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include, but are not limited to, statements regarding profitability, liquidity, adequacy of capital, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and the impact of the Company's acquisitions ofThe Bank of Fincastle (Fincastle ) and the SmartBank loan portfolio, including the expected benefits of the acquisition ofFincastle (Merger) and the potential impact of the acquisitions on the Company's andFirst Bank's (the Bank) financial and other goals. The words "believes," "expects," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends," or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:
• the effects of the COVID-19 pandemic, including its potential adverse effect
on economic conditions and the Company's employees, customers, credit quality,
and financial performance;
• general business conditions, as well as conditions within the financial
markets;
• general economic conditions, including unemployment levels, inflation and
slowdowns in economic growth;
• the Company's branch and market expansions, technology initiatives and other
strategic initiatives?
• the impact of competition from banks and non-banks, including financial
technology companies (Fintech)?
• the composition of the loan and deposit portfolio, including the types of
accounts and customers, may change, which could impact the amount of net
interest income and noninterest income in future periods, including revenue
from service charges on deposits?
• limited availability of financing or inability to raise capital?
• reliance on third parties for key services?
• the Company's credit standards and its on-going credit assessment processes
might not protect it from significant credit losses?
• the quality of the loan portfolio and the value of the collateral securing
those loans?
• demand for loan products;
• deposit flows;
• the level of net charge-offs on loans and the adequacy of the allowance for
loan losses?
• the concentration in loans secured by real estate may adversely affect
earnings due to changes in the real estate markets?
• the value of securities held in the Company's investment portfolio?
• legislative or regulatory changes or actions, including the effects of changes
in tax laws?
• accounting principles, policies and guidelines and elections made by the
Company thereunder?
• cyber threats, attacks or events?
• the ability to maintain adequate liquidity by retaining deposit customers and
secondary funding sources, especially if the Company's reputation would become
damaged?
• monetary and fiscal policies of the
of those policies on interest rates and business in the Company's markets;
• changes in interest rates could have a negative impact on the Company's net
interest income and an unfavorable impact on the Company's customers' ability
to repay loans?
geopolitical conditions, including acts or threats of terrorism, international
• hostilities, or actions taken by the
acts or threats of terrorism and/or military conflicts, which could impact
business and economic conditions in the
• other factors identified in Item 1A. Risk Factors of the Company's Form 10-K
for the year ending December 31, 2021 .
Because of these and other uncertainties, actual results may be materially
different from the results indicated by these forward-looking statements. In
addition, past results of operations do not necessarily indicate future results.
The following discussion and analysis of the financial condition at June 30,
2022 and statements of income of the Company for the three andsix months ended
June 30, 2022 and 2021 should be read in conjunction with the consolidated
financial statements and related notes included in Part I, Item 1, of this
Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending
December 31, 2021 . The statements of income for the three andsix months ended
June 30, 2022 may not be indicative of the results to be achieved for the year.
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Table of Contents Executive Overview The Company
•First Bank (the Bank). The Bank owns: •First Bank Financial Services, Inc. •Bank of Fincastle Services, Inc. •ESF, LLC •Shen-Valley Land Holdings, LLC •First National (VA) Statutory Trust II (Trust II)
•
II, the Trusts)
First Bank Financial Services, Inc. invests in entities that provide title
insurance and investment services. Bank of Fincastle Services, Inc. owns an
entity that provides mortgage services. Shen-Valley Land Holdings, LLC and ESF,
LLC were formed to hold other real estate owned and future office sites. The
Trusts were formed for the purpose of issuing redeemable capital securities,
commonly known as trust preferred securities and are not included in the
Company's consolidated financial statements in accordance with authoritative
accounting guidance because management has determined that the Trusts qualify as
variable interest entities.
Products, Services, Customers and Locations
The Bank offers loan, deposit, and wealth management products and services. Loan products and services include consumer loans, residential mortgages, home equity loans, and commercial loans. Deposit products and services include checking accounts, treasury management solutions, savings accounts, money market accounts, certificates of deposit, and individual retirement accounts. Wealth management services include estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, and estate settlement. Customers include small and medium-sized businesses, individuals, estates, local governmental entities, and non-profit organizations. The Bank's office locations are well-positioned in attractive markets along theInterstate 81 ,Interstate 66 , andInterstate 64 corridors in theShenandoah Valley , theRoanoke Valley , central regions ofVirginia , and the city ofRichmond . Within these markets, there are diverse types of industry including medical and professional services, manufacturing, retail, warehousing, Federal and local government, hospitality, and higher education. The Bank's products and services are delivered through 20 bank branch offices, a loan production office and customer service centers in two retirement villages. For the location and general character of each of these offices, see Item 2 of the Company's Form 10-K for the year endedDecember 31, 2021 . Many of the Bank's services are also delivered through the Bank's mobile banking platform, its website, www.fbvirginia.com, and a network of ATMs located throughout its market area.
Revenue Sources and Expense Factors
The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 70% and 80% of the Company's total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank's interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on deposits, fee income from wealth management services, and ATM and check card fees. Primary expense categories are salaries and employee benefits, which comprised 58% of noninterest expenses for the six months endedJune 30, 2022 , followed by occupancy and equipment expense, which comprised 13% of noninterest expenses. The provision for loan losses is also typically a primary expense of the Bank. The provision is determined by factors that include net charge-offs, asset quality, economic conditions, and loan growth. Changing economic conditions caused by inflation, recession, unemployment, or other factors beyond the Company's control have a direct correlation with asset quality, net charge-offs, and ultimately the required provision for loan losses. 31
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Overview of Quarterly Financial Performance
The following items had the most significant impact on financial performance, when comparing the second quarter of 2022 to the same period in 2021.
? The acquisition of
on balance sheet growth. On
total assets of
million, total securities of
loan losses, of $191.5 million , and total deposits of $236.3 million .
? The acquisition of the SmartBank loan portfolio from its
impacted the composition of the Bank's earning assets. On
the acquisition date, the loan portfolio totaled
funded the acquisition of the loan portfolio with cash, which decreased
interest-bearing deposits in banks in the third quarter of 2021.
? The provision for loan losses totaled
2022, which was a
losses of $1.0 million in the second quarter of 2021.
? Total loans increased
30, 2022.
? Accretion of PPP income, net of costs decreased to
quarter of 2022, compared to
year.
? Accretion of purchased loan discounts, net of premium amortization, totaled
accretion for the same period in the prior year
Net income increased by $493 thousand , or 15%, to $3.8 million , or $0.61 per
diluted share, for the three months ended June 30, 2022 , compared to $3.3
million , or $0.69 per diluted share, for the same period in 2021. Return on
average assets was 1.08% and return on average equity was 15.04% for the second
quarter of 2022, compared to 1.31% and 15.33%, respectively, for the same period
in 2021.
The increase in net income resulted primarily from a $3.8 million , or 51%,
increase in net interest income and a $345 thousand , or 14%, increase in total
noninterest income, which were partially offset by a $2.3 million , or 35%,
increase in total noninterest expense and an increase in the provision for loan
losses. The provision for loan losses totaled $400 thousand for the second
quarter of 2022, compared to a recovery of loan losses of $1.0 million for the
same period of 2021.
The $3.8 million , or 51%, increase in net interest income resulted from an
increase in total interest income and no change in total interest expense. Net
interest income increased as the net interest margin expanded by 32 basis points
and average earning assets increased by 37%. The margin expansion resulted from
an increase in earning asset yields, a change in the earning asset composition,
and a decrease in the cost of funds. Earning asset yields increased by 25 basis
points from a higher interest rate environment during the second quarter of
2022, while the cost of funds decreased by 7 basis points, primarily from lower
interest rates paid on deposits and subordinated debt. The change in the earning
asset composition favorably impacted the net interest margin as average total
securities increased and average interest-bearing deposits in banks decreased.
The growth in earning assets resulted from both the acquisition of Fincastle and
from deposit growth.
The provision for loan losses totaled $400 thousand for the second quarter of
2022 in contrast to the second quarter of 2021 when the Bank recorded a $1.0
million recovery of loan losses. The allowance for loan losses totaled $6.2
million , or 0.70% of total loans on June 30, 2022 , 0.69% of total loans on
December 31, 2021 , and 0.89% of total loans on June 30, 2021 .
The $345 thousand , or 14%, year-over-year quarterly increase in noninterest
income was primarily a result of a $251 thousand increase in service charges on
deposits, followed by increases in ATM and check card fees, wealth management
fees, and an increase in fees for other customer services. The merger with
Fincastle contributed to all increased income categories, except for wealth
management fees. The increases were partially offset by decreases in brokered
mortgage fees and other operating income.
Noninterest expense increased $2.3 million , or 35%, and was primarily
attributable to the increase in the number of employees, branch offices and
customers that resulted from the acquisition of Fincastle and the acquisition of
the SmartBank loan portfolio. Salaries and employee benefits increased by $1.4
million , followed by increases in occupancy, equipment, and other operating
expense.
For a more detailed discussion of the Company's quarterly performance, see "Net Interest Income," "Provision for Loan Losses," "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.
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Acquisition of
OnJuly 1, 2021 , the Company completed the acquisition ofThe Bank of Fincastle for an aggregate purchase price of$33.8 million of cash and stock. The Company paid cash consideration of$6.8 million and issued 1,348,065 shares of its common stock to the shareholders ofFincastle . Upon completion of the transaction,Fincastle was merged with and intoFirst Bank . At the time of closing of the acquisition,The Bank of Fincastle had six bank branch offices operating in theRoanoke Valley region ofVirginia and reported total assets of$267.9 million , total loans of$194.5 million and total deposits of$236.3 million . After the merger, the former Fincastle branches continued to operate asThe Bank of Fincastle , a division ofFirst Bank , until the systems were converted onOctober 16, 2021 . All branch offices have been operating asFirst Bank since the system conversion. For the three and six months endedJune 30, 2022 , the Company recorded merger related expenses of$20 thousand in connection with the acquisition ofFincastle . Purchased performing loans were recorded at fair value, including a credit discount. The fair value discount will be accreted as an adjustment to yield over the estimated lives of the loans. A provision for loan losses on the purchased loans is expected in future periods as the accretion decreases the fair value discount amount. A provision may also be required for any deterioration in these loans in future periods.
The Company expected to benefit from cost savings after the acquisition of
Acquisition of SmartBank Loan Portfolio
OnSeptember 30, 2021 , the Bank acquired$82.6 million of loans and certain fixed assets from SmartBank related to itsRichmond area branch, located inGlen Allen, Virginia .First Bank paid cash consideration of$83.7 million for the loans and fixed assets. Additionally, an experienced team of bankers based out of the SmartBank location have transitioned to become employees ofFirst Bank .First Bank did not assume any deposit liabilities from SmartBank in connection with the transaction, and SmartBank closed their branch operation onDecember 31, 2021 .First Bank assumed the facility lease and acquired the remaining assets at the branch onDecember 31, 2021 and now operates a loan production office in the location of the former SmartBank branch. The Company incurred expenses totaling$101 thousand related to the acquisition of loans and fixed assets of SmartBank in the fourth quarter of 2021. There were no additional expenses related to the acquisition for the three and six months endedJune 30, 2022 . Non-GAAP Financial Measures This report refers to the efficiency ratio, which is computed by dividing noninterest expense, excluding amortization of intangibles, net gains on disposal of premises and equipment, and merger related expenses, by the sum of net interest income on a tax-equivalent basis and noninterest income, excluding securities gains. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with GAAP and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands). Efficiency Ratio Three Months Ended Six Months Ended June 30, 2022 June 30, 2021 June 30, 2022 June 30, 2021 Noninterest expense $ 8,918 $ 6,630$ 17,562 $ 13,280 Add/(Subtract): other real estate owned (expense), net (41 ) - (69 ) - Subtract: amortization of intangibles (5 ) (5 ) (9 ) (19 ) Add: gains on disposal of premises and equipment, net - 14 - 26 Subtract: loss on disposal of premises and equipment, net - - (2 ) - Subtract: merger related expenses - (277 ) (20 ) (682 ) $ 8,872 $ 6,362$ 17,462 $ 12,605 Tax-equivalent net interest income$ 11,372 $ 7,560$ 22,008 $ 15,128 Noninterest income 2,780 2,435 5,491 4,578 Subtract: securities gains, net - - - (37 )$ 14,152 $ 9,995$ 27,499 $ 19,669 Efficiency ratio 62.69 % 63.65 % 63.50 % 64.09 % 33
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This report also refers to net interest margin, which is calculated by dividing
tax equivalent net interest income by total average earning assets. Because a
portion of interest income earned by the Company is nontaxable, the tax
equivalent net interest income is considered in the calculation of this ratio.
Tax equivalent net interest income is calculated by adding the tax benefit
realized from interest income that is nontaxable to total interest income then
subtracting total interest expense. The tax rate utilized in calculating the tax
benefit for both 2022 and 2021 is 21%. The reconciliation of tax equivalent net
interest income, which is not a measurement under GAAP, to net interest income,
is reflected in the table below (in thousands).
Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income
Three Months Ended Six Months Ended
June 30, June 30,
2022 June 30, 2021 2022 June 30, 2021
GAAP measures:
Interest income - loans $ 9,963 $ 7,074 $ 19,459 $ 14,217
Interest income - investments and other 1,876 971 3,404 1,923
Interest expense - deposits (413 ) (328 ) (753 ) (691 )
Interest expense - subordinated debt (69 ) (154 ) (138 ) (308 )
Interest expense - junior subordinated
debt (67 ) (68 ) (134 ) (134 )
Total net interest income $ 11,290 $ 7,495 $ 21,838 $ 15,007
Non-GAAP measures:
Tax benefit realized on non-taxable
interest income - loans $ - $ 8 $ 7 $ 16
Tax benefit realized on non-taxable
interest income - municipal securities 82 57 163 105
Total tax benefit realized on
non-taxable interest income $ 82 $ 65 $ 170 $ 121
Total tax-equivalent net interest income
Critical Accounting Policies
General
The Company's consolidated financial statements and related notes are prepared
in accordance with GAAP. The financial information contained within the
statements is, to a significant extent, financial information that is based on
measures of the financial effects of transactions and events that have already
occurred. A variety of factors could affect the ultimate value that is obtained
either when earning income, recognizing an expense, recovering an asset, or
relieving a liability. The Bank uses historical losses as one factor in
determining the inherent loss that may be present in the loan portfolio. Actual
losses could differ significantly from the historical factors used. In addition,
GAAP itself may change from one previously acceptable method to another.
Although the economics of transactions would be the same, the timing of events
that would impact transactions could change.
Presented below is a discussion of those accounting policies that management
believes are the most important (Critical Accounting Policies) to the portrayal
and understanding of the Company's financial condition and results of
operations. The Critical Accounting Policies require management's most
difficult, subjective, and complex judgments about matters that are inherently
uncertain. In the event that different assumptions or conditions were to
prevail, and depending upon the severity of such changes, the possibility of
materially different financial condition or results of operations is a
reasonable likelihood.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. Loan losses
are charged against the allowance when management determines that the loan
balance is uncollectible. Subsequent recoveries, if any, are credited to the
allowance. For further information about the Company's loans and the allowance
for loan losses, see Notes 3 and 4 to the Consolidated Financial Statements
included in this Form 10-Q.
The allowance for loan losses is evaluated on a quarterly basis by management
and is based upon management's periodic review of the collectability of the
loans in light of historical experience, the nature and volume of the loan
portfolio, adverse situations that may affect the borrower's ability to repay,
estimated value of any underlying collateral, and prevailing economic
conditions. This evaluation is inherently subjective as it requires estimates
that are susceptible to significant revision as more information becomes
available.
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The Company performs regular credit reviews of the loan portfolio to review credit quality and adherence to underwriting standards. The credit reviews consist of reviews by its internal credit administration department and reviews performed by an independent third party. Upon origination, each loan is assigned a risk rating ranging from one to nine, with loans closer to one having less risk. This risk rating scale is the Company's primary credit quality indicator. The Company has various committees that review and ensure that the allowance for loans losses methodology is in accordance with GAAP and loss factors used appropriately reflect the risk characteristics of the loan portfolio. The allowance represents an amount that, in management's judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management's judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower's ability to repay and the value of the collateral, overall portfolio quality, and review of specific potential losses. The evaluation also considers the following risk characteristics of each loan portfolio class:
• 1-4 family residential mortgage loans carry risks associated with the
continued creditworthiness of the borrower and changes in the value of the
collateral.
• Real estate construction and land development loans carry risks that the
project may not be finished according to schedule, the project may not be
finished according to budget, and the value of the collateral may, at any
point in time, be less than the principal amount of the loan. Construction
loans also bear the risk that the general contractor, who may or may not be a
loan customer, may be unable to finish the construction project as planned
because of financial pressure or other factors unrelated to the project.
• Other real estate loans carry risks associated with the successful operation
of a business or a real estate project, in addition to other risks associated
with the ownership of real estate, because repayment of these loans may be
dependent upon the profitability and cash flows of the business or project.
• Commercial and industrial loans carry risks associated with the successful
operation of a business because repayment of these loans may be dependent upon
the profitability and cash flows of the business. In addition, there is risk
associated with the value of collateral other than real estate which may
depreciate over time and cannot be appraised with as much reliability.
• Consumer and other loans carry risk associated with the continuedcreditworthiness of the borrower and the value of the collateral, if any.
Consumer loans are typically either unsecured or secured by rapidly
depreciating assets such as automobiles. These loans are also likely to be
immediately and adversely affected by job loss, divorce, illness, personal
bankruptcy, or other changes in circumstances. Other loans included in this
category include loans to states and political subdivisions.
The allowance for loan losses consists of specific and general components. The
specific component relates to loans that are classified as impaired, and is
established when the discounted cash flows, fair value of collateral less
estimated costs to sell, or observable market price of the impaired loan is
lower than the carrying value of that loan. For collateral dependent loans, an
updated appraisal is ordered if a current one is not on file. Appraisals are
typically performed by independent third-party appraisers with relevant industry
experience. Adjustments to the appraised value may be made based on recent sales
of like properties or general market conditions among other considerations.
The general component covers loans that are not considered impaired and is based
on historical loss experience adjusted for qualitative factors. The historical
loss experience is calculated by loan type and uses an average loss rate during
the preceding twelve quarters. The qualitative factors are assigned by
management based on delinquencies and asset quality, national and local economic
trends, effects of the changes in the value of underlying collateral, trends in
volume and nature of loans, effects of changes in the lending policy, the
experience and depth of management, concentrations of credit, quality of the
loan review system, and the effect of external factors such as competition and
regulatory requirements. The factors assigned differ by loan type. The general
allowance estimates losses whose impact on the portfolio has yet to be
recognized by a specific allowance. Allowance factors and the overall size of
the allowance may change from period to period based on management's assessment
of the above described factors and the relative weights given to each factor.
For further information regarding the allowance for loan losses, see Note 4 to
the Consolidated Financial Statements included in this Form 10-Q.
Loans acquired from Fincastle and SmartBank were recorded at fair value. There
was $254 thousand of allowance for loan losses attributable to purchased loans
at June 30, 2022 .
Loans Acquired in a Business Combination
Acquired loans are classified as either (i) purchased credit-impaired (PCI) loans or (ii) purchased performing loans and are recorded at fair value on the date of acquisition.
PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Corporation will not collect all contractually required principal and interest payments. When determining fair value, PCI loans are aggregated into pools of loans based on common risk characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the "nonaccretable difference." Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the "accretable yield" and is recognized as interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows. There were no acquired loans classified as PCI in the acquisition of theFincastle and the SmartBank loan portfolios.
Goodwill arises from business combinations and is determined as the excess fair value of the consideration transferred over the fair value of the net assets acquired and liabilities assumed as of the acquisition date.Goodwill and intangible assets acquired in a business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed. The Company has selectedJune 30 as the date to perform the annual impairment test. Intangible assets with finite useful lives are amortized over their estimated useful lives to their estimated residual values.Goodwill is the only intangible asset with an indefinite life on the balance sheet. Other intangible assets consist of core deposit intangible assets arising from whole bank and branch acquisitions and are amortized on an accelerated method over their estimated useful lives, which range from 6 to 10 years. 35
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Table of Contents Lending Policies
There have been no material changes in the Company's lending policies disclosed
in the Annual Report on Form 10-K for the year ended
Results of Operations General Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on interest-earning assets, predominantly loans and securities, exceeds interest expense on interest-bearing liabilities, including deposits, other borrowings, subordinated debt, and junior subordinated debt. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, are the components that impact the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The provision for loan losses, noninterest income, and noninterest expense are the other components that determine net income. Noninterest income and expense primarily consists of income from service charges on deposit accounts, revenue from wealth management services, ATM and check card income, revenue from other customer services, income from bank owned life insurance, general and administrative expenses, amortization expense, and other real estate owned expense. Net Income
Three Month Period Ended
Net income increased by$493 thousand , or 15%, to$3.8 million , or$0.61 per diluted share, for the three months endedJune 30, 2022 , compared to$3.3 million , or$0.69 per diluted share, for the same period in 2021. Return on average assets was 1.08% and return on average equity was 15.04% for the second quarter of 2022, compared to 1.31% and 15.33%, respectively, for the same period in 2021. The increase in net income resulted primarily from a$3.8 million , or 51%, increase in net interest income and a$345 thousand , or 14%, increase in total noninterest income, which were partially offset by a$2.3 million , or 35%, increase in total noninterest expense and an increase in the provision for loan losses. The provision for loan losses totaled$400 thousand for the second quarter of 2022, compared to a recovery of loan losses of$1.0 million for the same period of 2021.
Six Month Period Ended
Net income increased by$1.8 million , or 31%, to$7.6 million , or$1.21 per diluted share, for the six months endedJune 30, 2022 , compared to$5.8 million , or$1.19 per diluted share, for the same period in 2021. Return on average assets was 1.07% and return on average equity was 14.16% for the six months endedJune 30, 2022 , compared to 1.15% and 13.44%, respectively, for the same period in 2021. The increase in net income resulted primarily from a$6.8 million , or 46%, increase in net interest income and a$913 thousand , or 20%, increase in total noninterest income, which were partially offset by a$4.3 million , or 32%, increase in total noninterest expense and an increase in the provision for loan losses. The provision for loan losses totaled$400 thousand for the six months endedJune 30, 2022 , compared to a recovery of loan losses of$1.0 million for the same period of 2021. Net Interest Income
Three Month Period Ended
Net interest income increased$3.8 million , or 51%, comparing the second quarter of 2022 to the same period of 2021, and was positively impacted by a higher interest rate environment, a significant increase in average earning assets, and a change in the Company's earning asset composition. During the second quarter of 2022, the high-end of the Federal funds target increased from 0.50% to 1.75%, compared to a Federal funds rate that remained at 0.25% throughout the second quarter of 2021. The higher rate environment resulted in a 14-basis point increase in the yield on loans and a 72-basis point increase in the yield on interest-bearing deposits in other banks, while the total cost of interest-bearing deposits decreased two basis points. The cost of subordinated debt decreased by 64-basis points from the redemption of$5.0 million of higher rate subordinated debt onJanuary 1, 2022 . Although the Federal funds rate increased by 150 basis points, the Company's total cost of funds decreased seven basis points, when comparing the periods. Average earning assets increased$358.0 million , or 37%, as a result of the acquisition ofFincastle in the third quarter of 2021 and growth of the Bank's deposit portfolio over the last twelve months. Additionally, the composition of earning assets contributed to the increase in total interest and dividend income as total average securities increased from 20% to 27% of average earning assets, while average interest-bearing deposits in other banks decreased from 16% to 9%. Average loans were unchanged at 64% of average earning assets when comparing the same periods. The$3.8 million increase in net interest income resulted from a$3.8 million , or 47%, increase in total interest and dividend income, while total interest expense was unchanged. The increase in total interest and dividend income was attributable to a$2.9 million increase in interest income and fees on loans, a$214 thousand increase in interest on deposits in banks, and a$691 thousand increase in interest income and dividends on securities. There was no change in total interest expense as an increase in interest expense on deposits was offset by a decrease in interest expense on subordinated debt. The net interest margin increased to 3.42%, a 32-basis point increase from 3.10% in the same period one year ago. Accretion of PPP income, net of costs, and accretion of discounts on purchased loans, net of premiums, were included in interest and fees on loans. Net accretion of PPP income totaled$35 thousand in the second quarter of 2022, compared to$509 thousand for the same period of 2021. Net accretion of discounts on purchased loans totaled$351 thousand in the second quarter of 2022. There were no purchased loans in the second quarter of 2021, and as a result, there was no net accretion of discounts on purchased loans during the period.
Six Month Period Ended
Net interest income increased$6.8 million , or 46%, comparing the six months endedJune 30, 2022 , to the same period of 2021, and was positively impacted by a higher interest rate environment, a significant increase in average earning assets, and a change in the Company's earning asset composition. During the six months endedJune 30, 2022 , the high-end of the Federal funds target increased from 0.25% to 1.75%, compared to a Federal funds rate that remained at 0.25% throughout the same period of 2021. The higher rate environment resulted in a 11-basis point increase in the yield on loans and a 34-basis point increase in the yield on interest-bearing deposits in other banks, while the cost of interest-bearing deposits decreased six basis points. The cost of subordinated debt decreased by 133-basis points from the redemption of$5.0 million of higher rate subordinated debt onJanuary 1, 2022 . Although the Federal funds rate increased by 150 basis points, the Company's total cost of funds decreased nine basis points, when comparing the periods. Average earning assets increased$353.8 million , or 37%, as a result of the acquisition ofFincastle in the third quarter of 2021 and growth of the Bank's deposit portfolio over the last twelve months. Additionally, the composition of earning assets contributed to the increase in total interest and dividend income as total average securities increased from 18% to 24% of average earning assets, while average interest-bearing deposits in other banks decreased from 16% to 12% and average loans decreased from 66% to 64%. The$6.8 million increase in net interest income resulted from a$6.7 million , or 42%, increase in total interest and dividend income, while total interest expense decreased by$108 thousand . The increase in total interest and dividend income was attributable to a$5.2 million increase in interest income and fees on loans, a$251 thousand increase in interest on deposits in banks, and a$1.2 million increase in interest income and dividends on securities. The decrease in total interest expense resulted from a$170 thousand decrease in interest expense on subordinated debt, which was partially offset by a$62 thousand increase in interest expense on deposits. The net interest margin increased to 3.39%, a 30-basis point increase from 3.19% in the same period one year ago. Accretion of PPP income, net of costs, and accretion of discounts on purchased loans, net of premiums, were included in interest and fees on loans. Net accretion of PPP income totaled$358 thousand for the six months endedJune 30, 2022 , compared to$1.1 million for the same period of 2021. Net accretion of discounts on purchased loans totaled$718 thousand for the six months endedJune 30, 2022 . There were no purchased loans in the six months endedJune 30, 2021 , and as a result, there was no net accretion of discounts on purchased loans during the period. 36
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The following tables show interest income on earning assets and related average
yields as well as interest expense on interest-bearing liabilities and related
average rates paid for the periods indicated (dollars in thousands):
Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent
Basis)
Three Months Ended
June 30, 2022 June 30, 2021
Interest Interest
Average Balance Income/Expense Yield/Rate Average Balance Income/Expense Yield/Rate
Assets
Securities:
Taxable $ 296,318 $ 1,295 1.75 % $ 147,285 $ 697 1.90 %
Tax-exempt (1) 55,908 391 2.81 % 42,712 271 2.54 %
Restricted 1,908 21 4.48 % 1,631 22 5.37 %
Total securities $ 354,134 $ 1,707 1.93 % $ 191,628 $ 990 2.07 %
Loans: (2)
Taxable $ 858,045 $ 9,963 4.66 % $ 625,587 $ 7,044 4.52 %
Tax-exempt (1) - - - 3,400 38 4.49 %
Total loans $ 858,045 $ 9,963 4.66 % $ 628,987 $ 7,082 4.52 %
Federal funds sold - - - - - -
Interest-bearing deposits with other
institutions 122,797 251 0.82 % 156,317 38 0.10 %
Total earning assets $ 1,334,976 $ 11,921 3.58 % $ 976,932 $ 8,110 3.33 %
Less: allowance for loan losses (5,845 ) (7,466 )
Total non-earning assets 90,747 57,117
Total assets $ 1,419,878 $ 1,026,583
Liabilities and Shareholders' Equity
Interest bearing deposits:
Checking $ 300,473 $ 157 0.21 % $ 233,720 $ 100 0.17 %
Regular savings 209,513 26 0.05 % 134,266 20 0.06 %
Money market accounts 220,182 75 0.14 % 160,462 45 0.11 %
Time deposits:
$100,000 and over 62,346 80 0.51 % 40,212 83 0.83 %
Under $100,000 75,025 75 0.40 % 55,485 80 0.57 %
Brokered 553 - 0.12 % 578 - 0.20 %
Total interest-bearing deposits $ 868,092 $ 413 0.19 % $ 624,723 $ 328 0.21 %
Federal funds purchased 2 - - % - - 0.00 %
Subordinated debt 4,994 69 5.56 % 9,992 155 6.20 %
Junior subordinated debt 9,279 67 2.91 % 9,279 67 2.91 %
Total interest-bearing liabilities $ 882,367 $ 549 0.25 % $ 643,994 $ 550 0.34 %
Non-interest bearing liabilities
Demand deposits 431,995 292,960
Other liabilities 3,247 2,187
Total liabilities $ 1,317,609 $ 939,141
Shareholders' equity 102,269 87,442
Total liabilities and Shareholders'
equity $ 1,419,878 $ 1,026,583
Net interest income $ 11,372 $ 7,560
Interest rate spread 3.33 % 2.99 %
Cost of funds 0.17 % 0.24 %
Interest expense as a percent of
average earning assets 0.16 % 0.23 %
Net interest margin 3.42 % 3.10 %
(1) Income and yields are reported on a taxable-equivalent basis assuming a
federal tax rate of 21%. The tax-equivalent adjustment was
thousand for the three months ended
(2) Loans on non-accrual status are reflected in the balances.
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Six Months Ended
June 30, 2022 June 30, 2021
Interest Interest
Average Balance Income/Expense Yield/Rate Average Balance Income/Expense Yield/Rate
Assets
Securities:
Taxable $ 257,529 $ 2,427 1.90 % $ 135,305 $ 1,413 2.11 %
Tax-exempt (1) 58,647 777 2.67 % 38,856 499 2.59 %
Restricted 1,867 42 4.60 % 1,738 44 5.12 %
Total securities $ 318,043 $ 3,246 2.06 % $ 175,899 $ 1,956 2.24 %
Loans: (2)
Taxable $ 841,608 $ 19,439 4.66 % $ 628,012 $ 14,157 4.55 %
Tax-exempt (1) 1,106 27 4.49 % 3,412 76 4.49 %
Total loans $ 842,714 $ 19,466 4.66 % $ 631,424 $ 14,233 4.55 %
Federal funds sold - - - 67 - 0.10 %
Interest-bearing deposits with other
institutions 150,222 321 0.43 % 149,786 70 0.09 %
Total earning assets $ 1,310,979 $ 23,033 3.54 % $ 957,176 $ 16,259 3.43 %
Less: allowance for loan losses (5,806 ) (7,475 )
Total non-earning assets 120,409 59,929
Total assets $ 1,425,582 $ 1,009,630
Liabilities and Shareholders' Equity
Interest bearing deposits:
Checking $ 295,005 $ 256 0.17 % $ 230,723 $ 217 0.19 %
Regular savings 208,163 51 0.05 % 130,262 39 0.06 %
Money market accounts 233,496 126 0.11 % 157,902 88 0.11 %
Time deposits:
$100,000 and over 63,429 163 0.52 % 41,392 182 0.88 %
Under $100,000 76,566 154 0.40 % 55,667 164 0.60 %
Brokered 558 3 1.03 % 586 1 0.43 %
Total interest-bearing deposits $ 877,217 $ 753 0.17 % $ 616,532 $ 691 0.23 %
Federal funds purchased 2 - - 1 - 0.47 %
Subordinated debt 5,708 138 4.89 % 9,992 308 6.22 %
Junior subordinated debt 9,279 134 2.91 % 9,279 134 2.91 %
Other borrowings - - - % - - 0.00 % Total interest-bearing liabilities $ 892,206 $ 1,025
0.23 % $ 635,804 $ 1,133 0.36 %
Non-interest bearing liabilities
Demand deposits 421,785 284,542
Other liabilities 3,904 2,617
Total liabilities $ 1,317,895 $ 922,963
Shareholders' equity 107,686 86,667
Total liabilities and Shareholders'
equity $ 1,425,581 $ 1,009,630
Net interest income $ 22,008 $ 15,126
Interest rate spread 3.31 % 3.07 %
Cost of funds 0.16 % 0.25 %
Interest expense as a percent of
average earning assets 0.16 % 0.24 %
Net interest margin 3.39 % 3.19 %
(1) Income and yields are reported on a taxable-equivalent basis assuming a
federal tax rate of 21%. The tax-equivalent adjustment was
thousand for the six months ended
(2) Loans on non-accrual status are reflected in the balances.
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Table of Contents Provision for Loan Losses
Three Month Period Ended
The provision for loan losses totaled$400 thousand for the second quarter of 2022, compared to a$1.0 million recovery of loan losses for the same period of 2021. The provision for loan losses resulted primarily from an increase in the general reserve component of the allowance for loan losses, which was attributable to loan growth during the quarter. There were no specific reserves on impaired loans atJune 30, 2022 , compared to$78 thousand of specific reserves atJune 30, 2021 . Net charge-offs totaled$26 thousand during the second quarter of 2022, compared to$1.0 million of net charge-offs for the same period of 2021. The$1.0 million recovery of loan losses for the second quarter of 2021 resulted from the resolution of a previously impaired loan and a related decrease of the specific reserve component of the allowance for loan losses during the period. The allowance for loan losses totaled$6.2 million , or 0.70% of total loans atJune 30, 2022 , compared to$5.5 million , or 0.89% of total loans atJune 30, 2021 . The net discount on purchased loans totaled$2.9 million , or 0.33% of total loans atJune 30, 2022 . There were no discounts on purchased loans atJune 30, 2021 .
Six Month Period Ended
The provision for loan losses also totaled$400 thousand for the six months endedJune 30, 2022 , compared to a$1.0 million recovery of loan losses for the same period of 2021. Like the second quarter endedJune 30, 2022 , the provision for loan losses for the six-month period resulted primarily from an increase in the general reserve component of the allowance for loan losses and was attributable to loan growth. There were net recoveries of previously charged-off loans totaling$92 thousand for the first six months of 2022, compared to$1.0 of net charge-offs for the same period of 2021. Noninterest Income
Three Month Period Ended
Noninterest income increased$345 thousand , or 14%, to$2.8 million for the second quarter of 2022, compared to the same period of 2021. Service charges on deposits increased$251 thousand , or 56%, ATM and check card fees increased$115 thousand , or 17%, fees for other customer services increased$38 thousand , or 25%, and wealth management fees increased$103 thousand , or 16%. The increases were partially offset by a$99 thousand , or 63%, decrease in brokered mortgage fees, and a$77 thousand , or 34%, decrease in other operating income. The increases in service charges on deposits, ATM and check card fees, and fees for other customer services were favorably impacted by an increase in customer transactions and additional deposit accounts that resulted from the acquisition ofFincastle . The increase in wealth management income was attributable to an increase in the number of client accounts. Brokered mortgage fees and net gains on sale of loans held for sale decreased from a reduction in the number of mortgage loans originated, as well as an increase in the number of mortgage loans retained in the Bank's loan portfolio and not sold or brokered when comparing the periods. The decrease in other operating income was a result of income earned from an investment in a small business investment company partnership in the second quarter of 2021.
Six Month Period Ended
Noninterest income increased$913 thousand , or 20%, to$5.5 million for the six months endedJune 30, 2022 , compared to the same period of 2021. Service charges on deposits increased$418 thousand , or 47%, ATM and check card fees increased$264 thousand , or 21%, fees for other customer services increased$90 thousand , or 27%, and wealth management fees increased$263 thousand , or 20%. The increases were partially offset by a$110 thousand , or 42%, decrease in brokered mortgage fees and a$25 thousand decrease in gains on sale of loans held for sale. The increases in service charges on deposits, ATM and check card fees, and fees for other customer services were favorably impacted by an increase in customer transactions and additional deposit accounts that resulted from the acquisition ofFincastle . The increase in wealth management income was attributable to an increase in the number of client accounts. Brokered mortgage fees and net gains on sale of loans held for sale decreased from a reduction in the number of mortgage loans originated, as well as an increase in the number of mortgage loans retained in the Bank's loan portfolio and not sold or brokered when comparing the periods. 39
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Table of Contents Noninterest Expense
Three Month Period Ended
Noninterest expense increased$2.3 million , or 35%, to$8.9 million for the three-month period endedJune 30, 2022 , compared to the same period one year ago. The increase was primarily attributable to a$1.4 million , or 38% increase in salaries and employee benefits, a$146 thousand , or 37%, increase in occupancy expense, a$187 thousand , or 43%, increase in equipment expense, an$85 thousand , or 62%, increase in marketing, a$79 thousand , or 30%, increase in ATM and check card expense, and a$280 thousand , or 42%, increase in other operating expense. These increases were partially offset by a$102 thousand decrease in legal and professional fees. The increases were primarily attributable to the increase in the number of employees, branch offices and customers that resulted from the acquisition ofFincastle and the acquisition of the loan portfolio, branch assets and the addition of employees from the SmartBank office. The increase in marketing was also related to the timing of campaigns and promotion activities. The decrease in legal and professional fees was primarily attributable to merger related costs in the second quarter of 2021. Although there were no merger expenses in the second quarter of 2022, merger expenses totaled$277 thousand in the second quarter of 2021.
Six Month Period Ended
Noninterest expense increased$4.3 million , or 32%, to$17.6 million for the six-month period endedJune 30, 2022 , compared to the same period one year ago. The increase was primarily attributable to a$3.0 million , or 41% increase in salaries and employee benefits, a$315 thousand , or 36%, increase in equipment expense, a$271 thousand , or 32%, increase in occupancy expense, a$151 thousand , or 30%, increase in ATM and check card expense, a$137 thousand , or 93%, increase inFDIC assessment, a$130 thousand , or 53%, increase in marketing, a$114 thousand , or 34%, increase in bank franchise tax, and a$510 thousand , or 40%, increase in other operating expense. These increases were partially offset by a$506 thousand , or 41%, decrease in legal and professional fees. The increases were primarily attributable to the increase in the number of employees, branch offices and customers that resulted from the acquisition ofFincastle and the acquisition of the loan portfolio, branch assets and the addition of employees from the SmartBank office. The increase in marketing was also related to the timing of campaigns and promotion activities. The decrease in legal and professional fees was primarily attributable to merger related costs during the first six months of 2021. Merger expenses totaled$20 thousand for the first six months of 2022 compared to$682 thousand for the same period of 2021. Income Taxes
Three Month Period Ended
Income tax expense decreased$41 thousand for the second quarter of 2022, compared to the same period one year ago. The effective tax rate for the second quarter of 2022 was 19.3% compared to 22.3% for the same period in 2021. The reduced effective tax rate for 2022 was the result of lower non-deductible expenses in 2022 compared to 2021. The Company's income tax expense differed from the amount of income tax determined by applying theU.S. federal income tax rate to pretax income for the three months endedJune 30, 2022 , and 2021. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income, income from bank owned life insurance. A more detailed discussion of the Company's tax calculation is contained in Note 11 to the Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 .
Six Month Period Ended
Income tax expense increased$276 thousand , or 18%, for the first six months of 2022 compared with the same period in 2021. The effective tax rate for the first six months of 2022 was 19.2% compared with 20.9% for the same period in 2021. Like the three month period endedJune 30, 2022 , the reduced effective tax rate for 2022 was also the result of lower non-deductible expenses in 2022 compared to 2021. 40
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Table of Contents Financial Condition General Total assets increased$25.3 million to$1.4 billion atJune 30, 2022 , compared toDecember 31, 2021 . The increase was primarily attributable to an$54.5 million , or 7.0%, increase in loans, net of allowance for loan losses, and a$43.7 million , or 130.7%, increase in securities held to maturity. These increases were partially offset by a decrease in interest-bearing deposits in banks of$52.8 million , or 33.5%, and a decrease in securities available for sale of$24.7 million , or 8.5%, during the first quarter of 2022. AtJune 30, 2022 , total liabilities increased$42.0 million to$1.3 billion compared toDecember 31, 2021 . The increase was primarily attributable to an increase in savings and interest-bearing demand deposits of$41.1 million and in increase in noninterest-bearing deposits of$18.1 million . These increases were partially offset by a decrease in time deposits of$11.8 million during the first six months of 2022 and the Company's repayment of$5.0 million of subordinated debt onJanuary 1, 2022 . Total shareholders' equity decreased$16.7 million to$100.3 million atJune 30, 2022 , compared to$117.0 million atDecember 31, 2021 . This was primarily attributable to a$23.0 million decrease in accumulated other comprehensive (loss) income (AOCI). The decrease in AOCI is related to unrealized losses in the securities portfolio stemming from market rate increases during the first quarter. This decrease was partially offset by a$5.8 million increase in retained earnings. The Company's capital ratios continued to exceed the minimum capital requirements for regulatory purposes. Loans Loans, net of the allowance for loan losses, increased$54.5 million to$873.9 million atJune 30, 2022 , compared to$819.4 million atDecember 31, 2021 . This change was primarily due to increases in residential real estate, commercial real estate and commercial and industrial loans of$20.1 million ,$36.1 million and$9.7 million , respectively, during the first six months of 2022. Construction loans and consumer and other loans decreased by$6.6 million and$4.4 million , respectively, during the first six months of 2022. The Bank actively participated as a lender in theU.S. Small Business Administration's ("SBA") Paycheck Protection Program ("PPP") to support local small businesses and non-profit organizations by providing forgivable loans. Loan fees received from the SBA are accreted by the Bank into income evenly over the life of the loans, net of loan origination costs, through interest and fees on loans. PPP loans totaled$845 thousand atJune 30, 2022 , with$32 thousand scheduled to mature in the second and third quarters of 2022, and$813 thousand scheduled to mature in the first and second quarters of 2026. The total amount of deferred PPP income, net of origination costs, that has not yet been recognized through interest and fees on loans totaled$8 thousand atJune 30, 2022 . The Company believes the majority of these loans will ultimately be forgiven and repaid by the SBA in accordance with the terms of the program. It is the Company's understanding that loans funded through the PPP program are fully guaranteed by theU.S. government. Should those circumstances change, the Company could be required to establish additional allowance for loan losses through additional provision for loan losses charged to earnings. During the fourth quarter of 2020, the Bank modified terms of certain loans for customers that continued to be negatively impacted by the pandemic. The loan modifications lowered borrower loan payments by allowing interest only payments for periods ranging between 6 and 24 months. All loans modified were in the lodging sector of the Bank's commercial real estate loan portfolio and totaled$4.7 million atJune 30, 2022 . All modified loans were performing under their modified terms atJune 30, 2022 . 41
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Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances less the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued and credited to income based on the unpaid principal balance. Loan origination fees, net of certain origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. Interest income includes amortization of purchase premiums and discounts, recognized evenly over the life of the loans. A loan's past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on non-accrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. Loans greater than 90 days past due and still accruing totaled$92 thousand atJune 30, 2022 . There were no loans greater than 90 days past due and still accruing atDecember 31, 2021 . For those loans that are carried on non-accrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio. All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. When a loan is returned to accrual status, interest income is recognized based on the new effective yield to maturity of the loan.
Any unsecured loan that is deemed uncollectible is charged-off in full. Any secured loan that is considered by management to be uncollectible is partially charged-off and carried at the fair value of the collateral less estimated selling costs. This charge-off policy applies to all loan segments.
Impaired Loans A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value (net of selling costs), and the probability of collecting scheduled principal and interest payments when due. Additionally, management generally evaluates substandard and doubtful loans greater than$250 thousand for impairment. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair market value of the collateral, net of selling costs, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company typically does not separately identify individual consumer, residential, and certain small commercial loans that are less than$250 thousand for impairment disclosures, except for troubled debt restructurings (TDRs) as noted below. The recorded investment in impaired loans totaled$586 thousand and$2.3 million atJune 30, 2022 andDecember 31, 2021 , respectively.
Troubled Debt Restructurings (TDR)
In situations where, for economic or legal reasons related to a borrower's financial condition, management grants a concession to the borrower that it would not otherwise consider, the related loan is classified as a TDR. TDRs are considered impaired loans. Upon designation as a TDR, the Company evaluates the borrower's payment history, past due status, and ability to make payments based on the revised terms of the loan. If a loan was accruing prior to being modified as a TDR and if the Company concludes that the borrower is able to make such payments, and there are no other factors or circumstances that would cause it to conclude otherwise, the loan will remain on an accruing status. If a loan was on non-accrual status at the time of the TDR, the loan will remain on non-accrual status following the modification and may be returned to accrual status based on the policy for returning loans to accrual status as noted above. There were$116 thousand in loans classified as TDRs as ofJune 30, 2022 and$1.6 million as ofDecember 31, 2021 . Asset Quality Management classifies non-performing assets as non-accrual loans and OREO. OREO represents real property taken by the Bank when its customers do not meet the contractual obligation of their loans, either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for branch operations or expansion but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank had$1.7 million and$1.8 million in assets classified as OREO atJune 30, 2022 andDecember 31, 2021 , respectively. Non-performing assets totaled$2.1 million and$4.2 million atJune 30, 2022 andDecember 31, 2021 , representing approximately 0.15% and 0.30% of total assets, respectively. Non-performing assets consisted of OREO and non-accrual loans atJune 30, 2022 andDecember 31, 2021 . Non-performing assets included$1.7 million in properties formerly classified as bank premises byThe Bank of Fincastle which are now classified as held for sale. 42
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AtJune 30, 2022 , 4% of non-performing assets were commercial real estate loans and 21% were residential real estate loans. Additionally, 79% was related to bank-owned properties acquired fromThe Bank of Fincastle which will not be used in the Company's operations and are classified as held for sale. Non-performing assets could increase due to other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower's ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled$308 thousand and$1.1 million atJune 30, 2022 andDecember 31, 2021 , respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing a customers' ability to meet their debt requirements.
Loans greater than 90 days past due and still accruing totaled
The allowance for loan losses represents management's analysis of the existing loan portfolio and related credit risks. The provision for loan losses is based upon management's current estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio. The allowance for loan losses totaled$6.2 million atJune 30, 2022 and$5.7 million December 31, 2021 , representing 0.70% and 0.69% of total loans, respectively. For further discussion regarding the allowance for loan losses, see "Provision for Loan Losses" above. Recoveries of loan losses of$9 thousand and$40 thousand were recorded in the construction and land development and 1-4 family residential loans classes respectively, during the six months endedJune 30, 2022 . This recovery was offset by provision for loan losses totaling$334 thousand ,$20 thousand , and$95 thousand in the other real estate, commercial and industrial, and consumer and other loan classes, respectively. For more detailed information regarding the (recovery of) provision for loan losses, see Note 4 to the Consolidated Financial Statements. Impaired loans totaled$586 thousand and$2.3 million atJune 30, 2022 andDecember 31, 2021 , respectively. There was no related allowance for loan losses recorded for these loans atJune 30, 2022 . The related allowance for loan losses provided for these loans totaled$55 thousand atDecember 31, 2021 . The average recorded investment in impaired loans during the six months endedJune 30, 2022 and the year endedDecember 31, 2021 was$1.9 million and$4.5 million , respectively. Included in the impaired loans total are loans classified as TDRs totaling$116 thousand and$1.6 million atJune 30, 2022 andDecember 31, 2021 , respectively. Loans classified as TDRs represent situations in which a modification to the contractual interest rate or repayment structure has been granted to address a financial hardship. As ofJune 30, 2022 , none of these TDRs were performing under the restructured terms and all were considered non-performing assets. Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover losses inherent within the loan portfolio. For each period presented, the provision for loan losses charged to expense was based on management's judgment after taking into consideration all factors connected with the collectability of the existing portfolio. Management considers economic conditions, historical loss factors, past due percentages, internally generated loan quality reports, and other relevant factors when evaluating the loan portfolio. There can be no assurance, however, that an additional provision for loan losses will not be required in the future, including as a result of changes in the qualitative factors underlying management's estimates and judgments, changes in accounting standards, adverse developments in the economy, on a national basis or in the Company's market area, loan growth, or changes in the circumstances of particular borrowers. For further discussion regarding the allowance for loan losses, see "Critical Accounting Policies" above. 43
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Table of Contents Securities The securities portfolio plays a primary role in the management of the Company's interest rate sensitivity and serves as a source of liquidity. The portfolio is used as needed to meet collateral requirements, such as those related to secure public deposits and balances with theReserve Bank . The investment portfolio consists of held to maturity, available for sale, and restricted securities. Securities are classified as available for sale or held to maturity based on the Company's investment strategy and management's assessment of the intent and ability to hold the securities until maturity. Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Securities available for sale may be sold in response to changes in market interest rates, changes in prepayment risk, increases in loan demand, general liquidity needs and other similar factors and are carried at estimated fair value. Restricted securities, includingFederal Home Loan Bank ,Federal Reserve Bank , andCommunity Bankers' Bank stock, are generally viewed as long-term investments because there is minimal market for the stock and are carried at cost. Securities atJune 30, 2022 totaled$343.8 million , an increase of$18.9 million , or 6.0%, from$324.7 million atDecember 31, 2021 . Investment securities are comprised ofU.S. Treasury securities,U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate debt securities, and restricted securities. As ofJune 30, 2022 , neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Gross unrealized gains in the available for sale portfolio totaled$147 thousand and$2.0 million atJune 30, 2022 andDecember 31, 2021 , respectively. Gross unrealized losses in the available for sale portfolio totaled$31.1 million and$2.6 million atJune 30, 2022 andDecember 31, 2021 , respectively. Gross unrealized gains in the held to maturity portfolio totaled$2 thousand and$242 thousand atJune 30, 2022 andDecember 31, 2021 , respectively. Gross unrealized losses in the held to maturity portfolio totaled$6.7 million and$66 thousand atJune 30, 2022 andDecember 31, 2021 . Investments in an unrealized loss position were considered temporarily impaired atJune 30, 2022 andDecember 31, 2021 . The change in the unrealized gains and losses of investment securities fromDecember 31, 2021 toJune 30, 2022 was related to changes in market interest rates and was not related to credit concerns of the issuers. AtJune 30, 2022 , the securities portfolio was comprised of$264.8 million of securities available for sale and$77.2 million of securities held to maturity compared to$289.5 million and$33.4 million atDecember 31, 2021 , respectively. Securities held to maturity increased by$43.8 million during the first six months of 2022 from new purchases as a part of the Company's strategy to mitigate the risk of potential fluctuations in value and the related impact on shareholders' equity. The Company has not transferred any securities from available for sale to held to maturity during the first six months of 2022. Deposits AtJune 30, 2022 , deposits totaled$1.3 billion , an increase of$47.4 million , from$1.2 billion atDecember 31, 2021 . There was a slight change in the deposit mix when comparing the periods. AtJune 30, 2022 , noninterest-bearing demand deposits, savings and interest-bearing demand deposits, and time deposits composed 33%, 57%, and 10% of total deposits, respectively, compared to 33%, 57%, and 10% atDecember 31, 2021 . Liquidity Liquidity represents the ability to meet present and future financial obligations through either the sale or maturity of existing assets or with borrowings from correspondent banks or other deposit markets. The Company classifies cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, investment securities, and loans maturing within one year as liquid assets. As part of the Bank's liquidity risk management, stress tests and cash flow modeling are performed quarterly. As a result of the Bank's management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Bank maintains overall liquidity sufficient to satisfy its depositors' requirements and to meet its customers' borrowing needs. AtJune 30, 2022 , cash, interest-bearing and noninterest-bearing deposits with banks, securities, and loans maturing within one year totaled$210.8 million . AtJune 30, 2022 , 9.5% or$83.7 million of the loan portfolio matured within one year. Non-deposit sources of available funds totaled$385.0 million atJune 30, 2022 , which included$287.8 million of secured funds available fromFederal Home Loan Bank of Atlanta (FHLB),$46.2 million of secured funds available through the Federal Reserve Discount Window, and$51.0 million of unsecured federal funds lines of credit with other correspondent banks. 44
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Table of Contents Capital Resources The adequacy of the Company's capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company's asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses. The Company meets eligibility criteria of a small bank holding company in accordance with theFederal Reserve Board's Small Bank Holding Company Policy Statement issued inFebruary 2015 and is not obligated to report consolidated regulatory capital. EffectiveJanuary 1, 2015 , the Bank became subject to capital rules adopted by federal bank regulators implementing the Basel III regulatory capital reforms adopted by theBasel Committee on Banking Supervision (the Basel Committee), and certain changes required by the Dodd-Frank Act. The minimum capital level requirements applicable to the Bank under the final rules are as follows: a new common equity Tier 1 capital ratio of 4.5%; a Tier 1 capital ratio of 6%; a total capital ratio of 8%; and a Tier 1 leverage ratio of 4% for all institutions. The final rules also established a "capital conservation buffer" above the new regulatory minimum capital requirements. The capital conservation buffer was phased-in over four years and, as fully implemented effectiveJanuary 1, 2019 , requires a buffer of 2.5% of risk-weighted assets. This results in the following minimum capital ratios beginning in 2019: a common equity Tier 1 capital ratio of 7.0%, a Tier 1 capital ratio of 8.5%, and a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. Management believes, as ofJune 30, 2022 andDecember 31, 2021 , that the Bank met all capital adequacy requirements to which it is subject, including the capital conservation buffer.
The following table shows the Bank's regulatory capital ratios at
First Bank Total capital to risk-weighted assets 14.23 % Tier 1 capital to risk-weighted assets 13.56 %
Common equity Tier 1 capital to risk-weighted assets 13.56 % Tier 1 capital to average assets
8.87 %
Capital conservation buffer ratio(1) 6.23 %
(1) Calculated by subtracting the regulatory minimum capital ratio requirements
from the Company's actual ratio for Common equity Tier 1, Tier 1, and Total
risk based capital. The lowest of the three measures represents the Bank's
capital conservation buffer ratio.
The prompt corrective action framework is designed to place restrictions on
insured depository institutions if their capital levels begin to show signs of
weakness. Under the prompt corrective action requirements, which are designed to
complement the capital conservation buffer, insured depository institutions are
required to meet the following capital level requirements in order to qualify as
"well capitalized:" a common equity Tier 1 capital ratio of 6.5%; a Tier 1
capital ratio of 8%; a total capital ratio of 10%; and a Tier 1 leverage ratio
of 5%. The Bank met the requirements to qualify as "well capitalized" as of June
30, 2022 and December 31, 2021 .
On September 17, 2019 the FDIC finalized a rule that introduces an optional
simplified measure of capital adequacy for qualifying community banking
organizations (i.e., the community bank leverage ratio (CBLR) framework), as
required by the Economic Growth Act. The CBLR framework is designed to reduce
burden by removing the requirements for calculating and reporting risk-based
capital ratios for qualifying community banking organizations that opt into the
framework.
In order to qualify for the CBLR framework, a community banking organization
must have a tier 1 leverage ratio greater than 9%, less than $10 billion in
total consolidated assets, and limited amounts of off-balance sheet exposures
and trading assets and liabilities. The CARES Act temporarily lowered the tier 1
leverage ratio requirement to 8% until December 31, 2020 . A qualifying community
banking organization that opts into the CBLR framework and meets all
requirements under the framework will be considered to have met the
"well-capitalized" ratio requirements under the prompt corrective action
regulations and will not be required to report or calculate risk-based capital.
Although, the Company did not opt into the CBLR framework at June 30, 2022 , it
may opt into the CBLR framework in a future quarterly period.
During the fourth quarter of 2019, the Board of Directors of the Company
authorized a stock repurchase plan pursuant to which the Company was authorized
to repurchase up to $5.0 million of the Company's outstanding common stock
through December 31, 2020 . During 2020, the Company repurchased and retired
129,035 shares at an average price paid per share of $16.05 , for a total of $2.1
million . The Company's stock repurchase plan was suspended in the second quarter
of 2020, and remained suspended until it ended on December 31, 2020 . The
Company has not authorized another stock repurchase plan as of June 30, 2022 .
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Table of Contents Contractual Obligations There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 .
Off-Balance Sheet Arrangements
The Company, through the Bank, is a party to credit related financial instruments with risk not reflected in the consolidated financial statements in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank's exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments. Commitments to extend credit, which amounted to$161.3 million atJune 30, 2022 , and$161.4 million atDecember 31, 2021 , are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management's credit evaluation of the customer. Unfunded commitments under commercial lines of credit, revolving credit lines, and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are collateralized as deemed necessary and may or may not be drawn upon to the total extent to which the Bank is committed. Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. AtJune 30, 2022 andDecember 31, 2021 , the Bank had$18.1 million and$18.9 million in outstanding standby letters of credit, respectively. OnApril 21, 2020 , the Company entered into interest rate swap agreements related to its outstanding junior subordinated debt. The Company uses derivatives to manage exposure to interest rate risk through the use of interest rate swaps. Interest rate swaps involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date with no exchange of underlying principal amounts. The interest rate swaps qualified and are designated as cash flow hedges. The Company's cash flow hedges effectively modify the Company's exposure to interest rate risk by converting variable rates of interest on$9.0 million of the Company's junior subordinated debt to fixed rates of interest. The cash flow hedges end and the junior subordinated debt matures betweenJune 2034 andOctober 2036 . The cash flow hedges' total notional amount is$9.0 million . AtJune 30, 2022 , the cash flow hedges had a fair value of$2.2 million , which is recorded in other assets. The net gain/loss on the cash flow hedges is recognized as a component of other comprehensive (loss) income and reclassified into earnings in the same period(s) during which the hedged transactions affect earnings. The Company's derivative financial instruments are described more fully in Note 16 to the Consolidated Financial Statements.
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