SKYLINE BANKSHARES, INC. Management's Discussion and Analysis of Operations
Overview Management's Discussion and Analysis is provided to assist in the understanding and evaluation ofSkyline Bankshares, Inc's . financial condition and its results of operations. The following discussion should be read in conjunction with the Company's consolidated financial statements.Skyline Bankshares, Inc. (formerlyParkway Acquisition Corp. ) (the "Company"), is a bank holding company headquartered inFloyd, Virginia . The Company offers a wide range of retail and commercial banking services through its wholly-owned bank subsidiary,Skyline National Bank (the "Bank"). OnJanuary 1, 2023 , the Company changed its name fromParkway Acquisition Corp. toSkyline Bankshares, Inc. to align its brand across the entire organization.
The Company was incorporated as a
The
Company was formed as a business combination shell company for the purpose of completing a business combination transaction betweenGrayson Bankshares, Inc. ("Grayson") andCardinal Bankshares Corporation ("Cardinal"). OnNovember 6, 2015 , Grayson,Cardinal and the Company entered into an agreement pursuant to which Grayson andCardinal merged with and into the Company, with the Company as the surviving corporation (the "Cardinal merger"). The merger agreement established exchange ratios under which each share of Grayson common stock was converted to the right to receive 1.76 shares of common stock of the Company, while each share of Cardinal common stock was converted to the right to receive 1.30 shares of common stock of the Company. The exchange ratios resulted in Grayson shareholders receiving approximately 60% of the newly issued shares of the Company and Cardinal shareholders receiving approximately 40% of the newly issued shares of the Company. The Cardinal merger was completed onJuly 1, 2016 . Grayson was considered the acquiror and Cardinal was considered the acquiree in the transaction for accounting purposes. Upon completion of the Cardinal merger, theBank of Floyd , a wholly-owned subsidiary of Cardinal, was merged with and into the Bank (formerlyGrayson National Bank ), a wholly-owned subsidiary of Grayson. EffectiveMarch 13, 2017 , the Bank changed its name toSkyline National Bank . OnMarch 1, 2018 , the Company entered into a definitive agreement pursuant to which the Company acquiredGreat State Bank ("Great State"), based inWilkesboro, North Carolina . The agreement provided for the merger of Great State with and into the Bank, with the Bank as the surviving bank (the "Great State merger"). The transaction closed and the merger became effective onJuly 1, 2018 . Each share of Great State common stock was converted into the right to receive 1.21 shares of the Company's common stock. The Company issued 1,191,899 shares and recognized$15.5 million in surplus in the Great State merger. The Company was considered the acquiror and Great State was considered the acquiree in the transaction for accounting purposes. The Bank was organized under the laws ofthe United States in 1900 and now serves theVirginia counties of Grayson,Floyd ,Carroll ,Wythe ,Montgomery andRoanoke , and theNorth Carolina counties ofAlleghany ,Ashe ,Burke ,Caldwell ,Catawba ,Cleveland ,Davie ,Watauga ,Wilkes , andYadkin , and the surrounding areas, through twenty-five full-service banking offices. As aFederal Deposit Insurance Corporation ("FDIC") insured national banking association, the Bank is subject to regulation by the Comptroller of the Currency and theFDIC . The Company is regulated by theBoard of Governors of theFederal Reserve System . The Company had net earnings of$10.3 million for 2022 compared to$9.5 million for 2021. Our strong financial performance in 2022 can be attributed in part to our team's efforts that resulted in solid growth in the Bank's core loan portfolio of$97.1 million , or 14.84%, during 2022. Earnings for the year endedDecember 31, 2022 represented a return on average assets of 1.01% and a return on average equity of 13.35%, compared to 1.01% and 10.98%, respectively, for the year endedDecember 31, 2021 . The net interest margin was 3.68% in 2022, compared to 3.74% in 2021. As we look to 2023, competition for deposits has led to increased interest expense in recent months and we expect this trend to continue throughout 2023, and because of this we expect to see some near-term pressure on our net interest margin. The lagging effect of historic interest rate increases and continued inflationary pressures are also likely to dampen the overall economic activity in 2023 and may impact our operating costs. 24 --------------------------------------------------------------------------------
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Management's Discussion and Analysis
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Forward Looking Statements From time to time, the Company and its senior managers have made and will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements may be contained in this report and in other documents that the Company files with theSecurities and Exchange Commission . Such statements may also be made by the Company and its senior managers in oral or written presentations to analysts, investors, the media and others. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Also, forward-looking statements can generally be identified by words such as "may," "could," "should," "would," "believe," "anticipate," "estimate," "seek," "expect," "intend," "plan" and similar expressions. Forward-looking statements provide management's expectations or predictions of future conditions, events or results. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. These statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements were made. There are a number of factors, many of which are beyond the Company's control that could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements. These factors, some of which are discussed elsewhere in this report, include: ? any required increase in our regulatory capital ratios; ? inflation, interest rate levels and market and monetary fluctuations; ? the difficult market conditions in our industry;
? trade, monetary and fiscal policies and laws, including interest rate policies
of the federal government;
? applicable laws and regulations and legislative or regulatory changes;
? the timely development and acceptance of new products and services of the
Company;
? the willingness of customers to substitute competitors' products and services
for the Company's products and services;
? the financial condition of the Company's borrowers and lenders;
? the Company's success in gaining regulatory approvals, when required;
? technological and management changes;
? the Company's ability to implement its growth and acquisition strategies;
? the Company's critical accounting policies and the implementation of such
policies;
? lower-than-expected revenue or cost savings or other issues in connection with
mergers and acquisitions and branch expansion;
? changes in consumer spending and saving habits;
? deposit flows;
? the strength of
local economies in which the Company conducts its operations;
? the effects of the COVID-19 pandemic, including the Company's credit quality
and business operations, as well as its impact on general economic and
financial market conditions;
? 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
? the Company's potential exposure to fraud, negligence, computer theft, and
cyber-crime;
? the Company's success at managing the risks involved in the foregoing; and,
? other factors identified in Item 1A. "Risk Factors" above.
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Management's Discussion and Analysis
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Critical Accounting Policies The Company's financial statements are prepared in accordance with accounting principles generally accepted inthe United States ("GAAP"). The notes to the audited consolidated financial statements included in the Annual Report for the year endedDecember 31, 2022 contain a summary of its significant accounting policies. Management believes the Company's policies with respect to the methodology for the determination of the allowance for loan losses, and asset impairment judgments, such as the recoverability of intangible assets and other-than-temporary impairment of investment securities, involve a higher degree of complexity and require management to make difficult and subjective judgments that often require assumptions or estimates about highly uncertain matters. Accordingly, management considers the policies related to those areas as critical. The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: the first of which requires that losses be accrued when they are probable of occurring and estimable, and the second, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market, and the loan balance. The allowance for loan losses has three basic components: (i) the formula allowance, (ii) the specific allowance, and (iii) the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, expected cash flows and fair market value of collateral are used to estimate these losses. The use of these techniques is inherently subjective and our actual losses could be greater or less than the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowance. 26 --------------------------------------------------------------------------------
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Management's Discussion and Analysis
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Table 1. Net Interest Income and Average Balances (dollars in thousands)
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2022 2021
Interest Interest
Average Income/ Yield/ Average Income/ Yield/
Balance Expense Cost Balance Expense Cost
Interest-earning
assets:
Interest-bearing
deposits $ 55,635 $ 788 1.42 % $ 44,227 $ 88 0.20 %
Federal funds sold 8,307 29 0.35 % 37,365 44 0.12 %
Investment securities 159,196 3,063 1.92 % 96,020 1,535 1.60 %
Loans 1, 2 717,326 32,687 4.56 % 687,587 33,089 4.81 %
Total 940,464 36,567 865,199 34,756
Yield on average
interest-earning
assets 3.89 % 4.02 %
Non interest-earning
assets:
Cash and due from
banks 18,992 12,634
Premises and
equipment 32,261 28,342
Interest receivable
and other 46,775 39,299
Allowance for loan
losses (5,985 ) (5,296 )
Unrealized
gain/(loss) on
securities (17,028 ) (569 )
Total 75,015 74,410
Total assets $ 1,015,479 $ 939,609
Interest-bearing
liabilities:
Demand deposits $ 242,751 365 0.15 % $ 197,835 298 0.15 %
Savings deposits 195,976 196 0.10 % 172,847 198 0.11 %
Time deposits 179,839 1,181 0.66 % 195,008 1,847 0.95 %
Borrowings 4,188 188 4.49 % 9,862 86 0.87 %
Total 622,754 1,930 575,552 2,429
Cost on average
interest-bearing
liabilities 0.31 % 0.42 %
Non interest-bearing
liabilities:
Demand deposits 311,032 273,393
Interest payable and
other 4,663 4,298
Total 315,695 277,691
Total liabilities 938,449 853,243
Stockholder's equity: 77,030 86,366
Total liabilities and
stockholder's equity $ 1,015,479 $ 939,609
Net interest income $ 34,637 $ 32,327
Net yield on
interest-earning
assets 3.68 % 3.74 %
1 Includes nonaccural loans
2 Interest income includes loan fees
27
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Management's Discussion and Analysis
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Table 2. Rate/Volume Variance Analysis (dollars in thousands)
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2022 Compared to 2021 2021 Compared to 2020
Interest Variance Interest Variance
Income/ Attributable To(1) Income/ Attributable To(1)
Expense Expense
Variance Rate Volume Variance Rate Volume
Interest-earning
assets:
Interest bearing
deposits $ 700 $ 671 $ 29 $ (126 ) $ (119 ) $ (7 )
Federal funds sold (15 ) (25 ) 10 41 - 41
Investment securities 1,528 361 1,167 778 (147 ) 925
Loans (402 ) (2,167 ) 1,765 2,319 (221 ) 2,540
Total 1,811 (1,160 ) 2,971 3,012 (487 ) 3,499
Interest-bearing
liabilities:
Demand deposits 67 (1 ) 68 (30 ) 334 (364 ) Savings deposits (2 ) 37 (39 ) (217 ) (364 ) 147 Time deposits (666 ) (531 ) (135 ) (757 ) (791 ) 34 Borrowings 102 118 (16 ) (7 ) 56 (63 ) Total (499 ) (377 ) (122 )
(1,011 ) (765 ) (246 )
Net interest income
(1) The variance in interest attributed to both volume and rate has been
allocated to variance attributed to volume and variance attributed to rate in
proportion to the absolute value of the change in each.
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Net Interest Income Net interest income, the principal source of the Company's earnings, is the amount of income generated by earning assets (primarily loans and investment securities) less the interest expense incurred on interest-bearing liabilities (primarily deposits used to fund earning assets). Table 1 summarizes the major components of net interest income for the past three years and also provides yields and average balances. For the year endedDecember 31, 2022 total interest income increased by$1.8 million compared to the year endedDecember 31, 2021 . The increase in interest income in 2022 was primarily due to an increase of$1.5 million in interest income on securities and an increase of$700 thousand in interest income on interest-bearing deposits in banks, which offset a decrease in loan interest income of$402 thousand in the year over year comparison. Interest income on loans decreased primarily due to a decrease in SBA-PPP related interest and fees of$2.5 million from the year ago period. Excluding SBA-PPP related interest and fees of$1.9 million for the year endedDecember 31, 2022 and$4.4 million for the year endedDecember 31, 2021 , interest income on loans would have increased$2.1 million , reflecting our core loan growth as well as the current rate environment. The increases in interest income on investment securities was due to the$63.2 million increase in average investment securities due to investment purchases during 2022. Interest expense on deposits decreased by$601 thousand in the year over year comparison. This is a reflection of the reduced rates for the majority of 2022, as well as a reduction in time deposit balances from a year ago. However, in the fourth quarter of 2022, due to competitive pressures on deposits, rates were increased on deposit offerings. Management anticipates that interest expense will increase in the near term as competitive pressures for deposits continue. Amortization of premiums on acquired time deposits, which reduces interest expense, totaled$50 thousand in 2022, compared to$108 thousand in 2021, representing a decrease of$58 thousand . The effects of changes in volumes and rates on net interest income in 2022 compared to 2021, and 2021 compared to 2020 are shown in Table 2. 28 --------------------------------------------------------------------------------
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Management's Discussion and Analysis
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The aforementioned factors led to an increase in net interest income of$2.3 million or 7.15% for 2022 as compared to 2021. The net yield on interest-earning assets decreased by 6 basis points to 3.68% in 2022 compared to 3.74% in 2021. Provision for Loan Losses The allowance for loan losses is established to provide for expected losses in the Company's loan portfolio. Management determines the provision for loan losses required to maintain an allowance adequate to provide for probable losses. Some of the factors considered in making this decision are the levels and collectability of past due loans, volume of new loans, composition of the loan portfolio, and general economic outlook. The provision for loan losses was$606 thousand for the year endedDecember 31, 2022 , compared to$723 thousand for the year endedDecember 31, 2021 . The decrease in loan loss provisions from 2021 to 2022 despite the overall growth in the loan portfolio was due to the improvement in credit quality on the loan portfolio and the reduction of past due loans and nonperforming loans from 2021 to 2022. The allowance for loan losses for SBA-PPP loans remaining atDecember 31, 2022 were separately evaluated given the explicit government guarantee. This analysis, which incorporated historical experience with similar SBA guarantees and underwriting, concluded the likelihood of loss was remote and therefore these loans were assigned a zero expected credit loss in the allowance for loan losses. The reserve for loan losses was approximately 0.83% of total loans as ofDecember 31, 2022 and 2021, respectively. Management's estimate of probable credit losses inherent in the acquired Great State and Cardinal loan portfolios was reflected as a purchase discount which will continue to be accreted into income over the remaining life of the acquired loans. As ofDecember 31, 2022 and 2021, the remaining unaccreted discount on the acquired loan portfolios totaled$672 thousand and$1.0 million , respectively. Management believes the provision and the resulting allowance for loan losses are adequate. Additional information is contained in Tables 12 and 13, and is discussed in Nonperforming and Problem Assets. Other Income
The major components of noninterest income for the past two years are illustrated in Table 3.
For the year endedDecember 31, 2022 and 2021, noninterest income was$6.3 million and$6.6 million , respectively. Included in noninterest income for the twelve months endedDecember 31, 2022 was nonrecurring income from life insurance contracts of$217 thousand and a$10 thousand loss on the sales of securities. For the twelve months endedDecember 31, 2021 , there was nonrecurring income of$200 thousand from a one-time lease termination fee,$193 thousand from a one-time incentive bonus on a contract renegotiation with a service provider, and$265 thousand from net realized gains on the sale of securities. Excluding these items, noninterest income increased$140 thousand in the year over year comparison, primarily as a result of increased income from service charges on deposit accounts of$365 thousand and an increase of ATM, credit and debit card income of$551 thousand , partially offset by a decrease of$662 thousand in mortgage origination income. The mortgage department closed approximately$23.0 million of mortgage loans for the secondary market during 2022 compared to$57.0 million in 2021. The decrease in loan volume is due to the increase in interest rates during 2022. 29 --------------------------------------------------------------------------------
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Management's Discussion and Analysis
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Table 3. Sources of Noninterest Income (dollars in thousands)
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2022 2021
Service charges on deposit accounts
217 -
Mortgage originations fees 399 1,061
Safe deposit box rental 86 88
Gain (loss) on securities (10 ) 265
ATM, credit and debit card income 2,624 2,073
Merchant services income 222 182
Investment services income 56 60
Exchange income 183 203
Other income 61 649
Total noninterest income $ 6,257 $ 6,568 --------------------------------------------------------------------------------
Other Expense
The major components of noninterest expense for the past two years are illustrated in Table 4.
Total noninterest expenses increased by$1.2 million , or 4.65% for the year endedDecember 31, 2022 , compared to the year endedDecember 31, 2021 primarily due to employee and branch costs associated with branch expansion. Salary and benefit cost increased by$143 thousand fromDecember 31, 2021 toDecember 31, 2022 . Occupancy and equipment expenses increased by$347 thousand , due to the branch expansion. Data processing expenses remained comparable at$2.0 million for the year endedDecember 31, 2022 and 2021, respectively. ATM/EFT expenses increased by$445 thousand due to increased debit card usage. There was a decrease in core deposit intangible amortization of$117 thousand in the year-over-year comparison, which was offset by an increase in professional fees of$45 thousand and an increase in telephone expense of$92 thousand . 30 --------------------------------------------------------------------------------
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Management's Discussion and Analysis
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Table 4. Sources of Noninterest Expense (dollars in thousands)
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2022 2021
Salaries & wages $ 11,526 $ 11,251
Share-based compensation 179 155
Employee benefits 3,118 3,274
Total personnel expense 14,823 14,680
Director fees 354 368
Occupancy expense 1,891 1,676
Data processing expense 1,971 2,026
Other equipment expense 1,307 1,175
FDIC/OCC assessments 628 609
Insurance 172 156
Professional fees 684 639
Advertising 657 702
Postage & freight 536 458
Supplies 228 196
Franchise tax 506 499
Telephone 482 390
Travel, dues & meetings 579 435
ATM/EFT expense 1,212 767
Other real estate owned expenses 71 -
Core deposit intangible amortization 478 595
Other expense 909 896
Total noninterest expense $ 27,488 $ 26,267 -------------------------------------------------------------------------------- The overhead efficiency ratio of noninterest expense to adjusted total revenue (net interest income plus noninterest income) was 67.22% in 2022 and 67.53% in 2021. Income Taxes Income tax expense is based on amounts reported in the statements of income (after adjustments for non-taxable income and non-deductible expenses) and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. The deferred tax assets and liabilities represent the future Federal income tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Income tax expense (substantially all Federal) was$2.5 million in 2022 and$2.4 million in 2021, resulting in effective tax rates of 19.7% and 20.4%, respectively. The increase in income tax expense of$96 thousand in 2022 was primarily due to the increase in income before taxes of$895 thousand in 2022 compared to 2021. Net deferred tax assets of$5.7 million , and$1.1 million existed atDecember 31, 2022 and 2021 respectively. AtDecember 31, 2022 , net deferred tax assets included$5.6 million of deferred tax assets applicable to unrealized losses on investment securities available for sale, and$522 thousand of deferred tax assets applicable to funded projected pension benefit obligations. Accordingly, these amounts were not charged to income but recorded directly to the related stockholders' equity account. 31 --------------------------------------------------------------------------------
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Management's Discussion and Analysis
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Analysis of Financial Condition
Average earning assets increased$75.3 million , or 8.70%, from 2021 to 2022 due to asset growth primarily reflected in increased loans and investment securities, which was funded by average deposit growth of$90.5 million . Total earning assets represented 92.61% of total average assets in 2022 and 92.08% in 2021. The mix of average earning assets changed from 2021 to 2022 as average loans increased by$29.7 million , or 4.33%, and average investment securities increased by$63.2 million , or 65.79%. Average federal funds sold and average deposits in banks decreased by$17.6 million , or 21.63%, from 2021 to 2022.
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Table 5. Average Asset Mix (dollars in thousands)
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2022 2021
Average Average
Balance % Balance %
Earning assets:
Loans $ 717,326 70.64 % $ 687,587 73.18 %
Investment securities 159,196 15.67 % 96,020 10.22 %
Federal funds sold 8,307 0.82 % 37,365 3.97 %
Deposits in other banks 55,635 5.48 % 44,227 4.71 %
Total earning assets 940,464 92.61 % 865,199 92.08 %
Non earning assets:
Cash and due from banks 18,992 1.87 % 12,634 1.34 %
Premises and equipment 32,261 3.18 % 28,342 3.02 %
Other assets 46,775 4.61 % 39,299 4.18 %
Allowance for loan losses (5,985 ) -0.59 % (5,296 ) -0.56 %
Unrealized loss on securities (17,028 ) -1.68 % (569 ) -0.06 %
Total nonearning assets 75,015 7.39 % 74,410 7.92 %
Total assets $ 1,015,479 100.00 % $ 939,609 100.00 %
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Average loans for 2022 represented 70.64% of total average assets compared to
73.18% in 2021. Average federal funds sold decreased from 3.97% to 0.82% of
total average assets while deposits in other banks increased from 4.71% to 5.48%
of total average assets over the same time period. Average investment
securities increased from 10.22% in 2021 to 15.67% of total average assets in
2022. The balances of nonearning assets to total average assets decreased from
7.92% to 7.39% in the annual comparison.
32
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Management's Discussion and Analysis
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Loans Average loans totaled$717.3 million for the year endedDecember 31, 2022 . This represents an increase of$29.7 million , or 4.33%, from the average of$687.6 million for 2021. The increase was primarily due to organic core loan growth of$97.1 million during 2022. The loan portfolio consists primarily of real estate and commercial loans, including SBA-PPP loans. These loans accounted for 97.07% of the total loan portfolio atDecember 31, 2022 . This is up from the 96.31% that the categories maintained atDecember 31, 2021 . The amount of loans outstanding by type atDecember 31, 2022 and 2021 and the maturity distribution for variable and fixed rate loans as ofDecember 31, 2022 are presented in Tables 6 and 7, respectively.
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Table 6. Loan Portfolio Summary (dollars in thousands)
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December 31, 2022 December 31, 2021
Amount % Amount %
Construction and development $ 49,728 6.59 % $ 44,252 6.48 %
Residential, 1-4 families 292,318 38.72 % 240,359 35.16 %
Residential, 5 or more families 66,208 8.77 % 58,054 8.49 %
Farmland 23,688 3.14 % 25,026 3.66 %
Nonfarm, nonresidential 263,664 34.93 % 230,071 33.66 %
Total real estate 695,606 92.15 % 597,762 87.45 %
Agricultural 2,380 0.31 % 2,420 0.35 %
Commercial 37,054 4.91 % 36,022 5.27 %
SBA-PPP 71 0.01 % 24,528 3.59 %
Consumer 7,902 1.05 % 7,292 1.07 %
Other 11,859 1.57 % 15,508 2.27 %
Total $ 754,872 100.00 % $ 683,532 100.00 %
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Management's Discussion and Analysis
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Table 7. Maturity Schedule of Loans, as of
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Commercial,
Real Agricultural & Consumer Total
Estate SBA-PPP & Other Amount %
Fixed rate loans:
One year or less $ 12,723 $ 2,248 $ 3,892 $ 18,863 2.50 %
Over one to five years 66,002 18,791 8,709 93,502 12.38 %
Over five years to 15 years 38,200 2,761 2,577 43,538 5.77 %
Over 15 years 2,990 2 11 3,003 0.40 %
Total fixed rate loans $ 119,915 $ 23,802 $ 15,189 $ 158,906 21.05 %
Variable rate loans:
One year or less $ 12,980 $ 6,358 $ 2,134 $ 21,472 2.84 %
Over one to five years 18,158 673 173 19,004 2.52 %
Over five years to 15 years 139,337 8,325 1,255 148,917 19.73 %
Over 15 years 405,216 347 1,010 406,573 53.86 %
Total variable rate loans $ 575,691 $ 15,703 $ 4,572 $ 595,966 78.95 %
Total loans:
One year or less $ 25,703 $ 8,606 $ 6,026 $ 40,335 5.34 %
Over one to five years 84,160 19,464 8,882 112,506 14.90 %
Over five years to 15 years 177,537 11,086 3,832 192,455 25.50 %
Over 15 years 408,206 349 1,021 409,576 54.26 %
Total loans $ 695,606 $ 39,505 $ 19,761 $ 754,872 100.00 %
-------------------------------------------------------------------------------- Interest rates charged on loans vary with the degree of risk, maturity and amount of the loan. Competitive pressures, money market rates, availability of funds, and government regulations also influence interest rates. On average, loans yielded 4.56% in 2022 compared to an average yield of 4.81% in 2021. The decrease in loan yields was due to a decrease in SBA-PPP related interest and fees of$2.5 million from the year ago period. Excluding SBA-PPP related interest and fees of$1.9 million for the year endedDecember 31, 2022 and$4.4 million for the year endedDecember 31, 2021 , interest income on loans would have increased$2.1 million , reflecting our core loan growth of$97.1 million as well as the current rate environment. Management anticipates that this loan growth, in addition to higher rates in the current year, will have a positive impact on both earning assets and loan yields.Investment Securities
The Company uses its investment portfolio to provide liquidity for unexpected deposit decreases or loan generation, to meet the Bank's interest rate sensitivity goals, and to generate income.
Management of the investment portfolio has always been conservative with the majority of investments taking the form of purchases ofU.S. Treasury ,U.S. Government Agencies,U.S. Government Sponsored Enterprises and State and Municipal bonds, as well as investment grade corporate bond issues. Management views the investment portfolio as a source of income, and purchases securities with the intent of retaining them until maturity. However, adjustments are necessary in the portfolio to provide an adequate source of liquidity which can be used to meet funding requirements for loan demand and deposit fluctuations and to control interest rate risk. Therefore, from time to time, management may sell certain securities prior to their maturity. Table 8 presents the investment portfolio at the end of 2022 by major types of investments and contractual maturity ranges. Investment securities in Table 8 may have repricing or call options that are earlier than the contractual maturity date. 34 --------------------------------------------------------------------------------
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Management's Discussion and Analysis
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The total amortized cost of investment securities increased by approximately$30.1 million fromDecember 31, 2021 toDecember 31, 2022 , while the average balance of investment securities carried throughout the year increased by approximately$63.2 million from 2021 to 2022. The average yield of the investment portfolio increase to 1.92% for the year endedDecember 31, 2022 compared to 1.60% for 2021.
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Table 8.
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December 31, 2022
In One After One After Five After Book Market Book Book
Year or Through Through Ten Value Value Value Value
Less Five Years Ten Years Years 12/31/22 12/31/22 12/31/21 12/31/20
Investment
securities:
U.S. Treasury
securities $ - $ 4,980 $ - $ - $ 4,980 $ 4,834 $ - $ -
U.S. Government
agencies - 4,658 20,367 - 25,025 20,846 20,333 -
Mortgage-backed
securities 78 1,015 34,118 43,544 78,755 67,270 64,437 15,212
Corporate
securities - 1,500 - - 1,500 1,500 1,500 1,500
State and
municipal
securities - 1,506 19,656 30,238 51,400 40,701 45,314 16,059 Total
$ 78 $ 13,659 $ 74,141 $
73,782
Weighted average yields (1):U.S. Treasury securities 0.00 % 2.95 % 0.00 % 0.00 % 2.95 %U.S. Government agencies 0.00 % 3.08 % 1.68 % 0.00 % 1.94 % Mortgage-backed securities 2.18 % 2.01 % 2.19 % 1.45 % 1.78 % Corporate securities 0.00 % 4.11 % 0.00 % 0.00 % 4.11 % State and municipal securities 0.00 % 2.95 % 2.03 % 2.56 % 2.37 % Total 2.18 % 3.05 % 2.01 % 1.90 % 2.05 %
(1) Weighted average yields on investment securities are based on amortized cost
and are calculated on a tax equivalent basis.
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Deposits The Company relies on deposits generated in its market area to provide the majority of funds needed to support lending activities and for investments in liquid assets. More specifically, core deposits (total deposits less certificates of deposit in denominations of more than$250,000 ) are the primary funding source. The Company's balance sheet growth is largely determined by the availability of deposits in its markets, the cost of attracting the deposits, and the prospects of profitably utilizing the available deposits by increasing the loan or investment portfolios. The Company's management must continuously monitor market pricing, competitor's rates, and the internal interest rate spreads to maintain the Company's growth and profitability. The Company attempts to structure rates so as to promote deposit and asset growth while at the same time increasing overall profitability of the Company. Average total deposits for the year endedDecember 31, 2022 amounted to$929.6 million , which was an increase of$90.5 million , or 10.79% from 2021. Average core deposits totaled$893.4 million in 2022 representing a 11.53% increase over the$801.0 million in 2021. The percentage of the Company's average deposits that are interest-bearing decreased to 66.5% in 2022 compared to 67.4% in 2021. This decrease is due to the average demand deposits, which earn no interest, increasing 13.77% from$273.4 million in 2021 to$311.0 million in 2022. Average deposits for the periods endedDecember 31, 2022 and 2021 are summarized in Table 9. 35
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Management's Discussion and Analysis
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Table 9. Deposit Mix (dollars in thousands)
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December 31, 2022
Average % of Total Average Average % of Total Average
Balance Deposits Rate Paid Balance Deposits Rate Paid
Interest-bearing
deposits:
Interest-bearing DDA
accounts $ 133,854 14.4 % 0.09 % $ 113,840 13.6 % 0.09 %
Money market 108,897 11.7 % 0.22 % 83,995 10.0 % 0.23 %
Savings 195,976 21.1 % 0.10 % 172,847 20.6 % 0.11 %
Individual retirement
accounts 44,165 4.7 % 0.88 % 46,088 5.5 % 1.04 %
CD's $250,000 or less 99,443 10.7 % 0.55 % 110,825 13.2 % 0.94 %
CD's greater than
$250,000 36,231 3.9 % 0.68 % 38,095 4.5 % 0.87 %
Total interest-bearing
deposits 618,566 66.5 % 0.28 % 565,690 67.4 % 0.41 %
Noninterest-bearing
deposits 311,032 33.5 % 0.00 % 273,393 32.6 % 0.00 % Total deposits$ 929,598 100.0 % 0.19 %$ 839,083 100.0 % 0.28 %
-------------------------------------------------------------------------------- The average balance of certificates of deposit issued in denominations of more than$250,000 decreased by$1.9 million , or 4.89%, for the year endedDecember 31, 2022 compared toDecember 31, 2021 . The strategy of management has been to support loan and investment growth with core deposits and not to aggressively solicit the more volatile, large denomination certificates of deposit. Loan and investment securities growth in 2022 was primarily funded through core deposit growth, thus reducing management's reliance on large denomination certificates of deposit for funding purposes. Estimated uninsured deposits totaled$295.0 million and$279.3 million atDecember 31, 2022 andDecember 31, 2021 , respectively. Uninsured amounts are estimated based on the portion of account balance in excess ofFDIC insurance limits. Table 10 provides maturity information relating to uninsured time deposits atDecember 31, 2022 .
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Table 10. Estimated Uninsured Time Deposits Maturities (dollars in thousands)
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Estimated Uninsured Time Deposits at
Remaining maturity of three months or less$ 6,565
Remaining maturity over three months through six months 3,480 Remaining maturity over six months through twelve months 34,874 Remaining maturity over twelve months
4,537
Total estimated uninsured time deposits $ 49,456
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36
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Management's Discussion and Analysis
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Equity Stockholders' equity totaled$72.9 million atDecember 31, 2022 compared to$85.2 million atDecember 31, 2021 . The decrease of$12.3 million , or 14.39%, was due to earnings of$10.3 million , plus share-based compensation of$179 thousand , less common stock repurchases of$154 thousand , payment of dividends of$1.8 million , and less other comprehensive losses of$20.8 million primarily due to an increase in the unrealized losses on the value of the securities portfolio as a result of increased interest rates in 2022. Book value decreased from$15.20 per share atDecember 31, 2021 to$12.98 per share atDecember 31, 2022 . EffectiveJanuary 1, 2015 , the federal banking regulators adopted rules to implement the Basel III regulatory capital reforms from theBasel Committee on Banking Supervision and certain provisions of the Dodd-Frank Act. The final rules required the Bank to comply with the following minimum capital ratios: (i) a new common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6% of risk-weighted assets; (iii) a total capital ratio of 8% of risk-weighted assets; and (iv) a leverage ratio of 4% of total assets. As fully phased in onJanuary 1, 2019 , the rules require the Bank to maintain (i) a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% common equity Tier 1 ratio, effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio, effectively resulting in a minimum Tier 1 capital ratio of 8.5%), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio, effectively resulting in a minimum total capital ratio of 10.5%), and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets. UnderBasel III Capital requirements, a capital conservation buffer of 0.625% became effective beginning onJanuary 1, 2016 . The capital conservation buffer was gradually increased throughJanuary 1, 2019 to 2.50%. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banks are now required to maintain levels that meet the required minimum plus the capital conservation buffer in order to make distributions, such as dividends, or discretionary bonus payments. The Banks's capital conservation buffer is 4.42% as ofDecember 31, 2022 .
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Table 11. Bank's
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2022 2021
Tier 1 Capital $ 90,878 $ 84,900
Qualifying allowance for loan losses (limited to 1.25%
of risk-weighted assets) 6,294 5,717
Total regulatory capital $ 97,172 $ 90,617
Total risk-weighted assets $ 782,401 $ 740,706
Tier 1 capital as a percentage of
risk-weighted assets 11.6 % 11.5 %
Common Equity Tier 1 capital as a percentage of
risk-weighted assets 11.6 % 11.5 %
Total regulatory capital as a percentage of
risk-weighted assets 12.4 % 12.2 %
Leverage ratio* 8.8 % 8.6 %
* Tier 1 capital divided by average total assets for the quarter ended December
31 of each year.
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37
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Management's Discussion and Analysis
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Nonperforming and Problem Assets
Certain credit risks are inherent in making loans, particularly commercial and consumer loans. Management prudently assesses these risks and attempts to manage them effectively. The Bank attempts to use shorter-term loans and, although a portion of the loans have been made based upon the value of collateral, the underwriting decision is generally based on the cash flow of the borrower as the source of repayment rather than the value of the collateral. The Bank also attempts to reduce repayment risk by adhering to internal credit policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review and follow up on exceptions to credit policies. Table 12 provides information about the allowance for loan losses, nonperforming assets and loans past due 90 days or more and still accruing as ofDecember 31, 2022 and 2021.
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Table 12. Loan Loss Data (dollars in thousands)
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2022 2021
Allowance for loan losses $ 6,248 $ 5,677
Total loans $ 754,872 $ 683,532
Allowance for loan losses to total loans 0.83 % 0.83 %
Nonperforming loans:
Nonaccrual loans $ 1,634 $ 1,320
Restructured loans 2,330 3,167
Purchased credit-impaired loans on accrual status 89 103
Loans past due 90 days or more and still accruing - - Total nonperforming loans 4,053 4,590 Other real estate owned 235 - Total nonperforming assets$ 4,288 $ 4,590
Total nonperforming loans as a percentage to total loans 0.54 %
0.67 %
Total allowance for loan losses to nonperforming loans 154.16 % 123.68 %
Total nonperforming assets as a percentage to total assets 0.43 % 0.46 %
Total nonaccrual loans as a percentage to total loans 0.22 % 0.19 %
Total allowance for loan losses to nonaccrual loans 382.37 % 430.08 %
-------------------------------------------------------------------------------- Total nonperforming loans were 0.54% and 0.67% of total outstanding loans as ofDecember 31, 2022 and 2021, respectively. The majority of the increase in nonaccrual loans from 2022 to 2021 came in the "commercial mortgage" category as a result of one large credit of$381 thousand being placed in nonaccrual status in 2022. Nonaccrual loans in this category increased by$501 thousand . Loans are placed in nonaccrual status when, in management's opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Loans are removed from nonaccrual status when they are deemed a loss and charged to the allowance, transferred to foreclosed assets, or returned to accrual status based upon performance consistent with the original terms of the loan or a subsequent restructuring thereof. Management's ability to ultimately resolve these loans either with or without significant loss will be determined, to a great extent, by general economic and real estate market conditions. For the years endedDecember 31, 2022 and 2021, interest income recognized on loans in nonaccrual status was approximately$62 thousand and$39 thousand , respectively. Had these credits been current in accordance with their original terms, the gross interest income for these credits would have been approximately$88 thousand and$104 thousand , respectively for the years endedDecember 31, 2022 and 2021. 38
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Management's Discussion and Analysis
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Restructured loans represent troubled debt restructurings ("TDRs") that have
returned to accrual status after a period of performance in accordance with
their modified terms. The decrease in restructured loans from 2021 to 2022 came
primarily in the form of four TDRs going into nonaccrual status during 2022. A
TDR is considered to be successful if the borrower maintains adequate payment
performance under the modified terms and is financially stable.
There was $235 thousand in other real estate owned at December 31, 2022 ,
compared to no other real estate owned at December 31, 2021 . During the fourth
quarter of 2022, a former full service branch facility was transferred to other
real estate owned at a value of $235 thousand . A write-down of $72 thousand was
taken on the property as a result of this transfer based on the contract to
sell, less estimated selling costs, in place as of December 31, 2022 . Subsequent
to December 31, 2022 , the sale of the property settled on March 1, 2023 .
More information on nonperforming assets and loan modifications in response to COVID-19 can be found in Note 5 of the "Notes to Consolidated Financial Statements" found in Item 8 of this annual report on Form 10-K.
As ofDecember 31, 2022 and 2021 we had loans with a current principal balance of$5.0 million and$10.9 million rated "Watch" or "Special Mention". The "Watch" classification is utilized by us when we have an initial concern about the financial health of a borrower that indicate above average risk. We then gather current financial information about the borrower and evaluate our current risk in the credit. After this review we will either move the loan to a higher risk rating category or move it back to its original risk rating. Loans may be left rated "Watch" for a longer period of time if, in management's opinion, there are risks that cannot be fully evaluated without the passage of time, and we want to review it on a more regular basis. Assets that do not currently expose the Bank to sufficient risk to warrant a classification such as "Substandard" or "Doubtful" but otherwise possess weaknesses are designated "Special Mention". Loans rated as "Watch" or "Special Mention" are not considered "potential problem loans" until they are determined by management to be classified as "Substandard". As ofDecember 31, 2022 , potential problem loans classified as substandard totaled$4.3 million compared to$6.0 million atDecember 31, 2021 . Past due loans are often regarded as a precursor to further credit problems which would lead to future increases in nonaccrual loans or other real estate owned. As ofDecember 31, 2022 loans past due 30-89 days and still accruing totaled$236 thousand compared to$346 thousand atDecember 31, 2021 . Certain types of loans, such as option ARM products, subprime loans and loans with initial teaser rates, can have a greater risk of non-collection than other loans. The Bank has not offered these types of loans in the past and does not offer them currently. Junior-lien mortgages can also be considered higher risk loans. Our junior-lien portfolio atDecember 31, 2022 totaled$2.6 million , or 0.34% of total loans. The charge-off rates in this category do not vary significantly from other real estate secured loans in the current year. The allowance for loan losses is maintained at a level adequate to absorb potential losses. Some of the factors which management considers in determining the appropriate level of the allowance for loan losses are: past loss experience, an evaluation of the current loan portfolio, identified loan problems, the loan volume outstanding, the present and expected economic conditions in general, and in particular, how such conditions relate to the market area that the Bank serves. Bank regulators also periodically review the Bank's loans and other assets to assess their quality. Loans deemed uncollectible are charged to the allowance. Provisions for loan losses and recoveries on loans previously charged off are added to the allowance. The reserve for loan losses was approximately 0.83% of total loans as ofDecember 31, 2022 andDecember 31, 2021 , respectively. Management's estimate of probable credit losses inherent in the acquiredCardinal Bankshares Corporation and Great State loan portfolios was reflected as a purchase discount which will continue to be accreted into income over the remaining life of the acquired loans. As ofDecember 31, 2022 and 2021, the remaining unaccreted discount on the acquired loan portfolios totaled$672 thousand and$1.0 million , respectively. This remaining discount can be used for credit losses if a loss occurs on individual loans in the purchased portfolios. 39 --------------------------------------------------------------------------------
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Management's Discussion and Analysis
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To quantify the specific elements of the allowance for loan losses, the Bank begins by establishing a specific reserve for larger-balance, non-homogeneous loans, which have been identified as being impaired. This reserve is determined by comparing the principal balance of the loan with the net present value of the future anticipated cash flows or the fair market value of the related collateral. If the impaired loan is collateral dependent, then any excess in the recorded investment in the loan over the fair value of the collateral that is identified as uncollectible in the near term is charged off against the allowance for loan losses at that time. The bank also collectively evaluates for impairment smaller-balance TDRs. The specific component of the allowance for smaller-balance TDR loans is calculated on a pooled basis considering historical experience adjusted for qualitative factors. The bank then reviews certain loans in the portfolio and assigns grades to loans which have been reviewed. Loans which are adversely classified are given a specific allowance based on the historical loss experience of similar type loans in each adverse grade with further adjustments for external factors. The remaining portfolio is segregated into loan pools consistent with regulatory guidelines. An allocation is then made to the reserve for these loan pools based on the bank's historical loss experience with further adjustments for external factors. The allowance is allocated according to the amount deemed to be reasonably necessary to provide for the possibility of losses being incurred within the respective categories of loans, although the entire allowance is available to absorb any actual charge-offs that may occur.
Table 13 shows net charge-offs, average loan balances and the percentage of charge-offs to average loan balances. The allocation of the allowance for loan losses is detailed in Table 14.
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Table 13. Analysis of Net Charge-Offs (dollars in thousands)
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December 31, 2022
Percentage of Net
(Charge-Offs)
Net Recoveries to
(Charge-Offs) Average Average
Recoveries Loans Loans
Construction & development $ 3 $ 45,934 0.01 %
Farmland - 24,188 0.00 %
Residential 12 329,779 0.00 %
Commercial mortgage 8 247,350 0.00 %
Commercial & agriculture 16 39,288 0.04 %
SBA-PPP - 8,504 0.00 %
Consumer & other (74 ) 22,283 (0.33% )
Total $ (35 ) $ 717,326 0.00 %
December 31, 2021
Percentage of Net
(Charge-Offs)
Net Recoveries to
(Charge-Offs) Average Average
Recoveries Loans Loans
Construction & development $ 5 $ 44,437 0.01 %
Farmland - 29,766 0.00 %
Residential 2 289,445 0.00 %
Commercial mortgage 61 220,897 0.03 %
Commercial & agriculture 45 34,457 0.13 %
SBA-PPP - 49,438 0.00 %
Consumer & other (59 ) 19,147 (0.31% )
Total $ 54 $ 687,587 0.01 %
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40
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Management's Discussion and Analysis
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Table 14. Allocation of the Allowance for Loan Losses (dollars in thousands)
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December 31, 2022 December 31, 2021
Balance at the end of % of % of % of % of
the period applicable ALL to Loans to ALL to Loans to
to: Amount Loans Total Loans Amount Loans Total Loans
Construction &
development $ 526 1.06 % 6.59 % $ 484 1.09 % 6.48 %
Farmland 259 1.09 % 3.14 % 315 1.26 % 3.66 %
Residential 2,820 0.79 % 47.49 % 2,521 0.84 % 43.65 %
Commercial mortgage 2,197 0.83 % 34.93 % 1,908 0.83 % 33.66 %
Commercial &
agriculture 312 0.79 % 5.22 % 321 0.84 % 5.62 %
SBA-PPP - 0.00 % 0.01 % - 0.00 % 3.59 %
Consumer and other 134 0.68 % 2.62 % 128 0.56 % 3.34 %
Total $ 6,248 0.83 % 100.00 % $ 5,677 0.83 % 100.00 %
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Financial Instruments with Off-Balance Sheet Risk
The Bank is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the consolidated balance sheets. The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as for on-balance sheet instruments. A summary of the Bank's commitments atDecember 31, 2022 and 2021 is as follows: 2022 2021 Commitments to extend credit$ 163,250 $ 140,526 Standby letters of credit 833 1,161$ 164,083 $ 141,687 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which the Bank deems necessary. 41
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Management's Discussion and Analysis
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