Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2020
or
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________
Commission File Number: 000-26481
Financial Institutions, Inc.
(Exact name of registrant as specified in its charter)
New York
16-0816610
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
220 LIBERTY STREET, WARSAW, New York
14569
(Address of principal executive offices)
(Zip Code)
(585) 786-1100
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common stock, par value $0.01 per share
FISI
Nasdaq Global Select Market
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☑ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☑ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
Accelerated filer
☑
Non-accelerated filer
Smaller reporting company
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☑
The registrant had 16,038,220 shares of Common Stock, $0.01 par value, outstanding as of October 31, 2020.
FINANCIAL INSTITUTIONS, INC.
For the Quarterly Period Ended September 30, 2020
TABLE OF CONTENTS
PAGE
PART I.
FINANCIAL INFORMATION
ITEM 1.
Financial Statements
Consolidated Statements of Financial Condition (Unaudited) - at September 30, 2020 and December 31, 2019
3
Consolidated Statements of Income (Unaudited) - Three and nine months ended September 30, 2020 and 2019
4
Consolidated Statements of Comprehensive Income (Unaudited) - Three and nine months ended September 30, 2020 and 2019
5
Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) - Three and nine months ended September 30, 2020 and 2019
6
Consolidated Statements of Cash Flows (Unaudited) - Nine months ended September 30, 2020 and 2019
8
Notes to Consolidated Financial Statements (Unaudited)
9
ITEM 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
42
ITEM 3.
Quantitative and Qualitative Disclosures About Market Risk
63
ITEM 4.
Controls and Procedures
64
PART II.
OTHER INFORMATION
Legal Proceedings
65
ITEM 1A.
Risk Factors
ITEM 6.
Exhibits
67
Signatures
68
- 2 -
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Financial Condition (Unaudited)
(Dollars in thousands, except share and per share data)
September 30,
2020
December 31,
2019
ASSETS
Cash and due from banks
$
282,070
112,947
Securities available for sale, at fair value
515,971
417,917
Securities held to maturity, at amortized cost (net of allowance for credit losses of $8 and $0, respectively) (fair value of $301,878 and $363,259, respectively)
290,946
359,000
Loans held for sale
7,076
4,224
Loans (net of allowance for credit losses of $49,395 and $30,482, respectively)
3,519,144
3,190,505
Company owned life insurance
70,347
68,942
Premises and equipment, net
40,568
41,424
Goodwill and other intangible assets, net
74,062
74,923
Other assets
159,017
114,296
Total assets
4,959,201
4,384,178
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing demand
1,013,176
707,752
Interest-bearing demand
786,059
627,842
Savings and money market
1,724,463
1,039,892
Time deposits
841,230
1,180,189
Total deposits
4,364,928
3,555,675
Short-term borrowings
5,300
275,500
Long-term borrowings, net of issuance costs of $742 and $727, respectively
39,258
39,273
Other liabilities
93,354
74,783
Total liabilities
4,502,840
3,945,231
Shareholders’ equity:
Series A 3% preferred stock, $100 par value; 1,533 shares authorized;
1,435 shares issued
143
Series B-1 8.48% preferred stock, $100 par value; 200,000 shares authorized;
171,847 shares issued
17,185
Total preferred equity
17,328
Common stock, $0.01 par value; 50,000,000 shares authorized; 16,099,556 shares issued
161
Additional paid-in capital
124,812
124,582
Retained earnings
315,585
313,364
Accumulated other comprehensive loss
(209
)
(14,513
Treasury stock, at cost – 61,971 and 96,657 shares, respectively
(1,316
(1,975
Total shareholders’ equity
456,361
438,947
Total liabilities and shareholders’ equity
See accompanying notes to the consolidated financial statements.
- 3 -
Consolidated Statements of Income (Unaudited)
(In thousands, except per share amounts)
Three months ended
Nine months ended
Interest income:
Interest and fees on loans
35,602
37,904
107,659
112,177
Interest and dividends on investment securities
4,086
4,449
13,206
14,147
Other interest income
31
106
266
297
Total interest income
39,719
42,459
121,131
126,621
Interest expense:
Deposits
3,370
7,277
15,066
21,454
232
2,081
1,408
6,575
Long-term borrowings
618
1,853
Total interest expense
4,220
9,976
18,327
29,882
Net interest income
35,499
32,483
102,804
96,739
Provision for credit losses
4,028
1,844
21,689
5,391
Net interest income after provision for credit losses
31,471
30,639
81,115
91,348
Noninterest income:
Service charges on deposits
1,254
1,925
3,321
5,361
Insurance income
1,357
1,439
3,525
3,689
ATM and debit card
1,943
1,801
5,321
4,983
Investment advisory
2,443
2,269
6,940
6,812
470
459
1,397
1,293
Investments in limited partnerships
(105
116
(136
492
Loan servicing
49
102
316
Income from derivative instruments, net
1,931
890
4,617
1,013
Net gain on sale of loans held for sale
1,581
439
2,616
1,028
Net gain on investment securities
554
1,608
1,449
1,721
Net (loss) gain on other assets
(55
(2
56
Loss on tax credit investments
(40
—
(120
Other
1,019
1,315
3,151
3,950
Total noninterest income
12,401
12,361
32,195
30,714
Noninterest expense:
Salaries and employee benefits
15,085
14,411
45,173
41,661
Occupancy and equipment
3,263
4,650
10,407
10,106
Professional services
1,242
1,528
4,974
3,618
Computer and data processing
3,250
1,378
8,622
7,407
Supplies and postage
463
522
1,533
1,554
FDIC assessments
594
7
1,505
1,005
Advertising and promotions
955
745
2,055
2,351
Amortization of intangibles
280
309
861
948
Restructuring charges
1,362
2,165
2,336
6,583
7,410
Total noninterest expense
28,659
25,886
83,075
76,060
Income before income taxes
15,213
17,114
30,235
46,002
Income tax expense
2,940
4,281
5,703
10,247
Net income
12,273
12,833
24,532
35,755
Preferred stock dividends
365
1,096
Net income available to common shareholders
11,908
12,468
23,436
34,659
Earnings per common share (Note 3):
Basic
0.74
0.78
1.46
2.17
Diluted
2.16
Cash dividends declared per common share
0.26
0.25
0.75
- 4 -
Consolidated Statements of Comprehensive Income (Unaudited)
(Dollars in thousands)
Other comprehensive income (loss), net of tax:
Securities available for sale and transferred securities
(69
1,121
13,778
11,863
Hedging derivative instruments
123
43
(174
(317
Pension and post-retirement obligations
233
262
700
784
Total other comprehensive income, net of tax
287
1,426
14,304
12,330
Comprehensive income
12,560
14,259
38,836
48,085
- 5 -
Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)
Three and nine months ended September 30, 2020 and 2019
(Dollars in thousands, except per share data)
Preferred
Equity
Common
Stock
Additional
Paid-in
Capital
Retained
Earnings
Accumulated
Comprehensive
Loss
Treasury
Total
Shareholders’
Balance at December 31, 2019
Cumulative-effect adjustment
(8,719
Balance at January 1, 2020
304,645
430,228
Comprehensive income:
1,127
Other comprehensive income, net of tax
12,431
Purchases of common stock for treasury
(196
Share-based compensation plans:
Share-based compensation
332
Restricted stock units released
(469
469
Cash dividends declared:
Series A 3% Preferred-$0.75 per share
(1
Series B-1 8.48% Preferred-$2.12 per
share
(364
Common-$0.26 per share
(4,164
Balance at March 31, 2020
124,445
301,243
(2,082
(1,702
439,393
11,132
1,586
369
Restricted stock awards issued
(272
272
Stock awards
(19
114
95
(365
Balance at June 30, 2020
124,523
307,845
(496
448,045
289
(4,168
Balance at September 30, 2020
Continued on next page
- 6 -
Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) (Continued)
Balance at December 31, 2018
122,704
279,867
(21,281
(2,486
396,293
(710
Balance at January 1, 2019
279,157
395,583
11,521
5,510
Reclassification of income tax effects
2,783
(2,783
(193
182
(362
362
Common-$0.25 per share
(3,985
Balance at March 31, 2019
122,524
289,111
(18,554
(2,317
408,253
11,401
5,394
Common stock issued
1,151
453
(165
165
17
46
(3,995
Balance at June 30, 2019
123,980
296,151
(13,160
(2,106
422,354
(27
393
(51
51
(3,997
Balance at September 30, 2019
124,322
304,622
(11,734
432,617
- 7 -
Consolidated Statements of Cash Flows (Unaudited)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
5,924
6,221
Net amortization of premiums on securities
2,313
1,253
990
Deferred income tax (benefit) expense
(2,692
1,268
Proceeds from sale of loans held for sale
63,995
28,106
Originations of loans held for sale
(64,231
(30,751
Income on company owned life insurance
(1,397
(1,293
(2,616
(1,028
(1,449
(1,721
Net gain on other assets
(8
(56
Increase in other assets
(42,243
(6,768
Increase in other liabilities
15,491
3,757
Net cash provided by operating activities
20,298
41,162
Cash flows from investing activities:
Purchases of available for sale securities
(215,433
(103,627
Purchases of held to maturity securities
(6,008
(9,596
Proceeds from principal payments, maturities and calls on available for sale securities
65,244
58,283
Proceeds from principal payments, maturities and calls on held to maturity securities
73,114
69,090
Proceeds from sales of securities available for sale
70,729
110,042
Proceeds from sales of securities held to maturity
Net loan originations
(361,935
(98,430
Loans sold to others
21,077
Purchases of company owned life insurance, net of proceeds received
(24
Proceeds from sales of other assets
482
360
Purchases of premises and equipment
(2,800
(2,367
Net cash (used in) provided by investing activities
(376,609
44,808
Cash flows from financing activities:
Net increase in deposits
809,253
219,307
Net decrease in short-term borrowings
(270,200
(258,100
(220
Cash dividends paid to common and preferred shareholders
(13,423
(12,897
Net cash provided by (used in) financing activities
525,434
(51,910
Net increase in cash and cash equivalents
169,123
34,060
Cash and cash equivalents, beginning of period
102,755
Cash and cash equivalents, end of period
136,815
- 8 -
(1.)
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations
Financial Institutions, Inc. (the “Company”) is a financial holding company organized in 1931 under the laws of New York State (“New York”). The Company provides diversified financial services through its subsidiaries, Five Star Bank, SDN Insurance Agency, LLC (“SDN”), Courier Capital, LLC (“Courier Capital”) and HNP Capital, LLC (“HNP Capital”). The Company offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York through its wholly-owned New York chartered banking subsidiary, Five Star Bank (the “Bank”). The Bank also has indirect lending network relationships with franchised automobile dealers in the Capital District of New York and Northern and Central Pennsylvania. SDN provides a broad range of insurance services to personal and business clients. Courier Capital and HNP Capital provide customized investment management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans.
Basis of Presentation
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The accounting and reporting policies conform to U.S. generally accepted accounting principles (“GAAP”). Certain information and footnote disclosures normally included in financial statements prepared in conformity with GAAP have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying consolidated financial statements reflect all adjustments of a normal and recurring nature necessary for a fair presentation of the consolidated statements of financial condition, income, comprehensive income, changes in shareholders’ equity and cash flows for the periods indicated and contain adequate disclosure to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the Company’s 2019 Annual Report on Form 10-K for the year ended December 31, 2019. The results of operations for any interim periods are not necessarily indicative of the results which may be expected for the entire year.
Allowance for Credit Losses
On January 1, 2020, the Company adopted Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses (Topic 326) – Measurement of Credit Losses on Financial Instruments. ASU 2016-13 amends guidance on reporting credit losses for financial assets held at amortized cost basis and available for sale debt securities. Topic 326 eliminates the probable initial recognition threshold in current GAAP and instead, requires an entity to reflect its current estimate of all expected credit losses based on historical experience, current conditions and reasonable and supportable forecasts. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected. ASU 2016-13 also expands the disclosure requirements regarding an entity’s assumptions, models, and methods for estimating the reserve for credit losses. In addition, entities need to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. The Company adopted ASU 2016-13 using the modified retrospective approach. Results for the periods beginning after January 1, 2020 are presented under Accounting Standards Codification (“ASC”) 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded a net reduction of retained earnings of $8.7 million upon adoption. The transition adjustment includes an increase in credit-related reserves of $9.6 million, $14 thousand, and $2.1 million for loans, held to maturity investment securities and unfunded commitments, respectively, net of the corresponding increase in deferred tax assets of $3.0 million.
The allowance for credit losses is evaluated on a regular basis and established through charges to earnings in the form of a provision for credit losses. When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance and subsequent recoveries, if any, are credited to the allowance. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
a.
Portfolio Segmentation (“Pooled Loans”)
Portfolio segmentation is defined as the pooling of loans based upon similar risk characteristics such that quantitative methodologies and qualitative adjustment factors for estimating the allowance for credit losses is constructed for each segment. The Company has identified six portfolio segments of loans including Commercial Loans/Lines, Commercial Mortgage, Indirect Loans, Direct Loans, Residential Lines of Credit, and Residential Loans.
The allowance for credit losses for Pooled Loans estimate is based upon periodic review of the collectability of the loans quantitatively correlating historical loan experience with reasonable and supportable forecasts using forward looking information. Adjustments to the quantitative evaluation may be made for differences in current or expected qualitative risk characteristics such as changes in: underwriting standards, delinquency level, regulatory environment, economic condition, Company management and the status of portfolio administration including the Company’s Loan Review function.
- 9 -
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
b.
Individually Evaluated Loans
The Company establishes a specific reserve for individually evaluated loans which do not share similar risk characteristics with the loans included in the forecasted allowance for credit losses. These individually evaluated loans are removed from the pooling approach discussed above for the forecasted allowance for credit losses, and include nonaccrual loans, troubled debt restructurings (“TDRs”), and other loans deemed appropriate by management.
c.
Held to Maturity (“HTM”) Debt Securities
The Company’s HTM debt securities are also required to utilize the current expected credit losses approach to estimate expected credit losses. The Company’s HTM debt securities included securities that are issued by U.S. government or U.S. government-sponsored enterprises. These securities carry the explicit and/or implicit guarantee of the U.S. government, are widely recognized as “risk free,” and have a long history of zero credit loss. The Company also carries a portfolio of HTM municipal bonds. The Company measures its allowance for credit losses on HTM debt securities on a collective basis by major security type. The estimate is based on historical credit losses, if any, adjusted for current conditions and reasonable and supportable forecasts. The Company considers the nature of the collateral, potential future changes in collateral values and available loss information.
d.
Available for Sale (“AFS”) Debt Securities
For AFS securities in an unrealized loss position, we first assess whether (i) we intend to sell, or (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. If either case is affirmative, any previously recognized allowances are charged-off and the security's amortized cost is written down to fair value through income. If neither case is affirmative, the security is evaluated to determine whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency and any adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income. Adjustments to the allowance are reported in our income statement as a component of credit loss expense. AFS securities are charged-off against the allowance or, in the absence of any allowance, written down through income when deemed uncollectible by management or when either of the aforementioned criteria regarding intent or requirement to sell is met.
e.
Accrued Interest Receivable
Upon adoption of ASU 2016-13 and its related amendments on January 1, 2020, the Company made the following elections regarding accrued interest receivable:
•
Presenting accrued interest receivable balances separately within another line item on the statement of financial condition.
Excluding accrued interest receivable that is included in the amortized cost of financing receivables and debt securities from related disclosure requirements.
Continuing our policy to write off accrued interest receivable by reversing interest income. For commercial loans, the write off typically occurs upon becoming 90 days past due. For consumer loans, the write off typically occurs upon becoming 120 days past due. Historically, the Company has not experienced uncollectible accrued interest receivable on its investment securities. However, the Company would generally write off accrued interest receivable by reversing interest income if the Company does not reasonably expect to receive payments. Due to the timely manner in which accrued interest receivables are written off, the amounts of such write offs are immaterial.
Not measuring an allowance for credit losses for accrued interest receivable due to the Company’s policy of writing off uncollectible accrued interest receivable balances in a timely manner, as described above.
f.
Reserve for Unfunded Commitments
The reserve for unfunded commitments (the “Unfunded Reserve”) represents the expected credit losses on off-balance sheet commitments such as unfunded commitments to extend credit and standby letters of credit. However, a liability is not recognized for commitments unconditionally cancellable by the Company. The Unfunded Reserve is recognized as a liability (other liabilities in the consolidated statements of financial condition), with adjustments to the reserve recognized as a provision for credit loss expense in the consolidated statements of income. The Unfunded Reserve is determined by estimating expected future fundings, under each segment, and applying the expected loss rates. Expected future fundings are based on historical averages of funding rates (i.e., the likelihood of draws taken). To estimate future fundings on unfunded balances, current funding rates are compared to historical funding rates.
- 10 -
Operating, Accounting and Reporting Considerations related to COVID-19
The COVID-19 pandemic has negatively impacted the global economy, including our operating footprint of Western and Central New York. In response to this crisis, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was passed by Congress and signed into law on March 27, 2020. The CARES Act provides an estimated $2.2 trillion to fight the COVID-19 pandemic and stimulate the economy by supporting individuals and businesses through loans, grants, tax changes, and other types of relief. Some of the provisions applicable to the Company include, but are not limited to:
Accounting for Loan Modifications - The CARES Act provides that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a TDR and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes.
Paycheck Protection Program - The CARES Act established the Paycheck Protection Program (“PPP”), an expansion of the Small Business Administration’s (“SBA”) 7(a) loan program and the Economic Injury Disaster Loan Program (“EIDL”), administered directly by the SBA.
Mortgage Forbearance - Under the CARES Act, through the earlier of December 31, 2020, or the termination date of the COVID-19 national emergency, a borrower with a federally backed mortgage loan that is experiencing financial hardship due to COVID-19 may request a forbearance.
Also, in response to the COVID-19 pandemic, the Board of Governors of the Federal Reserve System (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”), the National Credit Union Administration (“NCUA”), the Office of the Comptroller of the Currency (“OCC”), and the Consumer Financial Protection Bureau (“CFPB”), in consultation with the state financial regulators (collectively, the “agencies”) issued a joint interagency statement (issued March 22, 2020; revised statement issued April 7, 2020). Some of the provisions applicable to the Company include, but are not limited to:
Accounting for Loan Modifications - Loan modifications that do not meet the conditions of the CARES Act may still qualify as a modification that does not need to be accounted for as a TDR. The agencies confirmed with FASB staff that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or insignificant delays in payment.
Past Due Reporting - With regard to loans not otherwise reportable as past due, financial institutions are not expected to designate loans with deferrals granted due to COVID-19 as past due because of the deferral. A loan’s payment date is governed by the due date stipulated in the legal agreement. If a financial institution agrees to a payment deferral, these loans would not be considered past due during the period of the deferral.
Nonaccrual Status and Charge-offs - During short-term COVID-19 modifications, these loans generally should not be reported as nonaccrual or as classified.
Effective March 23, 2020 through July 9, 2020, for consumer customers, the Bank waived early CD penalty fees for withdrawals up to $20,000 (limited to one penalty-free withdrawal per CD account); eliminated all insufficient funds (overdrafts) and returned item fees; eliminated all Pay by Phone fees; waived all late fees; offered the opportunity for monthly mortgage, home equity loan or home equity line payment relief; offered the opportunity to defer unsecured consumer loans or lines of credit and secured consumer loans and lines of credit payments; and offered unsecured personal loans up to $5,000, up to 60 months at 2.95% APR subject to credit approval (additional terms and conditions may apply). In addition, ATM access fees were reinitiated on September 19, 2020.
Reclassifications
Certain reclassifications of previously reported amounts have been made to conform to the current year presentation. Such reclassifications did not impact net income or shareholders’ equity as previously reported.
Subsequent Events
Subordinated Note Issuance
On October 7, 2020, the Company completed a private placement of $35.0 million in aggregate principal amount of fixed-to-floating rate subordinated notes due 2030 (the “Notes”) to qualified institutional buyers and accredited institutional investors. The Notes have a maturity date of October 15, 2030 and bear interest, payable semi-annually, at the rate of 4.375% per annum, until October 15, 2025. Commencing on that date, the interest rate will reset quarterly to an interest rate per annum equal to the then current three-month secured overnight financing rate (“SOFR”) plus 4.265%, payable quarterly until maturity.
- 11 -
The Company is entitled to redeem the Notes, in whole or in part, on any interest payment date on or after October 15, 2025, and to redeem the Notes in whole at any time upon certain other specified events. The Company intends to use the net proceeds for general corporate purposes, organic growth and to support regulatory capital ratios at Five Star Bank.
In connection with the issuance and sale of the Notes, the Company entered into a registration rights agreement with the purchasers of the Notes pursuant to which the Company has agreed to take certain actions to provide for the exchange of the Notes for subordinated notes that are registered under the Securities Act of 1933, as amended, with substantially the same terms as the Notes.
Enterprise Standardization Program
In October 2020, the Company announced the planned closure of one additional branch in January 2021. This location was not included in the branch consolidations announced in July, as alternative options were being considered and consolidation was not possible given its significant distance from other Five Star Bank branches. This closure is expected to result in one-time expenses related to severance costs and real estate related charges of approximately $130 thousand in the fourth quarter of 2020. Expected expense savings are anticipated at $340 thousand on an annualized basis.
Stock Repurchase Program
In November 2020, the Company announced that its Board of Directors approved a stock repurchase program for up to 801,879 shares of its common stock, or approximately 5% of the Company’s outstanding common shares. The repurchase program permits shares to be repurchased in open market transactions and pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934. The timing and number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements, market conditions, and other corporate liquidity requirements and priorities. The repurchase program does not obligate the Company to purchase any shares and it may be extended, modified or discontinued at any time.
Use of Estimates
The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates relate to the determination of the allowance for credit losses, the carrying value of goodwill and deferred tax assets, and assumptions used in the defined benefit pension plan accounting.
Cash Flow Reporting
Supplemental cash flow information is summarized as follows for the nine months ended September 30 (in thousands):
Supplemental information:
Cash paid for interest
23,533
28,672
Cash paid for income taxes
5,656
8,666
Noncash investing and financing activities:
Real estate and other assets acquired in settlement of loans
2,966
159
Accrued and declared unpaid dividends
4,534
4,363
Increase in net unsettled security purchases
(2,650
Common stock issued for Courier Capital contingent earn-out
- 12 -
Recent Accounting Pronouncements
In April 2019, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2019-04, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments. With respect to Topic 815, Derivatives and Hedging, ASU 2019-04 clarifies that the reclassification of a debt security from Held to Maturity (“HTM”) to Available for Sale (“AFS”) under the transition guidance in ASU No. 2017-12, Derivatives and Hedging (Topic 815) – Targeted Improvements to Accounting for Hedging Activities, would not (1) call into question the classification of other HTM securities, (2) be required to actually designate any reclassified security in a last-of-layer hedge, or (3) be restricted from selling any reclassified security. As part of the transition of ASU 2019-04, entities may reclassify securities that would qualify for designation as the hedged item in a last-of-layer hedging relationship from HTM to AFS; however, entities that already made such a reclassification upon their adoption of ASU 2017-12 are precluded from reclassifying additional securities. The Company did not reclassify any securities from HTM to AFS upon adoption of ASU 2017-12. The Company elected to early adopt the amendments to Topic 815 in December 2019, resulting in the reclassification of $26.2 million of qualified investment securities from HTM to AFS. With respect to Topic 326, Financial Instruments - Credit Losses, ASU 2019-04 clarifies the scope of the credit losses standard and addresses issues related to accrued interest receivable balances, recoveries, variable interest rates and prepayments, among other things. With respect to Topic 825, Financial Instruments, on recognizing and measuring financial instruments, ASU 2019-04 addresses the scope of the guidance, the requirement for remeasurement under ASC 820 (Fair Value Measurement) when using the measurement alternative, certain disclosure requirements and which equity securities have to be remeasured at historical exchange rates. The amendments to Topic 326 and the amendments to Topic 825, under ASU 2019-04, were adopted as of January 1, 2020 and did not have a significant impact on the Company’s financial statements.
In March 2020, the FASB issued ASU No. 2020-04, “Facilitation of the Effects of Reference Rate Reform on Financial Reporting.” This ASU provides temporary optional expedients and exceptions to GAAP guidance on contract modifications and hedge accounting to ease the financial reporting burdens of the expected market transition from LIBOR and other interbank offered rates to alternative rates, such as SOFR. For instance, entities can elect not to apply certain modification accounting requirements to contracts affected by reference rate reform, if certain criteria are met. An entity that makes this election would not have to remeasure the contracts at the modification date or reassess a previous accounting determination. Entities can also elect various optional expedients that would allow them to continue applying hedge accounting for hedging relationships affected by reference rate reform, if certain criteria are met. Finally, entities can make a one-time election to sell and/or reclassify HTM debt securities that reference an interest rate affected by reference rate reform. ASU 2020-04 is effective March 12, 2020, through December 31, 2022. The Company is in the process of determining which optional expedients to elect, if any, as well as the timing and application of those elections. At this time, the Company does not expect any elections to have a significant impact on its financial statements.
(2.)
RESTRUCTURING CHARGES
On July 17, 2020, the Bank announced management’s decision to adapt to a full-service branch model to streamline retail branches to better align with shifting customer needs and preferences. The transformation resulted in six branch closures and a reduction in staffing. The announcement was the result of a nine-month comprehensive assessment of all lines of business and functional areas, conducted in partnership with a leading process improvement organization. The data-driven analysis identified, among other things, overlapping service areas, automation opportunities and streamlining of processes and operations that would enhance customer experiences and facilitate the long-term sustainability of current and future branches. The announced consolidations represented about ten percent of the branch network and impacted approximately six percent of the total Company workforce. Where possible, those impacted were offered alternative roles or the opportunity to apply for open positions in other areas of the Company. Separated associates received a comprehensive severance package based on tenure. The Company expects to complete a substantial majority of these actions by December 31, 2020.
The Company incurred total pre-tax expense related to the branch closures of approximately $1.6 million, including approximately $0.2 million in employee severance, $0.5 million in lease termination costs and $0.9 million in valuation adjustments on branch facilities. The Company expects $0.7 million of total costs will result in future cash expenditures. The Company recognized all of these expenses during the third quarter of 2020. The Company anticipates annual expense savings of approximately $2.6 million as a result of these branch closures.
- 13 -
RESTRUCTURING CHARGES (continued)
The following table represents the consolidated statements of income classification of the Company’s restructuring charges (in thousands):
Income Statement Location
Severance costs
224
Lease termination costs
454
Valuation adjustments
908
The following table represents the changes in the restructuring reserve (in thousands):
Beginning balance
Cash payments
(249
Ending balance
1,337
(3.)
EARNINGS PER COMMON SHARE (“EPS”)
The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted EPS (in thousands, except per share amounts).
Weighted average common shares outstanding:
Total shares issued
16,100
16,081
Unvested restricted stock awards
(7
(4
(5
Treasury shares
(62
(77
(113
Total basic weighted average common shares outstanding
16,031
15,991
16,018
15,964
Incremental shares from assumed:
Exercise of stock options
Vesting of restricted stock awards
27
40
53
Total diluted weighted average common shares outstanding
16,058
16,056
16,017
Basic earnings per common share
Diluted earnings per common share
For each of the periods presented, average shares subject to the following instruments were excluded from the computation of diluted EPS because the effect would be antidilutive:
Stock options
Restricted stock awards
71
- 14 -
(4.)
INVESTMENT SECURITIES
The amortized cost and fair value of investment securities are summarized below (in thousands):
Amortized
Unrealized
Fair
Cost
Gains
Losses
Value
September 30, 2020
Securities available for sale:
U.S. Government agency and government sponsored enterprises
6,234
421
6,655
Mortgage-backed securities:
Federal National Mortgage Association
303,740
15,923
66
319,597
Federal Home Loan Mortgage Corporation
139,875
2,684
140
142,419
Government National Mortgage Association
23,300
851
24,151
Collateralized mortgage obligations:
18,104
229
18,333
4,365
16
4,381
Privately issued
435
Total mortgage-backed securities
489,384
20,138
206
509,316
Total available for sale securities
495,618
20,559
Securities held to maturity:
State and political subdivisions
151,611
5,052
156,663
11,576
725
12,301
6,183
6,548
39,631
1,402
41,033
33,396
1,236
34,632
39,905
1,835
41,740
8,652
8,961
139,343
5,872
145,215
Total held to maturity securities
290,954
10,924
301,878
Allowance for credit losses - securities
Total held to maturity securities, net
December 31, 2019
26,440
437
26,877
293,873
2,263
1,380
294,756
52,733
318
172
52,879
14,065
60
14,121
23,834
57
23,777
4,907
18
4,889
389,412
3,259
1,631
391,040
415,852
3,696
- 15 -
INVESTMENT SECURITIES (Continued)
December 31, 2019 (continued)
192,215
3,803
196,018
12,049
227
12,270
6,995
77
47
7,025
45,758
306
128
45,936
41,561
150
256
41,455
49,389
307
103
49,593
11,033
12
83
10,962
166,785
1,079
623
167,241
4,882
363,259
The Company elected to exclude accrued interest receivable (“AIR”) from the amortized cost basis of debt securities disclosed throughout this footnote. For AFS debt securities, AIR totaled $1.0 million as of September 30, 2020 and December 31, 2019. For HTM debt securities, AIR totaled $1.4 million and $1.2 million as of September 30, 2020 and December 31, 2019, respectively. AIR is included in other assets on the Company’s consolidated statements of financial condition.
For each of the three months ended September 30, 2020 and 2019, credit loss expense (credit) for HTM investment securities was $0. For the nine months ended September 30, 2020 and 2019, credit loss expense (credit) for HTM investment securities was $(6) thousand and $0, respectively.
Investment securities with a total fair value of $634.4 million and $676.9 million at September 30, 2020 and December 31, 2019, respectively, were pledged as collateral to secure public deposits and for other purposes required or permitted by law.
Sales of securities available for sale were as follows (in thousands):
Proceeds from sales
20,576
65,427
Gross realized gains
1,458
1,811
Gross realized losses
90
The scheduled maturities of securities available for sale and securities held to maturity at September 30, 2020 are shown below (in thousands). Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.
Debt securities available for sale:
Due in one year or less
1
Due from one to five years
36,525
38,323
Due after five years through ten years
162,953
175,586
Due after ten years
296,139
302,061
Debt securities held to maturity:
48,688
49,234
102,292
106,631
19,076
20,008
120,898
126,005
- 16 -
Unrealized losses on investment securities for which an allowance for credit losses has not been recorded and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):
Less than 12 months
12 months or longer
U.S. Government agency and government sponsored
enterprises
40,103
43,075
83,178
83,186
Total temporarily impaired securities
U.S. Government agencies and government sponsored
104,634
1,277
7,196
111,830
10,347
11
9,409
19,756
533
8,803
8,811
129,206
1,367
16,613
264
145,819
2,388
2,967
19
2,598
28
5,565
11,155
61
5,625
16,780
9,120
13,486
216
22,606
15,127
30
7,988
73
23,115
8,760
72
892
9,652
49,517
228
30,589
395
80,106
178,723
1,595
47,202
659
225,925
2,254
- 17 -
The total number of securities positions in the investment portfolio in an unrealized loss position at September 30, 2020 was 16 compared to 91 at December 31, 2019. At September 30, 2020, the Company had a position in one investment security with a fair value of $8 thousand and a total unrealized loss of less than $1 thousand that has been in a continuous unrealized loss position for more than 12 months. At September 30, 2020, there were a total of 15 securities positions in the Company’s investment portfolio with a fair value of $83.2 million and a total unrealized loss of $206 thousand that had been in a continuous unrealized loss position for less than 12 months. At December 31, 2019, the Company had positions in 34 investment securities with a fair value of $47.2 million and a total unrealized loss of $659 thousand that had been in a continuous unrealized loss position for more than 12 months. At December 31, 2019, there were a total of 57 securities positions in the Company’s investment portfolio with a fair value of $178.7 million and a total unrealized loss of $1.6 million that had been in a continuous unrealized loss position for less than 12 months. The unrealized loss on investment securities was predominantly caused by changes in market interest rates subsequent to purchase. The fair value of most of the investment securities in the Company’s portfolio fluctuates as market interest rates change.
Securities Available for Sale
As of September 30, 2020, no allowance for credit losses has been recognized on available for sale securities in an unrealized loss position as management does not believe any of the securities are impaired due to reasons of credit quality. This is based upon our analysis of the underlying risk characteristics, including credit ratings, and other qualitative factors related to our available for sale securities and in consideration of our historical credit loss experience and internal forecasts. The issuers of these securities continue to make timely principal and interest payments under the contractual terms of the securities. Furthermore, management does not have the intent to sell any of the securities classified as available for sale in the table above and believes that it is more likely than not that we will not have to sell any such securities before a recovery of cost. The unrealized losses are due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline.
Securities Held to Maturity
The Company’s HTM investment securities include debt securities that are issued by U.S. government agencies or U.S. government-sponsored enterprises. These securities carry the explicit and/or implicit guarantee of the U.S. government, are widely recognized as “risk free,” and have a long history of zero credit loss. In addition, the Company’s HTM investment securities include debt securities that are issued by state and local government agencies, or municipal bonds.
The Company monitors the credit quality of our municipal bonds through the use of a credit rating agency or by ratings that are derived by an internal scoring model. The scoring methodology for the internally derived ratings is based on a series of financial ratios for the municipality being reviewed as compared to typical industry figures. This information is used to determine the financial strengths and weaknesses of the municipality, which is indicated with a numeric rating. This number is then converted into a letter rating to better match the system used by the credit rating agencies. As of September 30, 2020, $151.6 million of our municipal bonds were rated as an equivalent to Standard & Poor’s A/AA/AAA, with $8.5 million internally rated to be the equivalent of Standard & Poor’s A/AA/AAA rating. Additionally, one municipal bond is rated below investment grade, with a BB+ Standard & Poor’s equivalent rating. The below investment grade bond was recently upgraded from a Standard & Poor’s equivalent rating of BB-, represents exposure of $279 thousand, or 0.18% of the municipal bond portfolio and is closely monitored for repayment.
As of September 30, 2020, the Company had no past due or nonaccrual held to maturity investment securities.
- 18 -
(5.)
LOANS
The Company’s loan portfolio consisted of the following as of the dates indicated (in thousands):
Principal
Amount
Outstanding
Net Deferred
Loan (Fees)
Costs
Loans,
Net
Commercial business
823,611
(5,476
818,135
Commercial mortgage
1,204,353
(2,307
1,202,046
Residential real estate loans
583,963
12,939
596,902
Residential real estate lines
90,899
3,118
94,017
Consumer indirect
813,345
27,234
840,579
Other consumer
16,703
157
16,860
3,532,874
35,665
3,568,539
Allowance for credit losses - loans
(49,395
Total loans, net
571,222
818
572,040
1,108,315
(2,032
1,106,283
560,717
11,633
572,350
101,048
3,070
104,118
822,179
27,873
850,052
15,984
160
16,144
3,179,465
41,522
3,220,987
(30,482
Loans held for sale (not included above) were comprised entirely of residential real estate mortgages and totaled $7.1 million and $4.2 million as of September 30, 2020 and December 31, 2019, respectively.
The CARES Act was passed by Congress and signed into law on March 27, 2020. The CARES Act established the PPP, an expansion of the SBA’s 7(a) loan program and the EIDL, administered directly by the SBA. The Company had $270.5 million of PPP loans (included in Commercial business above) as of September 30, 2020. In addition, the CARES Act provides that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a TDR and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes. Accordingly, the Company had $526.7 million of loans with modifications related to COVID-19 as of September 30, 2020.
The Company elected to exclude AIR from the amortized cost basis of loans disclosed throughout this footnote. As of September 30, 2020 and December 31, 2019, AIR for loans totaled $13.7 million and $9.1 million, respectively, and is included in other assets on the Company’s consolidated statements of financial condition.
- 19 -
LOANS (Continued)
Past Due Loans Aging
The Company’s recorded investment, by loan class, in current and nonaccrual loans, as well as an analysis of accruing delinquent loans is set forth as of the dates indicated (in thousands):
30-59
Days
Past
Due
60-89
Greater
Than
90 Days
Nonaccrual
Current
Loans
with no
allowance
139
2
141
2,628
820,842
894
3,372
1,200,981
3,175
389
35
424
3,305
580,234
288
207
90,404
3,520
566
1,244
808,015
126
20
16,410
Total loans, gross
4,462
5,226
10,762
3,516,886
8,831
361
1,177
569,684
531
3,146
1,104,638
929
1,043
2,484
557,190
231
37
268
100,678
3,729
4,748
1,725
815,706
130
15,854
5,897
1,178
7,081
8,634
3,163,750
There were no loans past due greater than 90 days and still accruing interest as of September 30, 2020 and December 31, 2019. There were $141 thousand and $6 thousand in consumer overdrafts which were past due greater than 90 days as of September 30, 2020 and December 31, 2019, respectively. Consumer overdrafts are overdrawn deposit accounts which have been reclassified as loans but by their terms do not accrue interest.
The Company recognized no interest income on nonaccrual loans during the nine months ended September 30, 2020 and 2019.
Troubled Debt Restructurings
A modification of a loan constitutes a TDR when a borrower is experiencing financial difficulty and the modification constitutes a concession. Commercial loans modified in a TDR may involve temporary interest-only payments, term extensions, reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, collateral concessions, forgiveness of principal, forbearance agreements, or substituting or adding a new borrower or guarantor.
There were no loans modified as a TDR during the nine months ended September 30, 2020 and 2019. During the third quarter of 2020, the Company discovered that the previously reported 2020 TDR was reported in error. This correction had no impact to any other section within our consolidated financial statements and the Company does not consider this correction to be material to any previously issued consolidated financial statement. There were no loans modified as a TDR within the previous 12 months that defaulted during the nine months ended September 30, 2020 and 2019. For purposes of this disclosure, a loan modified as a TDR is considered to have defaulted when the borrower becomes 90 days past due.
Collateral Dependent Loans
Management has determined that specific commercial loans on nonaccrual status and all loans that have had their terms restructured in a troubled debt restructuring where repayment is expected to be provided substantially through the operation or sale of the collateral to be collateral dependent loans. The following table presents the amortized cost basis of collateral dependent loans by collateral type as of September 30, 2020 (in thousands):
Collateral type
Business assets
Real property
4,287
4,364
14,465
14,542
18,829
- 20 -
Credit Quality Indicators
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors such as the fair value of collateral. The Company analyzes commercial business and commercial mortgage loans individually by classifying the loans as to credit risk. Risk ratings are updated any time the situation warrants. The Company uses the following definitions for risk ratings:
Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date.
Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loans that do not meet the criteria above that are analyzed individually as part of the process described above are considered “uncriticized” or pass-rated loans and are included in groups of homogeneous loans with similar risk and loss characteristics.
The following table sets forth the Company’s commercial loan portfolio, categorized by internally assigned asset classification, as of the dates indicated (in thousands):
Term Loans Amortized Cost Basis by Origination Year
2018
2017
2016
Prior
Revolving
Cost Basis
Converted
to Term
Commercial Business
Uncriticized
356,882
111,373
90,038
32,169
12,489
19,063
183,654
805,668
Special mention
709
108
802
2,088
3,753
Substandard
223
486
1,321
757
239
4,759
8,714
Doubtful
357,814
111,967
91,362
33,728
12,768
19,995
190,501
Commercial Mortgage
213,341
278,617
186,224
189,627
96,571
199,397
430
1,164,207
2,091
17,133
329
21,456
189
2,448
1,910
1,615
10,019
199
16,383
213,530
283,156
205,267
191,696
96,903
210,865
629
- 21 -
The Company utilizes payment status as a means of identifying and reporting problem and potential problem retail loans. The Company considers nonaccrual loans and loans past due greater than 90 days and still accruing interest to be non-performing. The following table sets forth the Company’s retail loan portfolio, categorized by performance status, as of the dates indicated (in thousands):
Residential Real Estate Loans
Performing
106,889
100,498
93,116
73,143
71,269
148,682
593,597
Nonperforming
200
1,209
790
312
794
100,698
94,325
73,933
71,581
149,476
Residential Real Estate Lines
83,746
10,064
93,810
83,792
10,225
Consumer Indirect
223,417
220,615
186,913
128,567
57,873
21,950
839,335
97
241
475
273
223,514
220,856
187,388
128,840
58,038
21,943
Other Consumer
5,950
3,684
2,073
1,083
466
688
2,910
16,854
1,088
2,911
Allowance for Credit Losses - Loans
The following table sets forth the changes in the allowance for credit losses - loans for the three- and nine-month periods ended September 30, 2020 (in thousands):
Commercial
Business
Mortgage
Residential
Real Estate
Lines
Consumer
Indirect
Three months ended September 30, 2020
12,399
15,666
5,769
939
11,222
321
46,316
Charge-offs
(15
(640
(1,388
(160
(2,203
Recoveries
1,503
1,715
Provision (credit)
507
1,417
(1,224
(121
2,833
155
3,567
12,994
16,480
4,552
14,170
381
49,395
Nine months ended September 30, 2020
Beginning balance, prior to adoption of ASC 326
11,358
5,681
1,059
118
11,852
414
30,482
Impact of adopting ASC 326
(246
7,310
3,290
607
(1,234
(133
9,594
Beginning balance, after adoption of ASC 326
11,112
12,991
4,349
10,618
281
40,076
(8,281
(1,712
(100
(7,366
(499
(17,958
1,644
25
4,550
282
6,541
Provision
8,519
5,164
278
6,368
317
20,736
- 22 -
The following table sets forth the changes in the allowance for credit losses - loans for the three- and nine-month periods ended September 30, 2019 (in thousands):
Three months ended September 30, 2019
11,717
8,790
1,217
145
12,157
408
34,434
(112
(2,994
(54
(2,420
(315
(5,903
14
1,103
448
1,002
254
12,155
5,922
1,183
146
11,842
420
31,668
Nine months ended September 30, 2019
14,312
5,219
1,112
210
12,572
489
33,914
(380
(2,997
(172
(10
(8,102
(867
(12,528
333
4,205
299
4,891
(2,110
3,683
212
(60
3,167
499
Loans and the related allowance for credit losses - loans are presented below as of the dates indicated (in thousands):
September 30, 2019
Loans:
573,610
1,037,304
547,839
104,545
834,968
16,467
3,114,733
Evaluated for impairment:
Individually
3,010
6,300
Collectively
570,600
1,034,014
3,108,433
Allowance for loan losses:
1,563
1,564
10,592
5,921
30,104
Risk Characteristics
Commercial business loans primarily consist of loans to small to mid-sized businesses in our market area in a diverse range of industries. These loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value. The credit risk related to commercial loans is largely influenced by general economic conditions, including the impact of the COVID-19 pandemic on small to mid-sized business in our market area, and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.
Commercial mortgage loans generally have larger balances and involve a greater degree of risk than residential mortgage loans, potentially resulting in higher potential losses on an individual customer basis. Loan repayment is often dependent on the successful operation and management of the properties, as well as on the collateral securing the loan. Economic events, including the impact of the COVID-19 pandemic on the ability of the tenants to pay rent at these properties, or conditions in the real estate market could have an adverse impact on the cash flows generated by properties securing the Company’s commercial real estate loans and on the value of such properties.
- 23 -
Residential real estate loans (comprised of conventional mortgages and home equity loans) and residential real estate lines (comprised of home equity lines) are generally made based on the borrower’s ability to make repayment from his or her employment and other income but are secured by real property whose value tends to be more easily ascertainable. Credit risk for these types of loans is generally influenced by general economic conditions, including the impact of the COVID-19 pandemic on the employment income of these borrowers, the characteristics of individual borrowers, and the nature of the loan collateral.
Consumer indirect and other consumer loans may entail greater credit risk than residential mortgage loans and home equities, particularly in the case of other consumer loans which are unsecured or, in the case of indirect consumer loans, secured by depreciable assets, such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances such as job loss, illness or personal bankruptcy, including the heightened risk that such circumstances may arise as a result of the COVID-19 pandemic. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.
(6.)
LEASES
ASC 842, Leases (“ASC 842”), establishes a right of use model that requires a lessee to record a right of use asset and a lease liability for all leases with terms longer than 12 months. The Company is obligated under a number of non-cancellable operating lease agreements for land, buildings and equipment with terms, including renewal options reasonably certain to be exercised, extending through 2047. One building lease is subleased for terms extending through 2021.
The following table represents the consolidated statements of financial condition classification of the Company’s right of use assets and lease liabilities:
Balance Sheet Location
Operating Lease Right of Use Assets:
Gross carrying amount
23,690
23,224
Accumulated amortization
(3,266
(1,861
Net book value
20,424
21,363
Operating Lease Liabilities:
Right of use lease obligations
21,947
22,800
The weighted average remaining lease term for operating leases was 21.5 years at September 30, 2020 and the weighted-average discount rate used in the measurement of operating lease liabilities was 3.80%. The Company utilizes its incremental borrowing rate at lease inception, on a collateralized basis, over a similar term for the discount rate.
The following table represents lease costs and other lease information:
Lease costs:
Operating lease costs
663
706
2,018
2,096
Variable lease costs (1)
111
112
313
Sublease income
(12
(35
Net lease costs
762
806
2,296
2,382
Other information:
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases
1,947
1,332
Initial recognition of operating lease right of use assets
23,275
Initial recognition of operating lease liabilities
23,985
Right of use assets obtained in exchange for new operating
lease liabilities
346
(1)
Variable lease costs primarily represent variable payments such as common area maintenance, insurance, taxes and utilities.
- 24 -
LEASES (Continued)
Future minimum payments under non-cancellable operating leases with initial or remaining terms of one year or more, are as follows at September 30, 2020 (in thousands):
Twelve months ended September 30,
2021
2,570
2022
2,039
2023
1,731
2024
2025
1,208
Thereafter
25,085
Total future minimum operating lease payments
33,965
Amounts representing interest
(12,018
Present value of net future minimum operating lease payments
(7.)
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill
The carrying amount of goodwill totaled $66.1 million as of both September 30, 2020 and December 31, 2019. The Company performs a goodwill impairment test on an annual basis as of October 1st or more frequently if events and circumstances warrant.
Banking
Non-Banking
Balance, December 31, 2019
48,536
17,526
66,062
No activity during the period
Balance, September 30, 2020
Goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis, and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Based on the volatility in the capital markets in 2020 and overall economic conditions as a result of the COVID-19 pandemic accompanied by a decline in the Company’s stock price, a quantitative assessment was performed for the Banking segment in the third quarter of 2020. Based on this quantitative assessment, the Company concluded that goodwill was not impaired for the Banking segment. Based on its qualitative assessment for each of the SDN, Courier Capital and HNP Capital reporting units, the Company concluded that it was more likely than not that goodwill was not impaired as of September 30, 2020. Therefore, no quantitative assessment was deemed necessary as of September 30, 2020.
Other Intangible Assets
The Company has other intangible assets that are amortized, consisting of core deposit intangibles and other intangibles (primarily related to customer relationships). Gross carrying amount, accumulated amortization and net book value, were as follows (in thousands):
Other intangibles assets:
15,925
(7,925
(7,064
8,000
8,861
Amortization expense for total other intangible assets was $280 thousand and $861 thousand for the three and nine months ended September 30, 2020, respectively, and $309 thousand and $948 thousand for the three and nine months ended September 30, 2019, respectively. As of September 30, 2020, the estimated amortization expense of other intangible assets for the remainder of 2020 and each of the next five years is as follows (in thousands):
2020 (remainder of year)
1,014
923
852
783
714
- 25 -
(8.)
DERIVATIVE INSTRUMENT AND HEDGING ACTIVITIES
Risk Management Objective of Using Derivatives
The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities, and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments.
Cash Flow Hedges of Interest Rate Risk
The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company uses interest rate caps and interest rate swaps as part of its interest rate risk management strategy. Interest rate caps designated as cash flow hedges involve the receipt of variable amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium. During the first nine months of 2020 and in 2019, such derivatives were used to hedge the variable cash flows associated with short-term borrowings. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The Company is hedging its exposure to the variability in future cash flows for forecasted transactions over a period of approximately 60 months. As of September 30, 2020, the Company had one outstanding forward starting interest rate derivative with a notional value of $50.0 million that was designated as a cash flow hedge of interest rate risk. The derivative becomes effective in April 2022.
For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in accumulated other comprehensive income (loss) and subsequently reclassified into interest expense in the same period(s) during which the hedged transaction affects earnings. Amounts reported in accumulated other comprehensive income (loss) related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s borrowings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company’s cash flow hedge derivatives did not have any hedge ineffectiveness recognized in earnings during the nine months ended September 30, 2020 and 2019. During the next twelve months, the Company estimates that $283 thousand will be reclassified as an increase to interest expense.
Interest Rate Swaps
The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. These interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate swaps associated with this program do not meet hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings.
Credit-risk-related Contingent Features
The Company has agreements with certain of its derivative counterparties that contain one or more of the following provisions: (a) if the Company defaults on any of its indebtedness, including a default where repayment of the indebtedness has not been accelerated by the lender, the Company could also be declared in default on its derivative obligations, and (b) if the Company fails to maintain its status as a well-capitalized institution, the counterparty could terminate the derivative positions and the Company would be required to settle its obligations under the agreements.
Mortgage Banking Derivatives
The Company extends rate lock agreements to borrowers related to the origination of residential mortgage loans. To mitigate the interest rate risk inherent in these rate lock agreements when the Company intends to sell the related loan, once originated, as well as closed residential mortgage loans held for sale, the Company enters into forward commitments to sell individual residential mortgages. Rate lock agreements and forward commitments are considered derivatives and are recorded at fair value.
- 26 -
DERIVATIVE INSTRUMENT AND HEDGING ACTIVITIES (Continued)
Fair Values of Derivative Instruments on the Balance Sheet
The table below presents the notional amounts, respective fair values of the Company’s derivative financial instruments, as well as their classification on the balance sheet as of September 30, 2020 and December 31, 2019 (in thousands):
Asset derivatives
Liability derivatives
Gross notional
amount
Balance
Fair value
Sept. 30,
Dec. 31,
sheet
line item
Derivatives designated as hedging instruments
Cash flow hedges
50,000
100,000
647
Total derivatives
Derivatives not designated as hedging instruments
Interest rate swaps (1)
575,707
272,962
23,079
6,419
23,498
6,720
Credit contracts
87,393
68,324
29
13
Mortgage banking
40,752
11,859
891
119
803,852
353,145
23,999
6,551
23,558
6,745
The Company secured its obligations under these contracts with $24.6 million and $6.7 million in cash at September 30, 2020 and December 31, 2019, respectively.
Effect of Derivative Instruments on the Income Statement
The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three and nine months ended September 30, 2020 and 2019 (in thousands):
Gain (loss) recognized in income
Line item of gain (loss)
Undesignated derivatives
recognized in income
Interest rate swaps
1,310
854
3,715
838
48
136
54
608
766
121
Total undesignated
- 27 -
(9.)
SHAREHOLDERS’ EQUITY
Common Stock
The changes in shares of common stock were as follows for the three and nine months ended September 30, 2020 and 2019:
Issued
Shares at December 31, 2019
16,002,899
96,657
16,099,556
22,921
(22,921
Treasury stock purchases
(6,436
6,436
Shares at March 31, 2020
16,019,384
80,172
12,798
(12,798
5,403
(5,403
Shares at June 30, 2020
16,037,585
61,971
Shares at September 30, 2020
Shares at December 31, 2018
15,928,598
127,580
16,056,178
18,580
(18,580
(6,368
Shares at March 31, 2019
15,940,810
115,368
43,378
8,226
(8,226
2,283
(2,283
Shares at June 30, 2019
15,994,697
104,859
2,500
(2,500
(839
839
Shares at September 30, 2019
15,996,358
103,198
- 28 -
(10.)
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
The following tables present the components of other comprehensive income (loss) for the three and nine months ended September 30, 2020 and 2019 (in thousands):
Pre-tax
Tax
Effect
Net-of-tax
Securities available for sale and transferred securities:
Change in unrealized gain/loss during the period
374
96
Reclassification adjustment for net gains included in net income (1)
(467
(347
Total securities available for sale and transferred securities
(93
Hedging derivative instruments:
Pension and post-retirement obligations:
Amortization of prior service credit included in income
(6
Amortization of net actuarial loss included in income
82
Total pension and post-retirement obligations
80
Other comprehensive income
385
98
19,737
5,057
14,680
(1,213
(311
(902
18,524
4,746
(234
(26
967
248
719
941
Other comprehensive loss
19,231
4,927
Includes amounts related to the amortization/accretion of unrealized net gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category. The unrealized net gains/losses will be amortized/accreted over the remaining life of the investment securities as an adjustment of yield.
- 29 -
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (Continued)
2,992
755
2,237
(1,492
(376
(1,116
1,500
379
(16
366
92
274
350
88
1,907
481
17,222
4,342
12,880
(1,360
(343
(1,017
15,862
3,999
(424
(107
(49
(37
1,098
277
821
1,049
265
16,487
4,157
- 30 -
Activity in accumulated other comprehensive income (loss), net of tax, for the three and nine months ended September 30, 2020 and 2019 was as follows (in thousands):
Hedging
Derivative
Instruments
Securities
Available
for Sale and
Transferred
Pension and
Post-
retirement
Obligations
Income (Loss)
Balance at beginning of period
(815
14,720
(14,401
Other comprehensive income before reclassifications
401
Amounts reclassified from accumulated other comprehensive
(loss) income
(114
Net current period other comprehensive income (loss)
Balance at end of period
(692
14,651
(14,168
(518
873
(14,868
Other comprehensive (loss) income before reclassifications
14,506
(202
(636
2,292
(14,816
2,280
(854
Net current period other comprehensive income
(593
3,413
(14,554
(276
(7,769
(13,236
Reclassification of income tax effects to retained earnings
(681
(2,102
12,563
income (loss)
(233
Net current period other comprehensive (loss) income
- 31 -
The following table presents the amounts reclassified out of each component of accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2020 and 2019 (in thousands):
Details About Accumulated Other
Comprehensive Income (Loss) Components
Amount Reclassified from
Accumulated Other
Affected Line Item in the
Consolidated Statement of Income
Realized gain on sale of investment securities
Amortization of unrealized holding losses
on investment securities transferred from
available for sale to held to maturity
(87
(116
Interest income
467
1,492
Total before tax
347
1,116
Net of tax
Amortization of pension and post-retirement items:
Prior service credit (1)
Net actuarial losses (1)
(321
(366
(313
(350
Income tax benefit
(262
Total reclassified for the period
(236
(361
1,213
1,360
Income tax (expense) benefit
902
1,017
26
(967
(1,098
(941
(1,049
(700
(784
202
These items are included in the computation of net periodic pension expense. See Note 12 – Employee Benefit Plans for additional information.
- 32 -
(11.)
SHARE-BASED COMPENSATION PLANS
The Company maintains certain share-based compensation plans, approved by the Company’s shareholders, that are administered by the Management Development and Compensation Committee (the “MD&C Committee”) of the Board. The share-based compensation plans were established to allow for the grant of compensation awards to attract, motivate and retain employees, executive officers and non-employee directors who contribute to the long-term growth and profitability of the Company and to give such persons a proprietary interest in the Company, thereby enhancing their personal interest in the Company’s success.
The MD&C Committee approved the grant of restricted stock units (“RSUs”) and performance share units (“PSUs”) shown in the table below to certain members of management during the nine months ended September 30, 2020.
Number of
Underlying
Shares
Weighted
Average
Per Share
Grant Date
Fair Value
RSUs
57,306
25.67
PSUs
23,302
25.63
The grant-date fair value for the RSUs granted during the nine months ended September 30, 2020 is equal to the closing market price of our common stock on the date of grant reduced by the present value of the dividends expected to be paid on the underlying shares.
Fifty percent of the PSUs that ultimately vest is contingent on achieving specified return on average equity (“ROAE”) targets relative to the SNL Small Cap Bank & Thrift Index, a market index the MD&C Committee has selected as a peer group for this purpose. These shares will be earned based on the Company’s achievement of a relative ROAE performance requirement, on a percentile basis, compared to the SNL Small Cap Bank & Thrift Index over a three-year performance period ended December 31, 2022. The shares earned based on the achievement of the ROAE performance requirement, if any, will vest on the third anniversary of the grant date assuming the recipient’s continuous service to the Company. The remaining fifty percent of the PSUs that ultimately vest is contingent upon achievement of an average return on average assets (“ROAA”) performance requirement over a three-year performance period ended December 31, 2022. The shares earned based on the achievement of the ROAA performance requirement, if any, will vest on the third anniversary of the grant date assuming the recipient’s continuous service to the Company.
The grant-date fair values for both the ROAE and the ROAA portions of PSUs granted during the nine months ended September 30, 2020 are equal to the closing market price of our common stock on the date of grant reduced by the present value of the dividends expected to be paid on the underlying shares.
During the nine months ended September 30, 2020, the Company issued a total of 5,403 shares of common stock in-lieu of cash for the annual retainer of four non-employee directors and granted a total of 12,798 restricted shares of common stock to non-employee directors, of which 6,399 shares vested immediately and 6,399 shares will vest after completion of a one-year service requirement. The market value of the stock and restricted stock at the close of the Nasdaq Global Select Market on the date of grant was $17.57.
The following is a summary of restricted stock awards and restricted stock units activity for the nine months ended September 30, 2020:
Market
Price at
Outstanding at beginning of year
151,808
27.80
Granted
93,406
24.55
Vested
(33,433
28.88
Forfeited
(39,406
27.99
Outstanding at end of period
172,375
25.78
At September 30, 2020, there was $2.5 million of unrecognized compensation expense related to unvested restricted stock awards and restricted stock units that is expected to be recognized over a weighted average period of 1.96 years.
- 33 -
SHARE-BASED COMPENSATION PLANS (Continued)
The Company uses the Black-Scholes valuation method to estimate the fair value of its stock option awards. There were no stock options awarded during the first nine months of 2020 or 2019. There was no unrecognized compensation expense related to unvested stock options as of September 30, 2020. There was no stock option activity for the nine months ended September 30, 2020.
The Company amortizes the expense related to share-based compensation awards over the vesting period. Share-based compensation expense is recorded as a component of salaries and employee benefits in the consolidated statements of income for awards granted to management and as a component of other noninterest expense for awards granted to directors. The share-based compensation expense included in the consolidated statements of income, is as follows (in thousands):
261
364
793
825
Other noninterest expense
197
203
Total share-based compensation expense
(12.)
EMPLOYEE BENEFIT PLANS
The components of the Company’s net periodic benefit expense for its pension and post-retirement obligations were as follows (in thousands):
Service cost
924
801
2,770
2,405
Interest cost on projected benefit obligation
635
696
1,905
2,086
Expected return on plan assets
(1,284
(1,184
(3,852
(3,552
Amortization of unrecognized prior service credit
Amortization of unrecognized net actuarial loss
Net periodic benefit expense
588
1,764
1,988
The net periodic benefit expense is recorded as a component of salaries and employee benefits in the consolidated statements of income. The Company’s funding policy is to contribute, at a minimum, an actuarially determined amount that will satisfy the minimum funding requirements determined under the appropriate sections of the Internal Revenue Code. The Company has no minimum required contribution for the 2020 fiscal year.
(13.)
COMMITMENTS AND CONTINGENCIES
Financial Instruments with Off-Balance Sheet Risk
The Company has financial instruments with off-balance sheet risk established 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, elements of credit and interest rate risk extending beyond amounts recognized in the financial statements.
The Company’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 essentially the same as that involved with extending loans to customers. The Company uses the same credit underwriting policies in making commitments and conditional obligations as for on-balance sheet instruments.
Off-balance sheet commitments consist of the following (in thousands):
Commitments to extend credit
973,129
820,282
Standby letters of credit
22,652
21,911
- 34 -
COMMITMENTS AND CONTINGENCIES (Continued)
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the agreement. Commitments generally have fixed expiration dates or other termination clauses which may require payment of a fee. Commitments may expire without being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Standby letters of credit are conditional lending commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support private borrowing arrangements. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers.
Unfunded Commitments
At September 30, 2020 and December 31, 2019, the allowance for credit losses for unfunded commitments totaled $3.1 million and $0, respectively, and was included in other liabilities on the Company's consolidated statements of financial condition. For the three months ended September 30, 2020 and 2019, credit loss expense for unfunded commitments was $461 thousand and $0, respectively. For the nine months ended September 30, 2020 and 2019, credit loss expense for unfunded commitments was $959 thousand and $0, respectively.
Contingent Liabilities and Litigation
In the ordinary course of business, there are various threatened and pending legal proceedings against the Company. Management believes that the aggregate liability, if any, arising from such litigation, except for the matter described below, would not have a material adverse effect on the Company’s consolidated financial statements.
As previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 as filed with the SEC on March 4, 2020 and as disclosed in Part II, Item 1 of this Quarterly Report on Form 10-Q, we are party to an action filed against us on May 16, 2017 by Matthew L. Chipego, Charlene Mowry, Constance C. Churchill and Joseph W. Ewing in the Court of Common Pleas in Philadelphia, Pennsylvania. The plaintiffs seek to represent a putative class of consumers who are alleged to have obtained direct or indirect financing from us for the purchase of vehicles that we later repossessed. The plaintiffs specifically claim that the notices the Bank sent to defaulting consumers after their vehicles were repossessed did not comply with the relevant portions of the Uniform Commercial Code in New York and Pennsylvania and are seeking statutory damages, interest and declaratory relief. The Company is pursuing insurance coverage for these claims, including reimbursement for defense costs. We dispute and believe we have meritorious defenses against these claims and plan to vigorously defend ourselves. If we are unsuccessful in defending ourselves from these claims or if we elect to settle these claims and if our insurer does not insure us against legal costs we incur in excess of our deductible, the result may materially adversely affect our business, results of operations and financial condition.
(14.)
FAIR VALUE MEASUREMENTS
Determination of Fair Value – Assets Measured at Fair Value on a Recurring and Nonrecurring Basis
Valuation Hierarchy
The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. There have been no changes in the valuation techniques used during the current period. The fair value hierarchy is as follows:
Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
Level 2 - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.
Level 3 - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.
Transfers between levels of the fair value hierarchy are recorded as of the end of the reporting period.
- 35 -
FAIR VALUE MEASUREMENTS (Continued)
In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
Securities available for sale: Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.
Derivative instruments: The fair value of derivative instruments is determined using quoted secondary market prices for similar financial instruments and are classified as Level 2 in the fair value hierarchy.
Loans held for sale: The fair value of loans held for sale is determined using quoted secondary market prices and investor commitments. Loans held for sale are classified as Level 2 in the fair value hierarchy.
Collateral dependent loans: Fair value of collateral dependent loans with specific allocations of the allowance for credit losses – loans is measured based on the value of the collateral securing these loans and is classified as Level 3 in the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory and/or accounts receivable and collateral value is determined based on appraisals performed by qualified licensed appraisers hired by the Company. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. Collateral dependent loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.
Loan servicing rights: Loan servicing rights do not trade in an active market with readily observable market data. As a result, the Company estimates the fair value of loan servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income. The assumptions used in the discounted cash flow model are those that we believe market participants would use in estimating future net servicing income, including estimates of loan prepayment rates, servicing costs, ancillary income, impound account balances, and discount rates. The significant unobservable inputs used in the fair value measurement of the Company’s loan servicing rights are the constant prepayment rates and weighted average discount rate. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the constant prepayment rate and the discount rate are not directly interrelated, they will generally move in opposite directions. Loan servicing rights are classified as Level 3 measurements due to the use of significant unobservable inputs, as well as significant management judgment and estimation.
Other real estate owned (foreclosed assets): Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. The appraisals are sometimes further discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.
Commitments to extend credit and letters of credit: Commitments to extend credit and fund letters of credit are principally at current interest rates, and, therefore, the carrying amount approximates fair value. The fair value of commitments is not material.
- 36 -
Assets Measured at Fair Value
The following tables present for each of the fair-value hierarchy levels the Company’s assets that are measured at fair value on a recurring and non-recurring basis as of the dates indicated (in thousands).
Quoted
Prices
in Active
Markets for
Identical
Assets or
Liabilities
(Level 1)
Significant
Observable
Inputs
(Level 2)
Unobservable
(Level 3)
Measured on a recurring basis:
Mortgage-backed securities
Other liabilities:
(647
Fair value adjusted through comprehensive income
515,324
Other assets:
Derivative instruments - cash flow hedges
Derivative instruments - interest rate swaps
Derivative instruments - credit contracts
Derivative instruments - mortgage banking
(23,498
(47
(13
Fair value adjusted through net income
441
Measured on a nonrecurring basis:
Collateral dependent loans
17,913
Loan servicing rights
1,175
Other real estate owned
2,999
22,087
29,163
There were no transfers between Levels 1 and 2 during the nine months ended September 30, 2020. There were no liabilities measured at fair value on a nonrecurring basis during the nine months ended September 30, 2020.
- 37 -
(6,720
(18
(194
Collateral dependent impaired loans
3,630
1,129
468
5,227
9,451
There were no transfers between Levels 1 and 2 during the nine months ended September 30, 2019. There were no liabilities measured at fair value on a nonrecurring basis during the nine months ended September 30, 2019.
The following table presents additional quantitative information about assets measured at fair value on a recurring and nonrecurring basis for which the Company has utilized Level 3 inputs to determine fair value as of September 30, 2020 (dollars in thousands).
Asset
Valuation Technique
Unobservable Input
Value or Range
Appraisal of collateral (1)
Appraisal adjustments (2)
10.0% (3)
Discounted cash flow
Discount rate
10.2% (3)
Constant prepayment rate
18.4% (3)
23.3% (3)
Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various Level 3 inputs which are not identifiable.
(2)
Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.
(3)
Weighted averages.
Changes in Level 3 Fair Value Measurements
There were no assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of or during the nine months ended September 30, 2020 and 2019.
- 38 -
Disclosures about Fair Value of Financial Instruments
The assumptions used below are expected to approximate those that market participants would use in valuing these financial instruments.
Fair value estimates are made at a specific point in time, based on available market information and judgments about the financial instrument, including estimates of timing, amount of expected future cash flows and the credit standing of the issuer. Such estimates do not consider the tax impact of the realization of unrealized gains or losses. In some cases, the fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial instrument. Care should be exercised in deriving conclusions about our business, its value or financial position based on the fair value information of financial instruments presented below.
The estimated fair value approximates carrying value for cash and cash equivalents, Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) stock, accrued interest receivable, non-maturity deposits, short-term borrowings and accrued interest payable.
The following presents (in thousands) the carrying amount, estimated fair value, and placement in the fair value measurement hierarchy of the Company’s financial instruments as of the dates indicated.
Level in
Estimated
Measurement
Carrying
Hierarchy
Financial assets:
Cash and cash equivalents
Level 1
Securities available for sale
Level 2
Securities held to maturity, net
3,501,231
3,536,646
3,186,875
3,201,814
Loans (1)
Level 3
Accrued interest receivable
16,230
11,308
FHLB and FRB stock
8,619
20,637
Derivative instruments – cash flow hedges
Derivative instruments – interest rate products
Derivative instruments – credit contracts
Derivative instruments – mortgage banking
Financial liabilities:
Non-maturity deposits
3,523,698
2,375,486
843,191
1,179,991
45,224
41,083
Accrued interest payable
5,737
10,942
Comprised of collateral dependent loans.
- 39 -
(15.)
SEGMENT REPORTING
The Company has two reportable segments: Banking and Non-Banking. These reportable segments have been identified and organized based on the nature of the underlying products and services applicable to each segment, the type of customers to whom those products and services are offered and the distribution channel through which those products and services are made available.
The Banking segment includes all of the Company’s retail and commercial banking operations. The Non-Banking segment includes the activities of SDN, a full-service insurance agency that provides a broad range of insurance services to both personal and business clients, and Courier Capital and HNP Capital, our investment advisor and wealth management firms that provide customized investment management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans. Holding company amounts are the primary differences between segment amounts and consolidated totals and are reflected in the Holding Company and Other column below, along with amounts to eliminate balances and transactions between segments.
The following tables present information regarding our business segments as of and for the periods indicated (in thousands).
Non-
Holding
Company
and Other
Consolidated
Totals
Other intangible assets, net
41
7,959
4,922,251
37,420
(470
8,763
4,346,615
36,733
830
Net interest income (expense)
36,117
(618
(4,028
Noninterest income
9,101
3,489
(189
Noninterest expense
(24,504
(3,571
(584
(28,659
Income (loss) before income taxes
16,686
(82
(1,391
(3,598
640
(2,940
Net income (loss)
13,088
(64
(751
104,657
(1,853
(21,689
23,169
9,543
(517
(72,008
(9,349
(1,718
(83,075
34,129
194
(4,088
(6,317
670
(5,703
27,812
138
(3,418
- 40 -
SEGMENT REPORTING (Continued)
33,101
Provision for loan losses
(1,844
9,398
3,149
(186
(22,153
(3,225
(508
(25,886
18,502
(76
(1,312
(4,034
(263
(4,281
14,468
(1,575
98,592
(5,391
22,452
8,809
(547
(65,256
(9,097
(1,707
(76,060
50,397
(288
(4,107
(10,693
59
387
(10,247
39,704
(229
(3,720
- 41 -
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q should be read in conjunction with the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2019. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein.
FORWARD LOOKING INFORMATION
Statements and financial analysis contained in this Quarterly Report on Form 10-Q that are based on other than historical data are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:
statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Financial Institutions, Inc. (the “Parent”) and its subsidiaries (collectively, the “Company,” “we,” “our” or “us”); and
statements preceded by, followed by or that include the words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “projects,” or similar expressions.
These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended December 31, 2019 (the “Form 10-K”), including, but not limited to, those presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations. Factors that might cause such material differences include, but are not limited to:
The ongoing novel coronavirus (“COVID-19”) pandemic, and governmental and individual efforts to contain the pandemic, have had a significant negative impact on the U.S. and New York State economy which will adversely affect our customers and have an adverse effect on our business, financial condition and results of operations;
If we experience greater credit losses than anticipated, earnings may be adversely impacted;
Geographic concentration may unfavorably impact our operations;
Our commercial business and mortgage loans increase our exposure to credit risks;
Our indirect and consumer lending involves risk elements in addition to normal credit risk;
Lack of seasoning in portions of our loan portfolio could increase risk of credit defaults in the future;
We accept deposits that do not have a fixed term, and which may be withdrawn by the customer at any time for any reason;
We depend on the accuracy and completeness of information about or from customers and counterparties;
We are subject to environmental liability risk associated with our lending activities;
We operate in a highly competitive industry and market area;
Changes to and replacement of the LIBOR Benchmark Interest Rate may adversely affect our business, financial condition, and results of operations;
Our insurance brokerage subsidiary is subject to risk related to the insurance industry;
Our investment advisory and wealth management operations are subject to risk related to the regulation of the financial services industry and market volatility;
Our tax strategies and the value of our deferred tax assets and liabilities could adversely affect our operating results and regulatory capital ratios;
We make certain assumptions and estimates in preparing our financial statements that may prove to be incorrect, which could significantly impact our results of operations, cash flows and financial condition, and we are subject to new or changing accounting rules and interpretations, and the failure by us to correctly interpret or apply these evolving rules and interpretations could have a material adverse effect;
We may be unable to successfully implement our growth strategies, including the integration and successful management of newly-acquired businesses;
Acquisitions may disrupt our business and dilute shareholder value;
The value of our goodwill and other intangible assets may decline in the future;
We use financial models for business planning purposes that may not adequately predict future results;
Liquidity is essential to our businesses;
We rely on dividends from our subsidiaries for most of our revenue;
We may not be able to attract and retain skilled people;
Severe weather, natural disasters, acts of war or terrorism, and other external events could significantly impact our business;
If our risk management framework does not effectively identify or mitigate our risks, we could suffer losses;
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MANAGEMENT’S DISCUSSION AND ANALYSIS
We face competition in staying current with technological changes and banking alternatives to compete and meet customer demands;
We rely on other companies to provide key components of our business infrastructure;
A breach in security of our or third-party information systems, including the occurrence of a cyber incident or a deficiency in cybersecurity, or a failure by us to comply with New York State cybersecurity regulations, may subject us to liability, result in a loss of customer business or damage our brand image;
Any future FDIC insurance premium increases may adversely affect our earnings;
We are highly regulated, and any adverse regulatory action may result in additional costs, loss of business opportunities, and reputational damage;
Legal and regulatory proceedings and related matters could adversely affect us and the banking industry in general;
The policies of the Federal Reserve have a significant impact on our earnings;
We are subject to interest rate risk, and a rising rate environment may reduce our income and result in higher defaults on our loans, whereas a falling rate environment may result in earlier loan prepayments than we expect, which may reduce our income;
The soundness of other financial institutions could adversely affect us;
Our business may be adversely affected by conditions in the financial markets and economic conditions generally;
We may need to raise additional capital in the future and such capital may not be available on acceptable terms or at all;
We may not pay or may reduce the dividends on our common stock;
We may issue debt and equity securities or securities convertible into equity securities, any of which may be senior to our common stock as to distributions and in liquidation, which could dilute our current shareholders or negatively affect the value of our common stock;
Our certificate of incorporation, our bylaws, and certain banking laws may have an anti-takeover effect; and
The market price of our common stock may fluctuate significantly in response to a number of factors.
We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advise readers that various factors, including those described above, could affect our financial performance and could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected. See also Item 1A, Risk Factors, in the Form 10-K and Item 1A, Risk Factors, below for further information. Except as required by law, we do not undertake, and specifically disclaim any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
GENERAL
The Parent is a financial holding company headquartered in New York State, providing diversified financial services through its subsidiaries, Five Star Bank (the “Bank”), SDN Insurance Agency, LLC (“SDN”), Courier Capital, LLC (“Courier Capital”) and HNP Capital, LLC (“HNP Capital”). The Company offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York through its wholly-owned New York-chartered banking subsidiary, the Bank. Our indirect lending network includes relationships with franchised automobile dealers in Western and Central New York, the Capital District of New York and Northern and Central Pennsylvania. SDN provides a broad range of insurance services to personal and business clients. Courier Capital and HNP Capital provide customized investment advice, wealth management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans.
Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from insurance, investment advisory and financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.
Our business strategy has been to maintain a community bank philosophy, which consists of focusing on and understanding the individualized banking and other financial needs of individuals, municipalities and businesses of the local communities surrounding our primary service area. We believe this focus allows us to be more responsive to our customers’ needs and provide a high level of personal service that differentiates us from larger competitors, resulting in long-standing and broad-based banking relationships. Our core customers are primarily small- to medium-sized businesses, individuals and community organizations who prefer to build banking, insurance and wealth management relationships with a community bank that combines high quality, competitively-priced products and services with personalized service. Because of our identity and origin as a locally operated bank, we believe that our level of personal service provides a competitive advantage over larger banks, which tend to consolidate decision-making authority outside local communities.
A key aspect of our current business strategy is to foster a community-oriented culture where our customers and employees establish long-standing and mutually beneficial relationships. We believe that we are well-positioned to be a strong competitor within our market area because of our focus on community banking needs and customer service, our comprehensive suite of deposit, loan, insurance and wealth management
- 43 -
products typically found at larger banks, our highly experienced management team and our strategically located banking centers. We have evolved to meet changing customer needs by opening what we refer to as financial solution center branches. These financial solution center branches have a smaller footprint than our traditional branches, focus on technology to provide solutions that fit our customer preferences for transacting business with us, and are staffed by certified personal bankers who are trained to meet a broad array of customer needs. In recent years, we have opened four financial solution centers in the Rochester and Buffalo markets. We believe that the foregoing factors all help to grow our core deposits, which supports a central element of our business strategy - the growth of a diversified and high-quality loan portfolio.
EXECUTIVE OVERVIEW
Summary of 2020 Third Quarter Results
Net income decreased $560 thousand, or 4%, to $12.3 million for the third quarter of 2020 compared to $12.8 million for the third quarter of 2019. Net income available to common shareholders for the third quarter of 2020 was $11.9 million, or $0.74 per diluted share, compared with $12.5 million, or $0.78 per diluted share, for the third quarter of last year. Return on average common equity was 10.72% and return on average assets was 1.02% for the third quarter of 2020 compared to 12.00% and 1.19%, respectively, for the third quarter of 2019.
Third quarter results were negatively impacted by a higher provision for credit losses of $4.0 million, as compared to $1.8 million in the third quarter of 2019. The higher provision was driven by the adoption of the current expected credit loss (“CECL”) standard and uncertainty around the long-term impact of the COVID-19 pandemic on the economic environment.
Net interest income totaled $35.5 million in the third quarter of 2020, up from $32.5 million in the third quarter of 2019. This increase was primarily the result of a change in the interest-earning asset mix as loans became a larger percentage of the portfolio. Average loans were up $368.2 million in the third quarter of 2020 compared to the same quarter in 2019.
The provision for credit losses - loans was $3.6 million in the third quarter of 2020 compared to $1.8 million in the third quarter of 2019. Net charge-offs during the recent quarter were $488 thousand, down from $4.6 million in the third quarter of 2019. Net charge-offs expressed as an annualized percentage of average loans outstanding were 0.06% during the third quarter of 2020 compared with 0.58% in the third quarter of 2019. See the “Allowance for Credit Losses - Loans” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion regarding the increase in the provision for credit losses - loans and the decrease in net charge-offs.
Noninterest income was relatively flat at $12.4 million in both the third quarter of 2020 and the third quarter of 2019. Changes in noninterest income for the third quarter were primarily attributed to increases in net gain on sale of loans held for sale and income from derivative instruments, net, partially offset by decreases in net gain on investment securities and service charges on deposits. Net gain on sale of loans held for sale of $1.6 million was recognized in the third quarter of 2020 due to increased residential real estate loans for sale volume and an increase in margin on these transactions. Income from derivative instruments of $1.9 million was recognized in the third quarter of 2020 driven primarily by an increase in the number and value of interest rate swap transactions executed and reflects growth and maturity of the Company’s commercial loan business. The Company sold investment securities during the third quarter of 2020 generating a net gain of $554 thousand as compared to a net gain of $1.6 million in the third quarter of 2019. The Company recognized $1.3 million in service charges on deposits in the third quarter of 2020 as compared to $1.9 million in the third quarter of 2019 primarily due to the Company’s COVID-19 relief initiatives of waiving or eliminating fees, implemented from March 23, 2020 through July 9, 2020, and the Company not re-initiating ATM access fees until September 19, 2020.
Noninterest expense in the third quarter of 2020 totaled $28.7 million compared with $25.9 million in the third quarter of 2019. The increase in noninterest expense was primarily the result of restructuring charges incurred in the third quarter of 2020 and increases in salaries and employee benefits, computer and data processing and FDIC assessments. Restructuring charges of $1.4 million represent non-recurring real estate related charges related to the previously described branch closings and staff reduction announced in July 2020. The increase in salaries and employee benefits includes $224 thousand of non-recurring severance costs incurred in connection with the previously described branch closings and staff reduction announced in July 2020. The increase in computer and data processing expense was primarily due to costs related to the Bank’s new online and mobile platform, Five Star Bank Digital Banking, launched in the second quarter of 2020. FDIC assessments were $594 thousand in the third quarter of 2020 compared to $7 thousand in the third quarter of 2019. The FDIC minimum reserve ratio was exceeded in 2018, resulting in credits used to offset expense in 2019 and the first quarter of 2020.
The regulatory Common Equity Tier 1 Ratio and Total Risk-Based Capital Ratio were 10.19%, and 12.74%, respectively, at September 30, 2020. See the “Liquidity and Capital Management” section of this Management’s Discussion and Analysis for further discussion regarding regulatory capital and the Basel III capital rules.
The Company’s enterprise standardization program is focused on improving operational efficiency and enhancing future profitability. On July 17, 2020, in connection with the program, Five Star Bank announced changes to adapt to a full-service branch model to streamline retail branches to better align with shifting customer needs and preferences.
The announcement was the result of a nine-month comprehensive assessment of all lines of business and functional areas, conducted in partnership with a leading process improvement organization. The data-driven analysis identified, among other things, overlapping service
- 44 -
areas, automation opportunities and streamlining of processes and operations that would enhance customer experiences and facilitate the long-term sustainability of current and future branches.
The July announcement included the consolidation of eleven branches into five, resulting in six branch closings and a reduction in staffing. The consolidations represent about ten percent of the branch network and impacted approximately six percent of the Company’s total workforce. These actions resulted in one-time expenses related to severance and real estate related charges of approximately $1.6 million in the third quarter of 2020. Expense savings of $2.6 million are anticipated on an annualized basis.
The enterprise standardization program is not yet complete as we continue to evaluate activities and functions across the organization, focusing on ways to improve operational efficiency while enhancing the employee and customer experience.
On October 7, 2020, the Company completed a private placement of $35.0 million of fixed-to-floating rate subordinated notes due 2030 (the “Notes”) to qualified institutional buyers and accredited institutional investors. The Notes have a maturity date of October 15, 2030 and bear interest, payable semi-annually, at the rate of 4.375% per annum, until October 15, 2025. Commencing on that date, the interest rate will reset quarterly to an interest rate per annum equal to the then current three-month secured overnight financing rate (“SOFR”) plus 4.265% basis points, payable quarterly until maturity.
The Company is entitled to redeem the Notes, in whole or in part, on any interest payment date on or after October 15, 2025, and in whole at any time upon certain other specified events. The Company intends to use the net proceeds for general corporate purposes, organic growth and to support regulatory capital ratios at Five Star Bank.
Operational, Accounting and Reporting Impacts Related to COVID-19
Accounting for Loan Modifications - The CARES Act provides that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a troubled debt restructuring (“TDR”) and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes.
- 45 -
Business customers are being faced with challenging and unique circumstances. The Bank’s relationship bankers are highly skilled in providing tailored financial solutions designed to meet the specific, individual needs of each business and they are actively reaching out to each business customer to understand how the Bank can help, given each unique business circumstance.
As of October 23, 2020, we have helped more than 1,700 customers obtain more than $270 million in loans through the PPP. Additionally, approximately 3% of our commercial loan and mortgage customers, 1% of our residential real estate loans and lines customers and less than 1% of our indirect loans customers have active payment deferrals.
RESULTS OF OPERATIONS
Net Interest Income and Net Interest Margin
Net interest income is our primary source of revenue, comprising 76% of revenue during the nine months ended September 30, 2020. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.
We use interest rate spread and net interest margin to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (“net free funds”), principally noninterest-bearing demand deposits and shareholders’ equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.
The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis (dollars in thousands):
Interest income per consolidated statements of income
Adjustment to fully taxable equivalent basis
201
258
680
849
Interest income adjusted to a fully taxable equivalent basis
39,920
42,717
121,811
127,470
Interest expense per consolidated statements of income
Net interest income on a taxable equivalent basis
35,700
32,741
103,484
97,588
- 46 -
Analysis of Net Interest Income for the Three Months Ended September 30, 2020 and 2019
Net interest income on a taxable equivalent basis for the three months ended September 30, 2020, was $35.7 million, an increase of $3.0 million versus the comparable quarter last year of $32.7 million. The increase in net interest income was due primarily to an increase in average loans of $368.2 million, or 12%, compared to the third quarter of 2019, partially offset by a decrease in investment securities of $15.9 million, or 2%, compared to the third quarter of 2019. The decrease in investment securities is primarily the result of the redeployment of assets from investment securities into loans, resulting in loans comprising a higher percentage of total interest-earning assets.
Our net interest margin for the third quarter of 2020 was 3.22%, seven-basis points lower than 3.29% for the same period in 2019. This comparable period decrease was a function of a 16-basis point lower contribution from net free funds, partially offset by a nine-basis point increase in the interest rate spread. The higher interest rate spread was a result of a 69-basis point decrease in the yield on average interest-earning assets and a 78-basis point decrease in the cost of average interest-bearing liabilities.
For the third quarter of 2020, the yield on average interest earning assets of 3.60% was 69-basis points lower than the third quarter of 2019 of 4.29%. Loan yields decreased 75 basis points during the third quarter of 2020 to 4.02% from 4.77%. The yield on investment securities decreased 17-basis points during the third quarter of 2020 to 2.23% from 2.40%. Overall, the earning asset rate changes decreased interest income by $6.8 million during the third quarter of 2020 and a favorable volume variance increased interest income by $4.0 million, which collectively drove a $2.8 million decrease in interest income.
Average interest-earning assets were $4.41 billion for the third quarter of 2020 compared to $3.96 billion for the third quarter of 2019, an increase of $454.9 million, or 12%, from the comparable quarter last year, with average loans up $368.2 million from $3.15 billion to $3.52 billion and average securities down $15.9 million from $785.6 million to $769.7 million. The growth in average loans reflected increases in the commercial loans, residential real estate loans and other consumer loans categories. Commercial loans, in particular, were up $381.1 million from $1.61 billion to $1.99 billion, or 24%, from the third quarter of 2019. The increase in commercial loans was primarily driven by the PPP loans. Residential real estate loans were up $37.1 million, partially offset by a decrease of $12.0 million in residential real estate lines. Consumer indirect loans decreased by $38.3 million and other consumer loans increased by $304 thousand. Loans comprised 79.8% of average interest-earning assets during the third quarter of 2020 compared to 79.7% during the third quarter of 2019. Loans generally have significantly higher yields compared to securities and federal funds sold and interest-bearing deposits and, as such, have a more positive effect on the net interest margin. The yield on average loans was 4.02% for the third quarter of 2020, a decrease of 75-basis points compared to 4.77% for the comparable quarter in 2019. An unfavorable rate variance resulted in a $6.3 million decrease in interest income, partially offset by an increase of $4.0 million due to the increase in the volume of average loans. Securities represented 17.4% of average interest-earning assets during the third quarter of 2020 compared to 19.8% during the third quarter of 2019. The decrease in the volume of average securities resulted in a $110 thousand decrease in interest income, in addition to a $310 thousand decrease due to the unfavorable rate variance.
The cost of average interest-bearing liabilities of 0.52% in the third quarter of 2020 compared to 1.30% in the third quarter of 2019, was 78-basis points lower. The cost of average interest-bearing deposits decreased 64-basis points from 1.07% to 0.43% and the cost of short-term borrowings decreased 91-basis points from 2.51% to 1.60% in the third quarter of 2020 compared to the same quarter of 2019. The decrease in the cost of short-term borrowings was a result of decreases in the federal funds rate. The cost of long-term borrowings for the third quarter of 2020 increased one-basis point from 6.30% to 6.31% compared to the same quarter of 2019. Overall, interest-bearing liability rate and volume decreases resulted in $5.8 million of lower interest expense.
Average interest-bearing liabilities of $3.24 billion in the third quarter of 2020 were $186.9 million, or 6%, higher than the third quarter of 2019. On average, interest-bearing deposits grew $457.9 million from $2.69 billion to $3.15 billion, and noninterest-bearing demand deposits (a principal component of net free funds) were up $270.4 million from $717.5 million to $987.9 million. The increase in average deposits was driven by PPP loan proceeds, successful business development efforts in retail banking, an increase in reciprocal deposit programs, and higher utilization of brokered deposits as a funding source. For further discussion of the reciprocal deposit programs, refer to the “Funding Activities - Deposits” section of this Management’s Discussion and Analysis. Overall, interest-bearing deposit rate and volume changes resulted in a $3.9 million decrease in interest expense during the third quarter of 2020. Average borrowings decreased $271.0 million from $368.2 million to $97.2 million compared to the third quarter of 2019. Overall, short and long-term borrowing rate and volume changes resulted in $1.8 million of lower interest expense during the third quarter of 2020.
Analysis of Net Interest Income for the Nine Months Ended September 30, 2020 and 2019
Net interest income on a taxable equivalent basis for the nine months ended September 30, 2020, was $103.5 million, an increase of $5.9 million versus the comparable period last year of $97.6 million. The increase in net interest income was due primarily to an increase in average earning assets of $260.1 million or 7% compared to the first nine months of 2019.
- 47 -
The net interest margin for the first nine months of 2020 was 3.25%, two-basis point lower than 3.27% for the same period in 2019. This comparable period decrease was a function of an eight-basis point increase in interest rate spread, partially offset by a ten-basis point lower contribution from net free funds. The higher interest rate spread was a result of a 52-basis point decrease in the cost of average interest-bearing liabilities and a 44-basis point decrease in the yield on average interest-earning assets.
For the first nine months of 2020, the yield on average earning assets of 3.83% was 44-basis points lower than the first nine months of 2019 of 4.27%. Loan yields decreased 54-basis points during the first nine months of 2020 to 4.25% from 4.79%. The yield on investment securities increased two-basis points during the first nine months of 2020 to 2.40% from 2.38%. Overall, the earning asset rate changes decreased interest income by $13.5 million during the first nine months of 2020 and a favorable volume variance increased interest income by $7.8 million, which collectively drove a $5.7 million decrease in interest income.
Average interest-earning assets were $4.25 billion for the first nine months of 2020 compared to $3.99 billion for the first nine months of 2019, an increase of $260.1 million, or 7%, from the comparable period last year, with average loans up $254.3 million from $3.13 billion to $3.38 billion and average securities down $66.9 million from $839.0 million to $772.1 million. The growth in average loans reflected increases in the commercial loans and residential real estate loans categories. Commercial loans, in particular, were up $277.1 million from $1.57 billion to $1.85 billion, or 18%, from the first nine months of 2019. Loans represented 79.7% of average interest-earning assets during the first nine months of 2020 compared to 78.5% during the first nine months of 2019. Loans generally have significantly higher yields compared to securities and federal funds sold and interest-bearing deposits and, as such, have a more positive effect on the net interest margin. The yield on average loans was 4.25% for the first nine months of 2020, a decrease of 54-basis points compared to 4.79% for first nine months of 2019. An unfavorable rate variance resulted in a $13.2 million decrease in interest income, partially offset by an increase of $8.7 million due to the increase in the volume of average loans. Securities represented 18.2% of average interest-earning assets during first nine months of 2020 compared to 21.0% during the first nine months of 2019. The decrease in the volume of average securities resulted in a $1.2 million decrease in interest income, partially offset by a $109 thousand increase due to the favorable rate variance.
The cost of average interest-bearing liabilities of 0.77% in the first nine months of 2020 compared to 1.29% in the first nine months of 2019 was 52-basis points lower than the first nine months of 2019. The cost of average interest-bearing deposits decreased 40-basis points from 1.06% to 0.66% and the cost of short-term borrowings decreased 97-basis points from 2.64% to 1.67% in the first nine months of 2020 compared to the same period of 2019. The decrease in the cost of short-term borrowings was a result of decreases in the federal funds rate. The cost of long-term borrowings for the first nine months of 2020 remained relatively flat at 6.30% compared to the same period of 2019. Overall, interest-bearing liability rate and volume decreases resulted in $11.6 million of lower interest expense.
Average interest-bearing liabilities of $3.19 billion in the first nine months of 2020 were $95.9 million, or 3%, higher than the first nine months of 2019. On average, interest-bearing deposits grew $316.3 million from $2.72 billion to $3.03 billion, and noninterest-bearing demand deposits (a principal component of net free funds) were up $154.8 million from $719.6 million to $874.5 million. The increase in average deposits was driven by PPP loans, successful business development efforts in retail banking, an increase in reciprocal deposit programs, and higher utilization of brokered deposits as a funding source. For further discussion of the reciprocal deposit programs, refer to the “Funding Activities - Deposits” section of this Management’s Discussion and Analysis. Overall, interest-bearing deposit rate and volume changes resulted in $6.4 million of lower interest expense during the first nine months of 2020. Average borrowings decreased $220.4 million from $372.1 million to $151.7 million compared to the first nine months of 2019. Overall, short and long-term borrowing rate and volume changes resulted in $5.2 million of lower interest expense during the first nine months of 2020.
- 48 -
The following tables sets forth certain information relating to the consolidated balance sheets and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the periods indicated (in thousands).
Three months ended September 30,
Interest
Rate
Interest-earning assets:
Federal funds sold and interest-earning deposits
121,929
0.10
%
19,370
Investment securities (1):
Taxable
614,465
3,330
587,069
3,478
2.37
Tax-exempt (2)
155,208
957
2.47
198,526
1,229
2.48
Total investment securities
769,673
2.23
785,595
4,707
2.40
808,582
6,792
3.34
586,293
7,620
5.16
1,180,747
12,160
4.10
1,021,931
13,244
5.14
590,483
5,314
3.60
553,382
5,326
3.85
95,288
874
3.65
107,290
5.17
830,647
10,039
4.81
868,927
9,813
4.48
16,445
423
10.23
16,141
504
12.40
Total loans
3,522,192
4.02
3,153,964
4.77
Total interest-earning assets
4,413,794
3,958,929
4.29
Less: Allowance for credit losses
(47,447
(35,271
Other noninterest-earning assets
408,986
337,152
4,775,333
4,260,810
Interest-bearing liabilities:
704,550
0.14
632,540
348
0.22
1,574,068
1,102
0.28
956,410
1,060
0.44
867,479
2,014
0.92
1,099,212
5,869
2.12
Total interest-bearing deposits
3,146,097
0.43
2,688,162
1.07
57,856
1.60
328,952
2.51
39,314
6.31
39,244
6.30
Total borrowings
97,170
850
3.50
368,196
2,699
2.91
Total interest-bearing liabilities
3,243,267
0.52
3,056,358
1.30
Noninterest-bearing demand deposits
987,908
717,473
Other noninterest-bearing liabilities
88,882
57,578
Shareholders’ equity
455,276
429,401
Net interest income (tax-equivalent)
Interest rate spread
3.08
2.99
Net earning assets
1,170,527
902,571
Net interest margin (tax-equivalent)
3.22
3.29
Ratio of average interest-earning assets to average
interest-bearing liabilities
136.09
129.53
Investment securities are shown at amortized cost.
The interest on tax-exempt securities is calculated on a tax-equivalent basis assuming a Federal income tax rate of 21% for each of the three-month periods ended September 30, 2020 and 2019.
- 49 -
Nine months ended September 30,
91,263
0.39
18,495
2.15
596,604
10,649
2.38
620,607
10,949
2.35
175,455
3,237
2.46
218,388
4,047
772,059
13,886
838,995
14,996
712,703
19,843
3.72
570,596
22,627
5.30
1,138,568
37,659
4.42
1,003,593
38,994
5.19
583,540
16,095
3.68
541,185
15,649
3.86
99,156
2,979
4.01
108,207
4,247
5.25
834,810
29,757
4.76
890,560
29,174
4.38
15,691
1,326
11.29
16,029
1,486
3,384,468
4.25
3,130,170
4.79
4,247,790
3.83
3,987,660
4.27
Less: Allowance for loan losses
(44,228
(34,759
389,047
328,369
4,592,609
4,281,270
694,830
840
0.16
653,780
1,030
0.21
1,349,931
3,724
0.37
973,005
3,143
989,236
10,502
1.42
1,090,896
17,281
3,033,997
0.66
2,717,681
1.06
112,451
1.67
332,922
2.64
39,297
39,227
151,748
3,261
2.87
372,149
8,428
3.03
3,185,745
0.77
3,089,830
1.29
874,456
719,630
85,069
56,449
447,339
415,361
3.06
2.98
1,062,045
897,830
3.25
3.27
133.34
129.06
The interest on tax-exempt securities is calculated on a tax-equivalent basis assuming a Federal income tax rate of 21% for each of the nine-month periods ended September 30, 2020 and 2019.
- 50 -
The following table presents, on a tax-equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest income not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands):
September 30, 2020 vs. 2019
Increase (decrease) in:
Volume
(183
(75
377
(408
(31
Investment securities:
(305
(148
(427
127
(300
Tax-exempt
(267
(792
(810
(110
(310
(420
(1,219
109
(1,110
2,360
(3,188
(828
4,871
(7,655
(2,784
1,876
(2,960
(1,084
4,874
(6,209
(1,335
345
(357
1,189
(743
446
(143
(523
(333
(935
(1,268
(444
226
(1,893
2,476
583
(90
(81
(129
4,003
(6,305
(2,302
8,677
(13,195
(4,518
4,001
(6,798
(2,797
7,835
(13,494
(5,659
36
(130
(94
62
(252
(190
524
(482
1,089
581
(1,047
(2,808
(3,855
(1,493
(5,286
(6,779
(487
(3,420
(3,907
(342
(6,046
(6,388
(1,280
(569
(1,849
(3,328
(1,839
(5,167
(3
(1,279
(570
(3,325
(1,842
(1,766
(3,990
(5,756
(3,667
(7,888
(11,555
5,767
2,959
11,502
(5,606
5,896
Provision for Credit Losses
The provision for credit losses for the three and nine months ended September 30, 2020 was $4.0 million and $21.7 million, respectively, compared to $1.8 million and $5.4 million for the corresponding periods in 2019. The increase was driven by the adoption of the CECL standard, higher net charge-offs in the first quarter of 2020 and deterioration in the economic environment as a result of the COVID-19 pandemic, which adversely impacted our unemployment forecast, the designated loss driver for our CECL model. Although the unemployment forecast improved in the latest quarter, qualitative factors were increased to more than offset the improved unemployment forecast due to uncertainty around the long-term impact of the pandemic on the economy. The increase in net charge-offs in the first nine months of 2020 is primarily attributable to one commercial credit that was downgraded and partially charged-off during the first quarter of 2020. The borrower’s business was related to the hospitality industry and the downgrade and charge-off were precipitated by the impact of the COVID-19 pandemic. The provision for credit losses - loans varies based primarily on forecasted unemployment rates, loan growth, net charge-offs, collateral values associated with collateral dependent loans and qualitative factors.
See the “Allowance for Credit Losses - Loans” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion.
- 51 -
Noninterest Income
The following table details the major categories of noninterest income for the periods presented (in thousands):
Net gain (loss) on investment securities
Net gain (loss) on other assets
Net loss on tax credit investments
Service charges on deposits decreased $671 thousand, or 35%, to $1.3 million for the third quarter of 2020 compared to $1.9 million for the third quarter of 2019. For the first nine months of 2020, service charges on deposits decreased $2.0 million, or 38%, to $3.3 million compared to $5.4 million for the first nine months of 2019. The decreases were primarily due to our COVID-19 relief initiatives implemented between March 23, 2020 to July 9, 2020, including waiving or eliminating certain fees. In addition, insufficient fund fees in the remainder of the quarter were lower than historic levels, potentially due to the positive impact of stimulus programs on consumer account balances. ATM access fees were not re-initiated until September 19th.
Income (loss) from investments in limited partnerships decreased $221 thousand, to a loss of $105 thousand for the third quarter of 2020 compared to income of $116 thousand for the third quarter of 2019. For the first nine months of 2020, income (loss) from investments in limited partnerships decreased $628 thousand, to a loss of $136 thousand compared to income of $492 thousand for the first nine months of 2019. We have investments in limited partnerships, primarily small business investment companies, and account for these investments under the equity method. The income from these equity method investments fluctuates based on the maturity and performance of the underlying investments.
Income from derivative instruments, net increased $1.0 million to $1.9 million for the third quarter of 2020 compared to $890 thousand for the third quarter of 2019. For the first nine months of 2020, income from derivative instruments, net increased $3.6 million to $4.6 million compared to $1.0 million for the first nine months of 2019. The increases were primarily the result of an increase in the number and value of interest rate swap transactions executed and reflects growth and maturity of our commercial loan business.
Net gain on sale of loans held for sale was $1.6 million for the third quarter of 2020 compared to $439 thousand for the third quarter of 2019. For the first nine months of 2020, net gain on sale of loans held for sale was $2.6 million compared to $1.0 million for the first nine months of 2019. The increases were primarily due to increased residential real estate loans for sale volume and an increase in margin on these transactions. The low interest rate environment has resulted in a significant increase in mortgage refinancing activity.
Net gain on investment securities was $554 thousand for the third quarter of 2020 compared to $1.6 million for the third quarter of 2019. For the first nine months of 2020, net gain on investment securities was $1.4 million compared to $1.7 million for the first nine months of 2019. The net gain in the current quarter is attributable to the management of premium risk, largely achieved through the sale of $20.0 million of fixed rate mortgage backed securities with higher expected prepayment speeds. Proceeds were reinvested in current coupon bonds, with lower anticipated prepayment behavior.
Other noninterest income decreased $296 thousand, or 23%, to $1.0 million for the third quarter of 2020 compared to $1.3 million for the third quarter of 2019. The decrease was due to the impact of stay-at-home orders for COVID-19 that reduced certain volume-based fees like merchant revenue and correspondent credit card fees. Our FHLB dividends have also declined year-over-year due to the lower level of FHLB borrowings in 2020 versus 2019. For the first nine months of 2020, other noninterest income decreased $799 thousand, or 20%, to $3.2 million compared to $4.0 million for the first nine months of 2019. The decrease was due to lower pay-by-phone fees associated with our COVID-19 consumer relief initiatives, coupled with the impact of stay-at-home orders that reduced certain volume-based fees like merchant revenue and correspondent credit card fees. Our FHLB dividends have also declined year-over-year due to the lower level of FHLB borrowings in 2020 versus 2019.
- 52 -
Noninterest Expense
The following table details the major categories of noninterest expense for the periods presented (in thousands):
13,562
3,951
-
Salaries and employee benefits expense increased by $674 thousand, or 5%, to $15.1 million for the third quarter of 2020 compared to $14.4 million for the third quarter of 2019. The increase in the current quarter includes $224 thousand of non-recurring severance costs incurred in connection with the previously described branch closings and staff reduction announced in July 2020. For the first nine months of 2020, salaries and employee benefits expense increased by $3.5 million, or 8%, to $45.2 compared to $41.7 million for the first nine months of 2019. The increase in the first nine months of 2020 was primarily the result of incentive compensation (including producer incentives and commissions), annual merit increases, COVID-19-related incremental pay to front-line retail associates, expense related to the departure of a senior officer on June 26, 2020 and higher medical expense.
Professional services expense decreased $286 thousand, or 19%, to $1.2 million for the third quarter of 2020 compared to $1.5 million for the third quarter of 2019. For the first nine months of 2020, professional services expense increased $1.4 million, or 37%, to $5.0 million compared to $3.6 million for the first nine months of 2019. The decrease in the third quarter of 2020 and increase in the first nine months of 2020 were primarily due to the timing of fees for consulting and advisory projects, including the Company’s improvement initiatives. Expenses related to improvement initiatives totaled $56 thousand and $1.0 million for the three- and nine-month periods ended September 30, 2020, respectively, and $298 thousand and $511 thousand for the three- and nine-month periods ended September 30, 2019, respectively.
Computer and data processing expense increased $603 thousand, or 23%, to $3.3 million for the third quarter of 2020 compared to $2.6 million for the third quarter of 2019. For the first nine months of 2020, computer and data processing expense increased $1.2 million, or 16%, to $8.6 million compared to $7.4 million for the first nine months of 2019. The increases in computer and data processing expense were primarily due to costs related to the Bank’s new online and mobile platform, Five Star Bank Digital Banking, launched in the second quarter of 2020.
FDIC assessments increased $587 thousand to $594 thousand for the third quarter of 2020 compared to $7 thousand for the third quarter of 2019. For the first nine months of 2020, FDIC assessments increased $500 thousand, or 50%, to $1.5 million compared to $1.0 million for the first nine months of 2019. In 2018, the FDIC minimum reserve ratio was exceeded, resulting in credits used to offset expense in 2019 and the first quarter of 2020.
Advertising and promotions expense increased $210 thousand, or 28%, to $955 thousand for the third quarter of 2020 compared to $745 thousand for the third quarter of 2019. For the first nine months of 2020, advertising and promotions expense decreased $296 thousand, or 13%, to $2.1 million compared to $2.4 million for the first nine months of 2019. Advertising and promotions expense was reduced in March 2020 when the COVID-19 pandemic impacted operations in Western New York. Higher expense in the third quarter of 2020 is attributable to promotional costs for Five Star Bank Digital Banking. The advertising campaign started after the last wave of customers was transitioned to the new platform in mid-June and ended in late August.
Restructuring charges of $1.4 million for the third quarter of 2020 represents non-recurring real estate related charges related to the previously described branch closings and staff reduction announced in July 2020.
Our efficiency ratio for the first nine months of 2020 was 61.89% compared with 60.09% for the first nine months of 2019. The higher efficiency ratio is a result of the higher noninterest expenses associated with our improvement initiatives and COVID-related impacts on noninterest income and noninterest expenses. The efficiency ratio is calculated by dividing total noninterest expense by net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains on investment securities. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease indicates a more efficient allocation of resources. The efficiency ratio, a banking industry financial measure, is not required by GAAP. However, the efficiency ratio is used by management in its assessment of financial performance specifically as it relates to noninterest expense control. Management also believes such information is useful to investors in evaluating Company performance.
- 53 -
Income Taxes
For the nine months ended September 30, 2020, we recorded income tax expense of $5.7 million, versus $10.2 million for the same period in the prior year. In the first nine months of 2020, the Company recognized tax credit investments resulting in a $606 thousand reduction in income tax expense and a $120 thousand net loss recorded in noninterest income. For the three months ended September 30, 2020, we recorded income tax expense of $2.9 million, versus $4.3 million for the same period in the prior year. As a result of the Tax Cuts and Jobs Act, the Company estimated tax benefits and recorded a provisional amount in and for the year ended December 31, 2017. In the third quarter of 2019 an adjustment was made to the provisional amount resulting in incremental expense of approximately $600 thousand.
The effective tax rates for the first nine months of 2020 and 2019 were 18.9% and 22.3%, respectively. The effective tax rates for the third quarter of 2020 and 2019 were 19.3% and 25.0%, respectively. Effective tax rates are typically impacted by items of income and expense that are not subject to federal or state taxation. Our effective tax rates reflect the impact of these items, which include, but are not limited to, interest income from tax-exempt securities, earnings on Company owned life insurance and the impact of tax credit investments. In addition, our effective tax rate for 2020 and 2019 reflects the New York State tax benefit generated by our real estate investment trust.
ANALYSIS OF FINANCIAL CONDITION
INVESTING ACTIVITIES
Investment Securities
The following table summarizes the composition of our investment securities portfolio as of the dates indicated (in thousands):
Investment Securities Portfolio Composition
U.S. Government agency and government-sponsored enterprise
securities
Agency mortgage-backed securities
508,881
390,422
Non-Agency mortgage-backed securities
786,564
817,849
774,852
781,176
The available for sale (“AFS”) investment securities portfolio increased $98.1 million from $417.9 million at December 31, 2019 to $516.0 million at September 30, 2020. The AFS portfolio had net unrealized gains of $20.4 million and $2.1 million at September 30, 2020 and December 31, 2019, respectively. The fair value of most of the investment securities in the AFS portfolio fluctuates as market interest rates change.
- 54 -
Security Yields and Maturities Schedule
The following table sets forth certain information regarding the amortized cost (“Cost”), weighted average yields (“Yield”) and contractual maturities of our debt securities portfolio as of September 30, 2020. Mortgage-backed securities are included in maturity categories based on their stated maturity date. Actual maturities may differ from the contractual maturities presented because borrowers may have the right to call or prepay certain investments. No tax-equivalent adjustments were made to the weighted average yields (dollars in thousands).
Due in one
year or less
Due from one
to five years
Due after five
years through
ten years
Yield
Available for sale debt securities:
U.S. Government agencies and
government-sponsored enterprises
2.43
6.04
30,291
2.45
2.36
1.76
2.00
2.01
Held to maturity debt securities:
2.27
99,947
1.93
2,976
2.02
2.04
2,345
2.30
2.14
1.94
2.20
48,689
138,817
2.07
182,029
2.33
417,037
786,572
2.08
Impairment Assessment
For AFS securities in an unrealized loss position, we first assess whether (i) we intend to sell, or (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. If either case is affirmative, any previously recognized allowances are charged-off and the security's amortized cost is written down to fair value through income. If neither case is affirmative, the security is evaluated to determine whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency and any adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income. Adjustments to the allowance are reported in our income statement as a component of credit loss expense. AFS securities are charged-off against the allowance or, in the absence of any allowance, written down through income when deemed uncollectible by management or when either of the aforementioned criteria regarding intent or requirement to sell is met. For the nine months ended September 30, 2020 and 2019 no allowance for credit losses has been recognized on AFS securities in an unrealized loss position as management does not believe any of the securities are impaired due to reasons of credit quality.
LENDING ACTIVITIES
The following table summarizes the composition of our loan portfolio, excluding loans held for sale and including net unearned income and net deferred fees and costs, as of the dates indicated (in thousands).
Loan Portfolio Composition
% of
22.9
17.8
33.7
34.3
Total commercial
2,020,181
56.6
1,678,323
52.1
16.7
2.6
3.2
23.6
26.4
0.5
Total consumer
1,548,358
43.4
1,542,664
47.9
100.0
- 55 -
Total loans increased $347.6 million to $3.57 billion at September 30, 2020 from $3.22 billion at December 31, 2019. The increase in loans was primarily attributable to PPP loans in our commercial business portfolio. PPP loans of approximately $2 million and $269 million were funded in the third and second quarters of 2020, respectively. The loans carry a 1% interest rate and the Company recorded net PPP loan origination fees of approximately $7.4 million that are amortized over a 24-month period.
Commercial loans increased $341.9 million during the nine months ended September 30, 2020 and represented 56.6% of total loans as of September 30, 2020. The increase in commercial loans was primarily attributable to PPP loans. At September 30, 2020, the PPP loan balance was $264.1 million, net of deferred fees.
The consumer indirect portfolio totaled $840.6 million and represented 23.6% of total loans as of September 30, 2020. During the first nine months of 2020, we originated $230.0 million in indirect auto loans with a mix of approximately 32% new auto and 68% used auto. During the first nine months of 2019, we originated $234.6 million in indirect auto loans with a mix of approximately 34% new auto and 66% used auto. Our origination volumes and mix of new and used vehicles financed fluctuate depending on general market conditions.
Loans Held for Sale and Loan Servicing Rights
Loans held for sale (not included in the loan portfolio composition table) were entirely comprised of residential real estate loans and totaled $7.1 million and $4.2 million as of September 30, 2020 and December 31, 2019, respectively.
We sell certain qualifying newly originated or refinanced residential real estate loans on the secondary market. Residential real estate loans serviced for others, which are not included in the consolidated statements of financial condition, amounted to $220.7 million and $189.8 million as of September 30, 2020 and December 31, 2019, respectively.
The following table summarizes the activity in the allowance for credit losses - loans for the periods indicated (in thousands).
Loan Loss Analysis
Allowance for credit losses - loans, beginning of period, prior to adoption
of ASC 326
Allowance for credit losses - loans, beginning of period, after adoption of
ASC 326
Charge-offs:
15
8,281
380
2,994
1,712
2,997
100
10
1,388
2,420
7,366
8,102
315
867
Total charge-offs
2,203
5,903
17,958
12,528
Recoveries:
Total recoveries
Net charge-offs
488
4,610
11,417
7,637
Provision for credit losses - loans
Allowance for credit losses - loans, end of period
Net loan charge-offs to average loans (annualized)
0.06
0.58
0.45
0.33
Allowance for credit losses - loans to total loans
1.38
1.00
Allowance for credit losses - loans to non-performing loans
324
- 56 -
The Company adopted CECL effective January 1, 2020, which resulted in an increase to the allowance for credit losses - loans of $9.6 million and established a reserve for unfunded commitments of $2.1 million, for a total pre-tax cumulative effect adjustment of $11.7 million.
The allowance for credit losses for Pooled Loans estimate is based upon periodic review of the collectability of the loans quantitatively correlating historical loan experience with reasonable and supportable forecasts using forward looking information. Adjustments to the quantitative evaluation may be made for differences in current or expected qualitative risk characteristics such as changes in: underwriting standards, delinquency level, regulatory environment, economic condition, Company management and the status of portfolio administration including the Company’s Loan Review function. The Company establishes a specific reserve for individually evaluated loans which do not share similar risk characteristics with the loans included in the forecasted allowance for credit losses. These individually evaluated loans are removed from the pooling approach discussed above for the forecasted allowance for credit losses, and include nonaccrual loans, troubled debt restructurings (“TDRs”), and other loans deemed appropriate by management.
Assessing the adequacy of the allowance for credit losses - loans involves substantial uncertainties and is based upon management’s evaluation of the amounts required to meet estimated charge-offs in the loan portfolio after weighing a variety of factors, including the risk profile of our loan products and customers.
The adequacy of the allowance for credit losses - loans is subject to ongoing management review. While management evaluates currently available information in establishing the allowance for credit losses - loans, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for credit losses - loans. Such agencies may require the financial institution to increase the allowance based on their judgments about information available to them at the time of their examination.
Net charge-offs of $488 thousand in the third quarter of 2020 represented 0.06% of average loans on an annualized basis compared to $4.6 million, or 0.58%, in the third quarter of 2019. The decrease from the prior year period is primarily attributable to the third quarter 2019 $3.0 million partial charge-off of a $5.6 million loan that had been classified as non-performing in the second quarter of 2019. For the nine months ended September 30, 2020, net charge-offs of $11.4 million represented 0.45% of average loans, compared to $7.6 million or 0.33% of average loans for the same period in 2019. The increase in net charge-offs in the nine months ended September 30, 2020 was primarily due to an $8.2 million partial charge-off of an $11.9 million commercial loan downgraded in the first quarter of 2020. The borrower’s business was related to the hospitality industry and the downgrade and charge-off were precipitated by the impact of the COVID-19 pandemic. The allowance for credit losses - loans was $49.4 million at September 30, 2020, compared with $30.5 million at December 31, 2019. The ratio of the allowance for credit losses -loans to total loans was 1.33% and 0.95% at September 30, 2020 and December 31, 2019, respectively. The ratio of allowance for credit losses - loans to non-performing loans was 453% at September 30, 2020, compared with 353% at December 31, 2019.
Non-Performing Assets and Potential Problem Loans
The table below summarizes our non-performing assets at the dates indicated (in thousands).
Non-Performing Assets
Nonaccrual loans:
Total nonaccrual loans
Accruing loans 90 days or more delinquent
Total non-performing loans
10,903
8,640
Foreclosed assets
Total non-performing assets
13,902
9,108
Non-performing loans to total loans
0.31
0.27
Non-performing assets to total assets
Non-performing assets include non-performing loans and foreclosed assets. Non-performing assets at September 30, 2020 were $13.9 million, an increase of $4.8 million from the $9.1 million balance at December 31, 2019. The primary component of non-performing assets is non-performing loans, which were $10.9 million or 0.31% of total loans at September 30, 2020, compared with $8.6 million or 0.27% of total loans at December 31, 2019. The increase in non-performing assets in the nine months ended September 30, 2020 is primarily due to an $11.9 million commercial loan downgraded, with $8.2 million charged-off, in the first quarter of 2020. In the third quarter of 2020, this commercial loan was recategorized as a foreclosed asset. The borrower’s business was related to the hospitality industry and the downgrade and charge-off were precipitated by the impact of the COVID-19 pandemic.
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Approximately $1.8 million, or 16.6%, of the $10.9 million in non-performing loans as of September 30, 2020 were current with respect to payment of principal and interest but were classified as non-accruing because repayment in full of principal and/or interest was uncertain. Included in nonaccrual loans are TDRs of $254 thousand and $297 thousand at September 30, 2020 and December 31, 2019, respectively. There were no TDRs accruing interest as of September 30, 2020 and one TDR of $550 thousand was accruing interest as of December 31, 2019.
Foreclosed assets consist of real property formerly pledged as collateral for loans, which we have acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. Foreclosed asset holdings represented three properties totaling $3.0 million at September 30, 2020 and three properties totaling $468 thousand at December 31, 2019. The increase in foreclosed assets in the nine months ended September 30, 2020 is primarily due to one commercial credit that was partially charged off during the first quarter of 2020 and foreclosure occurred in the third quarter.
Potential problem loans are loans that are currently performing, but information known about possible credit problems of the borrowers causes us to have concern as to the ability of such borrowers to comply with the present loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future. These loans remain in a performing status due to a variety of factors, including payment history, the value of collateral supporting the credits, and/or personal or government guarantees. We consider loans classified as substandard, which continue to accrue interest, to be potential problem loans. We identified $19.1 million and $14.6 million in loans that continued to accrue interest which were classified as substandard as of September 30, 2020 and December 31, 2019, respectively.
FUNDING ACTIVITIES
The following table summarizes the composition of our deposits at the dates indicated (dollars in thousands):
Deposit Composition
25.3
19.9
18.2
17.7
29.2
Time deposits < $250,000
660,300
17.6
893,177
25.1
Time deposits of $250,000 or more
180,930
4.6
287,012
8.1
We offer a variety of deposit products designed to attract and retain customers, with the primary focus on building and expanding long-term relationships. At September 30, 2020, total deposits were $4.36 billion, representing an increase of $809.3 million from December 31, 2019. The increase was driven by growth in nonpublic deposits and the reciprocal and brokered deposits portfolios. Time deposits were approximately 19% and 33% of total deposits at September 30, 2020 and December 31, 2019, respectively.
Nonpublic deposits, the largest component of our funding sources, totaled $2.50 billion and $2.16 billion at September 30, 2020 and December 31, 2019, respectively, and represented 57% and 61% of total deposits as of the end of each period, respectively. The increase in nonpublic deposits was in part attributable to PPP loan proceeds received by customers. We have managed this segment of funding through a strategy of competitive pricing that minimizes the number of customer relationships that have only a single service high cost deposit account.
As an additional source of funding, we offer a variety of public (municipal) deposit products to the towns, villages, counties and school districts within our market. Public deposits generally range from 20% to 30% of our total deposits. There is a high degree of seasonality in this component of funding, because the level of deposits varies with the seasonal cash flows for these public customers. We maintain the necessary levels of short-term liquid assets to accommodate the seasonality associated with public deposits. Total public deposits were $989.4 million and $860.7 million at September 30, 2020 and December 31, 2019, respectively, and represented 23% and 24% of total deposits as of the end of each period, respectively. The increase in public deposits during 2020 was due largely to seasonality.
We also participate in reciprocal deposit programs, which enable depositors to receive FDIC insurance coverage for deposits otherwise exceeding the maximum insurable amount. Through these programs, deposits in excess of the maximum insurable amount are placed with multiple participating financial institutions. Prior to the Economic Growth, Regulatory Relief and Consumer Protection Act (“EGRRCPA”) enacted on May 14, 2018, all reciprocal deposits were considered brokered deposits for regulatory reporting purposes. With the enactment of EGRRCPA, reciprocal deposits, subject to certain restrictions, are no longer required to be reported as brokered deposits. Reciprocal deposits totaled $243.9 million and $337.2 million, respectively, at September 30, 2020, compared to $157.9 million and $172.0 million, respectively, at December 31, 2019. Reciprocal deposits represented 13% and 9% of total deposits as of the end of each period, respectively.
Brokered deposits totaled $294.9 million and $208.8 million at September 30, 2020 and December 31, 2019, respectively, and represented 7% and 6% of total deposits as of the end of each period, respectively.
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Borrowings
The Company classifies borrowings as short-term or long-term in accordance with the original terms of the applicable agreement. Outstanding borrowings consisted of the following as of the dates indicated (in thousands):
Short-term borrowings - FHLB
Long-term borrowings - Subordinated notes, net
44,558
314,773
Short-term Borrowings
Short-term Federal Home Loan Bank (“FHLB”) borrowings have original maturities of less than one year and include overnight borrowings which we typically utilize to address short term funding needs as they arise. Short-term FHLB borrowings at September 30, 2020 consisted of $5.3 million in short-term borrowings. The maximum amount of short-term FHLB borrowings outstanding at any month-end during the nine months ended September 30, 2020 was $198.9 million. Short-term FHLB borrowings at December 31, 2019 consisted of $10.0 million in overnight borrowings and $265.5 million in short-term borrowings. The lower level of short-term borrowings at September 30, 2020, is attributable to growth in brokered deposits, which were utilized as a cost-effective alternative to FHLB borrowings. Short-term borrowings and brokered deposits have historically been utilized to manage the seasonality of public deposits, which reached a seasonal high point during the third quarter.
We have credit capacity with the FHLB and can borrow through facilities that include amortizing and term advances or repurchase agreements. We had approximately $218.6 million of immediate credit capacity with the FHLB as of September 30, 2020. We had approximately $538.8 million in secured borrowing capacity at the Federal Reserve Bank (“FRB”) discount window, none of which was outstanding at September 30, 2020. The FHLB and FRB credit capacity are collateralized by securities from our investment portfolio and certain qualifying loans. We had approximately $145.0 million of credit available under unsecured federal funds purchased lines with various banks as of September 30, 2020 and December 31, 2019. Additionally, we had approximately $174.6 million of unencumbered liquid securities available for pledging.
The Parent has a revolving line of credit with a commercial bank allowing borrowings up to $20.0 million in total as an additional source of working capital. At September 30, 2020, no amounts have been drawn on the line of credit.
Long-term Borrowings
On April 15, 2015, we issued $40.0 million of Subordinated Notes in a registered public offering. The Subordinated Notes bear interest at a fixed rate of 6.0% per year, payable semi-annually, for the first 10 years. From April 15, 2025 to the April 15, 2030 maturity date, the interest rate will reset quarterly to an annual interest rate equal to the then-current three-month London Interbank Offered Rate (LIBOR) plus 3.944%, payable quarterly. After the discontinuance of LIBOR, the interest rate will be determined by an alternate method as reasonably selected by the Company. The Subordinated Notes are redeemable by us at any quarterly interest payment date beginning on April 15, 2025 to maturity at par, plus accrued and unpaid interest. Proceeds, net of debt issuance costs of $1.1 million, were $38.9 million. The Subordinated Notes qualify as Tier 2 capital for regulatory purposes.
On October 7, 2020, the Company completed a private placement of $35.0 million in aggregate principal amount of fixed-to-floating rate subordinated notes due 2030 to qualified institutional buyers and accredited institutional investors. The Notes have a maturity date of October 15, 2030 and bear interest, payable semi-annually, at the rate of 4.375% per annum, until October 15, 2025. Commencing on that date, the interest rate will reset quarterly to an interest rate per annum equal to the then current three-month SOFR plus 4.265% basis points, payable quarterly until maturity. The Company is entitled to redeem the Notes, in whole or in part, on any interest payment date on or after October 15, 2025, and to redeem the Notes in whole at any time upon certain other specified events. The Company intends to use the net proceeds for general corporate purposes, organic growth and to support regulatory capital ratios at Five Star Bank.
LIQUIDITY AND CAPITAL MANAGEMENT
Liquidity
We continue to actively monitor our liquidity profile and funding concentrations in accordance with our Board approved Liquidity Policy. While funding pressures have not occurred, management is actively monitoring customer activity by way of commercial and consumer line of credit utilization, as well as deposit flows. As of September 30, 2020, all structural liquidity ratios and early warning indicators remain in compliance, with what we believe are ample funding sources available in the event of a stress scenario.
The objective of maintaining adequate liquidity is to assure that we meet our financial obligations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of matured borrowings, the ability to fund new and existing loan commitments and the ability to take advantage of new business opportunities. We achieve liquidity by maintaining a strong base of both core customer funds and maturing short-term assets; we also rely on our ability to sell or pledge securities and lines-of-credit and our overall ability to access to the financial and capital markets.
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Liquidity for the Bank is managed through the monitoring of anticipated changes in loans, the investment portfolio, deposits and wholesale funds. The strength of the Bank’s liquidity position is a result of its base of core customer deposits. These core deposits are supplemented by wholesale funding sources that include credit lines with other banking institutions, the FHLB and the FRB. The primary source of our non-deposit short-term borrowings is FHLB advances, of which we had $5.3 million outstanding at September 30, 2020. In addition to this amount, we have additional collateralized wholesale borrowing capacity of approximately $902.4 million from various funding sources which include the FHLB, the FRB, and commercial banks that we can use to fund lending activities, liquidity needs, and/or to adjust and manage our asset and liability position.
The Parent’s funding requirements consist primarily of dividends to shareholders, debt service, income taxes, operating expenses, funding of non-bank subsidiaries, repurchases of our stock, and acquisitions. The Parent obtains funding to meet obligations from dividends received from the Bank, net taxes collected from subsidiaries included in the federal consolidated tax return, and the issuance of debt and equity securities. In addition, the Parent maintains a revolving line of credit with a commercial bank for an aggregate amount of up to $20.0 million, all of which was available at September 30, 2020. The line of credit has a one-year term and matures in May 2021. Funds drawn would be used for general corporate purposes and backup liquidity.
Cash and cash equivalents were $282.1 million as of September 30, 2020, up $169.1 million from $112.9 million as of December 31, 2019. Net cash provided by operating activities totaled $20.3 million and the principal source of operating activity cash flow was net income adjusted for noncash income and expense items. Net cash used in investing activities totaled $376.6 million, which included outflows of $361.9 million for net loan originations, and $12.3 million from net investment securities transactions. Net cash provided by financing activities of $525.4 million was attributed to a $809.3 million increase in deposits, partially offset by a $270.2 million decrease in short-term borrowings and by $13.4 million in dividend payments.
Capital Management
We actively manage capital, commensurate with our risk profile, to enhance shareholder value. We also seek to maintain capital levels for the Company and the Bank at amounts in excess of the regulatory “well-capitalized” thresholds. Periodically, we may respond to market conditions by implementing changes to our overall balance sheet positioning to manage our capital position.
Banks and financial holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Failure to meet minimum capital requirements can result in certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material impact on our consolidated financial statements. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.
Shareholders’ equity was $456.4 million at September 30, 2020, an increase of $17.5 million from $438.9 million at December 31, 2019. Net income for the nine months ended September 30, 2020 increased shareholders’ equity by $24.5 million, offset by an $8.7 million cumulative effect adjustment from the adoption of ASC 326 and common and preferred stock dividends declared of $13.6 million. Accumulated other comprehensive loss included in shareholders’ equity decreased $14.3 million during the first nine months of 2020 due primarily to higher net unrealized gains on securities available for sale.
The FRB and FDIC have adopted a system using risk-based capital guidelines to evaluate the capital adequacy of banks and bank holding companies. The final rules implementing the Basel Committee on Banking Supervision’s (“BCBS”) capital guidelines for U.S. banks became effective for the Company on January 1, 2015 and was fully phased-in on January 1, 2019. As of September 30, 2020, the Company’s capital levels remained characterized as “well-capitalized” under the new rules.
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The following table reflects the ratios and their components (dollars in thousands):
Common shareholders’ equity
439,033
421,619
Add: CECL transitional amount
11,286
Less: Goodwill and other intangible assets
71,135
71,987
Net unrealized gain (loss) on investment securities (1)
Net periodic pension and postretirement benefits plan adjustments
Common Equity Tier 1 (“CET1”) Capital
379,393
364,145
Plus: Preferred stock
Less: Other
Tier 1 Capital
396,721
381,473
Plus: Qualifying allowance for credit losses
38,186
Subordinated Notes
Total regulatory capital
474,165
451,228
Adjusted average total assets (for leverage capital purposes)
4,713,549
4,237,596
Total risk-weighted assets
3,723,091
3,533,281
Regulatory Capital Ratios
Tier 1 Leverage (Tier 1 capital to adjusted average assets)
8.42
9.00
CET1 Capital (CET1 capital to total risk-weighted assets)
10.19
10.31
Tier 1 Capital (Tier 1 capital to total risk-weighted assets)
10.66
10.80
Total Risk-Based Capital (Total regulatory capital to total risk-weighted assets)
12.74
12.77
Includes unrealized gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category.
We have elected to apply the 2020 CECL transition provision related to the impact of the CECL accounting standard on regulatory capital, as provided by the US banking agencies’ March 2020 interim final rule. Under the 2020 CECL transition provision, the regulatory capital impact of the Day 1 adjustment to the allowance for credit losses (after-tax) upon the January 1, 2020 CECL adoption date has been deferred, and will phase in to regulatory capital at 25% per year commencing January 1, 2022. For the ongoing impact of CECL, we are allowed to defer the regulatory capital impact of the allowance for credit losses in an amount equal to 25% of the change in the allowance for credit losses (pre-tax) recognized through earnings for each period between January 1, 2020, and December 31, 2021. The cumulative adjustment to the allowance for credit losses between January 1, 2020, and December 31, 2021, will also phase in to regulatory capital at 25% per year commencing January 1, 2022.
BCBS Capital Rules
The BCBS Capital Rules include a new common equity Tier 1 capital to risk-weighted assets minimum ratio of 4.5%, increase the minimum Tier 1 capital to risk-weighted assets ratio from 4.0% to 6.0%, require a minimum total capital to risk-weighted assets ratio of 8.0%, and require a minimum Tier 1 leverage ratio of 4.0%. A new capital conservation buffer is also established above the regulatory minimum capital requirements, effectively increasing the minimum required risk-weighted asset ratios. This capital conservation buffer was fully phased-in as of January 1, 2019 at 2.5% of risk-weighted assets. Banking institutions with a capital conservation buffer below the minimum level will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. The BCBS Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and does not have any current applicability to the Company or the Bank. Strict eligibility criteria for regulatory capital instruments were also implemented under the final rules. The final rules also revised the definition and calculation of Tier 1 capital, total capital, and risk-weighted assets.
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The following table presents actual and required capital ratios as of September 30, 2020 and December 31, 2019 for the Company and the Bank under the BCBS Capital Rules. The minimum required capital amounts presented include the minimum required capital levels as of those dates based on the phase-in provisions of the BCBS Capital Rules and the minimum required capital levels as of January 1, 2019 when the BCBS Capital Rules have been fully phased-in. Capital levels required to be considered well capitalized are based upon prompt corrective action regulations, as amended to reflect the changes under the BCBS Capital Rules (in thousands):
Required to be
Minimum Capital
Considered Well
Actual
Required – Basel III
Capitalized
Ratio
Tier 1 leverage:
188,542
4.00
235,677
5.00
Bank
422,605
8.98
188,265
235,332
CET1 capital:
260,616
7.00
242,001
6.50
11.38
259,959
241,391
Tier 1 capital:
316,463
8.50
297,847
8.00
315,665
297,096
Total capital:
390,925
10.50
372,309
10.00
460,791
12.41
389,939
371,370
169,504
211,880
409,031
9.67
169,189
211,486
247,330
229,663
11.61
246,674
229,055
300,329
282,663
299,533
281,914
370,995
353,328
439,514
12.47
370,011
352,392
Dividend Restrictions
In the ordinary course of business, the Company is dependent upon dividends from the Bank to provide funds for the payment of dividends to shareholders and to provide for other cash requirements. Banking regulations may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of the Bank to fall below specified minimum levels. Approval is also required if dividends declared exceed the net profits for that year combined with the retained net profits for the preceding two years.
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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk refers to the potential impact on earnings or capital arising from movements in interest rates. The Bank’s market risk management framework has been developed to control both short-term and long-term exposure within Board approved policy limits and is monitored by the Asset-Liability Management Committee and Board of Directors. Quantitative and qualitative disclosures about market risk were presented at December 31, 2019 in Item 7A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, as filed with the Securities and Exchange Commission on March 4, 2020. The following is an update of the discussion provided therein.
Portfolio Composition
There was no material change in the composition of assets, deposit liabilities or borrowings from December 31, 2019 to September 30, 2020, aside from asset growth due to the PPP program, remixing of the wholesale funding base and an increase Federal Reserve Bank excess cash position resulting from deposit growth. See the section titled “Analysis of Financial Condition” in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of asset, deposit and borrowing activity during the period.
Net Interest Income at Risk
A primary tool used to manage interest rate risk is “rate shock” simulation to measure the rate sensitivity. Rate shock simulation is a modeling technique used to estimate the impact of changes in rates on net interest income as well as economic value of equity.
Net interest income at risk is measured by estimating the changes in net interest income resulting from instantaneous and sustained parallel shifts in interest rates of different magnitudes over a period of 12 months. The following table sets forth the estimated changes to net interest income over the 12-month period ending September 30, 2021 assuming instantaneous changes in interest rates for the given rate shock scenarios (dollars in thousands):
Changes in Interest Rate
-100 bp
+100 bp
+200 bp
+300 bp
Estimated change in net interest income
921
1,788
4,077
6,756
% Change
1.28
2.92
4.84
In the rising rate environments, the model results indicate increases in net interest income compared to the flat rate scenario over a one-year timeframe. This is a result of assumed commercial loan products repricing at a higher frequency than underlying borrowing and deposit costs. As intermediate and longer-term assets continue to mature and are replaced at higher yields, net interest income improves over longer term timeframes. Model results in the declining rate environments also indicate increases in net interest income due to floating rate loans, tied to Prime, no longer repricing downwards due to Prime rate being floored, while interest rate sensitive liabilities still have slight sensitivity to downward movement in rates.
In addition to the changes in interest rate scenarios listed above, other scenarios are typically modeled to measure interest rate risk. These scenarios vary depending on the economic and interest rate environment.
The simulation referenced above is based on our assumption as to the effect of interest rate changes on assets and liabilities and assumes a parallel shift of the yield curve. It also includes certain assumptions about the future pricing of loans and deposits in response to changes in interest rates. Further, it assumes that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. While this simulation is a useful measure as to net interest income at risk due to a change in interest rates, it is not a forecast of future results, does not measure the effect of changing interest rates on noninterest income and is based on many assumptions that, if changed, could cause a different outcome.
Economic Value of Equity At Risk
The economic (or “fair”) value of financial instruments on our balance sheet will also vary under the interest rate scenarios previously discussed. This variance is measured by simulating changes in our economic value of equity (“EVE”), which is calculated by subtracting the estimated fair value of liabilities from the estimated fair value of assets. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at current replacement rates for each account type, while fair values of non-financial assets and liabilities are assumed to equal book value and do not vary with interest rate fluctuations. An economic value simulation is a static measure for balance sheet accounts at a given point in time, but this measurement can change substantially over time as the characteristics of our balance sheet evolve and as interest rate and yield curve assumptions are updated.
The amount of change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including the stated interest rate or spread relative to current market rates or spreads, the likelihood of prepayment, whether the rate is fixed or floating, and the maturity date of the instrument. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical data (back-testing).
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The analysis that follows presents the estimated EVE resulting from market interest rates prevailing at a given quarter-end (“Pre-Shock Scenario”), and under other interest rate scenarios (each a “Rate Shock Scenario”) represented by immediate, permanent, parallel shifts in interest rates from those observed at September 30, 2020 and December 31, 2019 (dollars in thousands). The analysis additionally presents a measurement of the interest rate sensitivity at September 30, 2020 and December 31, 2019. EVE amounts are computed under each respective Pre-Shock Scenario and Rate Shock Scenario. An increase in the EVE amount is considered favorable, while a decline is considered unfavorable. The following table sets forth the estimated changes to EVE assuming instantaneous changes in interest rates for the given rate shock scenarios (dollars in thousands):
Rate Shock Scenario:
EVE
Change
Percentage
Pre-Shock Scenario
545,804
632,832
- 100 Basis Points
549,695
3,891
0.71
676,362
43,530
6.88
+100 Basis Points
565,710
19,906
627,409
(5,423
(0.86
+ 200 Basis Points
587,022
41,218
7.55
614,927
(17,905
(2.83
+ 300 Basis Points
604,760
58,956
600,636
(32,196
(5.09
The decrease in the Pre-Shock Scenario EVE at September 30, 2020 compared to December 31, 2019 is a result of a 15% increase in non-public deposits. The decrease in the -100 basis point Rate Shock Scenario EVE is reflective of the assumption that deposit pricing is nearly floored and has the inability to reprice to a lower level. This is compounded by the assumption that the discount curve on the fixed rate portfolio is nearly floored, resulting in less premium on the portfolio in a falling rate environment. The overall level of change is in line with expectations due to the Federal Open Market Committee action to reduce the Federal Funds target rate by 150 basis points within the period and programs introduced to help small businesses with loans.
ITEM 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of September 30, 2020, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(b), as adopted by the SEC under the Securities Exchange Act of 1934, as amended (“Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.
Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2020 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
From time to time we are a party to or otherwise involved in legal proceedings arising out of the normal course of business. Regardless of the outcome, litigation can have an adverse impact on us because of prosecution, defense and settlement costs, unfavorable awards, diversion of management resources and other factors.
We are party to an action filed against us on May 16, 2017 by Matthew L. Chipego, Charlene Mowry, Constance C. Churchill and Joseph W. Ewing in the Court of Common Pleas in Philadelphia, Pennsylvania. Plaintiffs seek class certification to represent classes of consumers in New York and Pennsylvania along with statutory damages, interest and declaratory relief. The plaintiffs seek to represent a putative class of consumers who are alleged to have obtained direct or indirect financing from us for the purchase of vehicles that we later repossessed. The plaintiffs specifically claim that the notices the Bank sent to defaulting consumers after their vehicles were repossessed did not comply with the relevant portions of the Uniform Commercial Code in New York and Pennsylvania. We dispute and believe we have meritorious defenses against these claims and plan to vigorously defend ourselves.
In February 2020, we agreed to engage in mediation with the plaintiffs but mediation has not yet commenced. On October 19, 2020, the Court granted plaintiffs’ motion for judgment on the pleadings dismissing our affirmative defense against one named New York plaintiff that his claim was time-barred under New York law, applying a six-year statute of limitations rather than the three years limitation period we had argued. Under the current scheduling order, briefing on any class certification request is scheduled to occur in November 2020.
If we settle these claims or the action is not resolved in our favor, we may suffer reputational damage and incur legal costs, settlements or judgments that exceed the amounts covered by our existing insurance policies. We can provide no assurances that our insurer will insure the legal costs, settlements or judgements we incur in excess of our deductible. If we are unsuccessful in defending ourselves from these claims or if our insurer does not insure us against legal costs we incur in excess of our deductible, the result may materially adversely affect our business, results of operations and financial condition.
ITEM 1A. Risk Factors
Except as stated below, there have been no material changes from the risk factors previously disclosed in Part I – Item 1A of the Company’s Form 10-K for the year ended December 31, 2019.
The ongoing novel coronavirus (“COVID-19”) pandemic, and governmental and individual efforts to contain the pandemic, have had a significant negative impact on the U.S. and global economy which has and will continue to adversely affect our business, financial condition and results of operations.
In response to the COVID-19 pandemic and resulting economic downturn, the Federal Reserve reduced the target federal funds rate to a range of 0.00% to 0.25% and has stated that it intends to keep the rate near 0.00% until signs of higher inflation and a tighter labor market emerge. This lower rate reduces the rate of interest we earn on loans and pay on borrowings and interest-bearing deposits, and can affect the value of financial instruments we hold. In an environment with lower interest rates, we will not be able to earn as much on our interest-earning assets, which will likely reduce net interest margin. In addition, our ability to earn interest and receive dividend income from investment securities will be reduced. If interest rates remain low for an extended period of time, our results of operations could be materially adversely affected.
The U.S. economy generally and our customers and employees in particular have been directly impacted by governmental orders reducing travel and in-person interactions. Executive orders from the Governor of the State of New York may impact our ability to keep our bank branch locations open. We expect we and our customers will continue to be impacted by social distancing efforts for the duration of the COVID-19 pandemic. A significant proportion of our employees are working remotely, which may slow response times to customers’ inquiries or preclude providing the level of service our employees are typically able to offer in person. Our reputation and results of operations may be impacted if our competitors are better able to adjust to the restrictions on in-person interactions and remote work. Furthermore, as our employees continue to work from home, our operational risk, including data security risk, is higher than it would otherwise be, as cybercriminal activity has increased in an attempt to profit from the disruption to typical operations. The cybersecurity-related risks we face include more phishing, malware, and other cybersecurity attacks, vulnerability to disruptions of our information technology infrastructure and telecommunications systems for remote operations, and unauthorized dissemination, misuse or destruction of confidential or valuable information.
While we have experienced higher loan origination volume due to the Paycheck Protection Program (“PPP”) under the CARES Act, there can be no assurance that the borrowers under the CARES Act programs will be able to pay the interest, and principal payments, if applicable, when they are due. If the borrower of a PPP loan fails to qualify for loan forgiveness under the program, we will have to hold the loan at an unfavorable interest rate as compared to a loan we may otherwise have extended to our customer. Even though those loans are guaranteed by the U.S. Small Business Association (the “SBA”), we may not be able to collect from the SBA as quickly as those payments come due, and our cash flow and earnings may be reduced accordingly. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which we originated, funded or serviced the PPP loan, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already made payment under the guaranty, seek recovery of any loss related to the deficiency from us. Originations for consumer indirect lending, which currently constitutes 23.6% of our total loans, have declined since the outbreak of the COVID-19 pandemic. If this trend continues, our financial condition and results of operations could be materially adversely affected.
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Our loan customers will likely be impacted by the overall decline in the U.S. economy, which may cause them to make late or reduced payments on their loans or default on their loans with us. In particular, our commercial mortgage customers may be experiencing higher rates of tenants not paying rent due to the COVID-19 pandemic. As a lender, we are exposed to the risk that customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. The collateral securing our indirect loan portfolio in particular may not be sufficient to cover the full value of an outstanding loan because the collateral, namely automobiles, are depreciating assets. Our credit risk has increased since the start of the COVID-19 pandemic and related decline in the U.S. economy. In the event of delinquencies, regulatory changes and policies designed to protect borrowers may slow or prevent us from taking certain remediation actions, including foreclosure. We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral, and we provide an allowance for estimated loan losses based on a number of factors. We believe that the allowance for loan losses is adequate. However, if our assumptions or judgments are wrong, the allowance for loan losses may not be sufficient to cover the actual credit losses. We may have to increase the allowance in the future in response to the COVID-19 pandemic and resulting changes to the U.S. economy. The actual amount of future provisions for credit losses may vary from the amount of past provisions. The longer the economic results of the COVID-19 pandemic negatively impact our customers, the more likely our credit quality is to decline and the more likely our customers will be to default on their loans with us. Continued economic disruption and fear of the spread of COVID-19 could result in business shutdowns, limitations on commercial activity and financial transactions, labor shortages, supply chain interruptions, increased unemployment and commercial property vacancy rates and reduced profitability and ability for property owners to make mortgage payments. If a significant proportion of our customers are unable to repay their loans and the collateral securing repayment is insufficient to cover our losses, we may have to increase our allowance for credit losses - loans, the quality of our loan portfolio will decline, our net income will decrease and our results of operations will be materially adversely impacted. In addition, our capital and leverage ratios may be adversely impacted.
At September 30, 2020, we held $151.6 million in debt securities that are issued by state and local government agencies, or municipal bonds, that are backed by the credit and taxing power of the issuing jurisdiction. As these state and local governments experience the impacts of the pandemic and stay at home orders, they are earning less sales tax revenue while incurring higher than expected costs as a result of the COVID-19 pandemic. The impact of the COVID-19 pandemic may cause the credit rating of the municipal bonds we hold to be downgraded, which could in turn cause us to incur credit losses. If these bond issuers are unable to repay us when the bonds mature, we could lose our investment and our results of operations and cash flows could be materially adversely impacted.
The market volatility related to the COVID-19 pandemic has driven market values of publicly traded securities downward. Because the majority of our investment advisory revenue is from fees based on a percentage of assets under management, our investment advisory revenues and profitability have fallen and will continue to fluctuate with the overall market conditions.
The spread of COVID-19 has led to an economic recession and continues to cause severe disruptions in the U.S. economy. Should the COVID-19 pandemic continue for an extended period of time, our business, financial condition, results of operations and cash flows may likewise be materially adversely impacted for an extended period of time.
The value of our goodwill and other intangible assets may decline in the future.
As of September 30, 2020, we had $66.1 million of goodwill and $8.0 million of other intangible assets. Although we did not record any impairment to our goodwill for the first nine months of 2020, significant and sustained declines in our stock price and market capitalization, significant declines in our expected future cash flows, significant adverse changes in the business climate and slower growth rates, any or all of which could be materially impacted by the ongoing COVID-19 pandemic, may necessitate our taking charges in the future related to the impairment of our goodwill. If the recent capital markets downturn resulting from the COVID-19 pandemic continues for an extended period of time, or the capital markets continue to experience increased volatility, we may record an impairment to our goodwill in subsequent fiscal periods. Future regulatory actions could also have a material impact on assessments of goodwill for impairment. If the fair value of our net assets improves at a faster rate than the market value of our reporting units, or if we were to experience increases in book values of a reporting unit in excess of the increase in fair value of equity, we may also have to take charges related to the impairment of our goodwill. If we were to conclude that a future write-down of our goodwill is necessary, we would record the appropriate charge, which could have a material adverse effect on our results of operations.
Identifiable intangible assets other than goodwill consist of core deposit intangibles and other intangible assets (primarily customer relationships). Adverse events or circumstances could impact the recoverability of these intangible assets including loss of core deposits, significant losses of customer accounts and/or balances, increased competition or adverse changes in the economy, such as those related to the ongoing COVID-19 pandemic. To the extent these intangible assets are deemed unrecoverable, a non-cash impairment charge would be recorded which could have a material adverse effect on our results of operations.
For further discussion, see Note 7, Goodwill and Other Intangible Assets, to the Consolidated Financial Statements (Unaudited) included in Item 1 of this Quarterly Report on Form 10-Q.
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ITEM 6. Exhibits
(a)
The following is a list of all exhibits filed or incorporated by reference as part of this Report:
Exhibit
Number
Description
Location
4.1
Subordinated Indenture, dated as of October 7, 2020, between Financial Institutions, Inc. and Wilmington Trust, National Association, as Trustee
Incorporated by reference to Exhibit 4.1 of the Form 8-K, dated October 7, 2020
4.2
Form of 4.375% Fixed-to-Floating Rate Subordinated Note due October 15, 2030 (included in Exhibit 4.1)
Incorporated by reference to Exhibit 4.2 of the Form 8-K, dated October 7, 2020
10.1
Subordinated Note Purchase Agreement, dated as of October 7, 2020, by and among Financial Institutions, Inc. and the Purchasers*
Filed Herewith
10.2
Registration Rights Agreement, dated as of October 7, 2020, by and among Financial Institutions, Inc. and the Purchasers
31.1
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Principal Executive Officer
31.2
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Principal Financial Officer
32
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS
Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.
101.SCH
Inline XBRL Taxonomy Extension Schema Document
101.CAL
Inline XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB
Inline XBRL Taxonomy Extension Label Linkbase Document
101.PRE
Inline XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF
Inline XBRL Taxonomy Extension Definition Linkbase Document
104
Cover Page Interactive Data File (embedded within the Inline XBRL document)
* Schedules and similar attachments have been omitted pursuant to Item 601(a)(5) of Regulation S-K. The registrant will furnish a copy of any omitted schedule or similar attachment to the Securities and Exchange Commission upon request.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
/s/ Martin K. Birmingham
, November 6, 2020
Martin K. Birmingham
President and Chief Executive Officer
(Principal Executive Officer)
/s/ Justin K. Bigham
Justin K. Bigham
Executive Vice President and Chief Financial Officer
(Principal Financial Officer)
/s/ Sonia M. Dumbleton
Sonia M. Dumbleton
Senior Vice President and Controller
(Principal Accounting Officer)
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