UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 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 June 30, 2019
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 0-17706
QNB Corp.
(Exact Name of Registrant as Specified in Its Charter)
Pennsylvania
23-2318082
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
15 North Third Street, P.O. Box 9005 Quakertown, PA
18951-9005
(Address of Principal Executive Offices)
(Zip Code)
(215) 538-5600
Registrant's Telephone Number, Including Area Code
Not Applicable
Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report.
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 definition 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 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 ☒
Securities registered pursuant to Section 12(b) of the Act: None.
Title of each class
Trading
Symbol(s)
Name of each exchange on which registered
QNBC
N/A
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
Class
Outstanding at August 1, 2019
Common Stock, par value $0.625
3,501,446
1
QNB CORP. AND SUBSIDIARY
QUARTER ENDED JUNE 30, 2019
INDEX
PART I - FINANCIAL INFORMATION
ITEM 1.
CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
PAGE
Consolidated Balance Sheets at June 30, 2019 and December 31, 2018
3
Consolidated Statements of Income for the Three and Six Months Ended June 30, 2019 and 2018
4
Consolidated Statements of Comprehensive Income (Loss) for the Three and Six Months Ended June 30, 2019 and 2018
5
Consolidated Statement of Shareholders’ Equity for the Three and Six Months Ended June 30, 2019 and 2018
6
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2019 and 2018
8
Notes to Consolidated Financial Statements
9
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
38
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
57
ITEM 4.
CONTROLS AND PROCEDURES
PART II - OTHER INFORMATION
LEGAL PROCEEDINGS
58
ITEM 1A.
RISK FACTORS
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
DEFAULTS UPON SENIOR SECURITIES
MINE SAFETY DISCLOSURES
ITEM 5.
OTHER INFORMATION
ITEM 6.
EXHIBITS
59
SIGNATURES
CERTIFICATIONS
2
QNB Corp. and Subsidiary
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(current period unaudited)
June 30, 2019
December 31, 2018
Assets
Cash and due from banks
$
13,036
12,888
Interest-bearing deposits in banks
1,032
570
Total cash and cash equivalents
14,068
13,458
Investments:
Available-for-sale (amortized cost $348,229 and $353,249)
347,728
344,221
Equity securities (cost of $6,985 and $10,079)
6,898
9,421
Restricted investment in stocks
1,872
797
Loans receivable
817,593
785,448
Allowance for loan losses
(9,164
)
(8,834
Net loans
808,429
776,614
Bank-owned life insurance
11,330
11,192
Premises and equipment, net
12,249
9,918
Accrued interest receivable
3,962
2,852
Net deferred tax assets
1,528
3,724
Other assets
3,941
3,255
Total assets
1,212,005
1,175,452
Liabilities
Deposits
Demand, non-interest bearing
149,591
128,615
Interest-bearing demand
317,717
304,652
Money market
79,044
78,781
Savings
249,998
279,762
Time
123,131
117,569
Time of $100 or more
111,180
106,219
Total deposits
1,030,661
1,015,598
Short-term borrowings
59,048
50,872
Accrued interest payable
599
449
Other liabilities
5,819
4,185
Total liabilities
1,096,127
1,071,104
Shareholders' Equity
Common stock, par value $0.625 per share;
authorized 10,000,000 shares; 3,666,015 shares and 3,648,649
shares issued; 3,501,446 and 3,484,080 shares outstanding
2,291
2,280
Surplus
20,607
20,041
Retained earnings
95,852
91,635
Accumulated other comprehensive loss, net of tax
(396
(7,132
Treasury stock, at cost; 164,569 shares
(2,476
Total shareholders' equity
115,878
104,348
Total liabilities and shareholders' equity
The accompanying notes are an integral part of the consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data - unaudited)
Three months
ended June 30,
Six months
2019
2018
Interest income
Interest and fees on loans
9,637
8,512
18,860
16,939
Interest and dividends on investment securities (Available-for-sale & Equity):
Taxable
1,660
1,551
3,274
3,128
Tax-exempt
382
461
808
944
Interest on interest-bearing balances and other interest income
33
60
Total interest income
11,712
10,562
23,001
21,071
Interest expense
Interest on deposits
788
436
1,481
810
227
62
512
120
397
369
805
699
479
379
898
757
Time of $100,000 or more
514
415
972
814
Interest on short-term borrowings
196
201
386
380
Total interest expense
2,601
1,862
5,054
3,580
Net interest income
9,111
8,700
17,947
17,491
Provision for loan losses
150
187
375
Net interest income after provision for loan losses
8,961
8,513
17,572
17,116
Non-interest income
Net gain on sales of investments available-for-sale and equity securities
584
48
590
133
Unrealized (loss) gain on investment equity securities
(405
41
571
(205
Fees for services to customers
422
408
815
829
ATM and debit card
519
487
989
917
Retail brokerage and advisory
105
274
208
70
69
138
137
Merchant
99
82
174
156
Net gain on sale of loans
28
37
49
44
Other
204
177
363
302
Total non-interest income
1,654
1,454
3,963
2,521
Non-interest expense
Salaries and employee benefits
3,790
3,627
7,571
6,972
Net occupancy
506
448
1,011
919
Furniture and equipment
591
563
1,148
1,050
Marketing
263
221
500
531
Third party services
446
886
916
Telephone, postage and supplies
152
173
351
354
State taxes
207
164
378
335
FDIC insurance premiums
135
146
265
321
703
685
1,407
1,313
Total non-interest expense
6,793
6,533
13,517
12,711
Income before income taxes
3,822
3,434
8,018
6,926
Provision for income taxes
679
572
1,496
1,129
Net income
3,143
2,862
6,522
5,797
Earnings per share - basic
0.90
0.83
1.87
1.68
Earnings per share - diluted
0.82
1.86
1.67
Cash dividends per share
0.33
0.32
0.66
0.64
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands - unaudited)
Three months ended June 30,
Before
tax
amount
Tax
expense
(benefit)
Net of
Other comprehensive income (loss) :
Net unrealized holding gains (losses) on available-for-sale securities:
Unrealized holding gains (losses) arising during the period
4,097
861
3,236
(1,215
(255
(960
Reclassification adjustment for gains included in net income
—
(4
(1
(3
Other comprehensive income (loss)
(1,219
(256
(963
Total comprehensive income (loss)
7,919
1,540
6,379
2,215
316
1,899
Six months ended June 30,
Other comprehensive income:
8,488
1,783
6,705
(6,263
(1,315
(4,948
Reclassification adjustment for losses (gains) included in net income
39
31
(2
8,527
1,791
6,736
(6,266
(1,316
(4,950
16,545
3,287
13,258
660
(187
847
Tax rate of 21% for 2019 and 2018
The accompanying notes are an integral part of the consolidated financial statements
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
Three month ended June 30, 2019 and 2018
Accumulated
Number of
(unaudited)
Shares
Common
Retained
Comprehensive
Treasury
(in thousands, except share and per share data)
Outstanding
Stock
Earnings
Income (Loss)
Total
Balance, April 1, 2019
3,493,935
2,286
20,319
93,863
(3,632
110,360
Other comprehensive income, net of tax
Cash dividends declared ($0.33 per share)
(1,154
Stock issued in connection with dividend
reinvestment and stock purchase plan
5,644
194
198
Stock issued for employee stock purchase plan
1,617
53
54
Stock issued for options exercised
250
Stock-based compensation expense
Balance, June 30, 2019
Balance, April 1, 2018
3,454,016
2,262
18,778
86,564
(8,624
96,504
Other comprehensive loss, net of tax
Cash dividends declared ($0.32 per share)
(1,107
9,934
423
429
1,426
56
92
36
Balance, June 30, 2018
3,465,468
2,269
19,293
88,319
(9,587
97,818
Six months ended June 30, 2019 and 2018
Balance, January 1, 2019
3,484,080
Cash dividends declared ($0.66 per share)
(2,305
12,290
425
433
3,459
30
Balance, January 1, 2018
3,448,108
2,258
18,691
84,183
(4,086
98,570
Cash dividends declared ($0.64 per share)
(2,212
Equity securities fair value reclassification (1)
(254
254
ASU 2018-02 stranded tax reclassification (2)
(805
6,000
65
(1) Refer to Note 1, ASU 2016-01
(2) Refer to Note 1, ASU 2018-02
7
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands, unaudited)
Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Net gain on sales of debt and equity securities
(590
(133
Net unrealized (gain) loss on equity securities
(571
205
Net gain on sale of other real estate owned, repossessed assets and premises and equipment
(58
(49
(44
Proceeds from sales of residential mortgages held-for-sale
1,864
1,949
Origination of residential mortgages held-for-sale
(1,815
(2,309
Increase in cash surrender value of bank-owned life insurance
(138
(137
Deferred income tax provision
405
110
Net increase (decrease) in income taxes payable
172
(294
Net increase in accrued interest receivable
(1,110
(28
Amortization of mortgage servicing rights and change in valuation allowance
25
Net amortization of premiums and discounts on investment securities
740
Net increase (decrease) in accrued interest payable
(13
Operating lease payments
(282
Increase in other assets
(881
(388
Decrease in other liabilities
(591
(260
Net cash provided by operating activities
4,995
6,094
Investing Activities
Proceeds from payments, maturities and calls of investments available-for-sale
21,419
22,380
Proceeds from the sale of investments available-for-sale
20,783
4,159
Proceeds from the sale of equity securities
4,520
1,390
Purchases of investments available-for-sale
(37,919
(3,166
Purchases of equity securities
(798
(6,090
Proceeds from redemption of investment in restricted stock
4,600
4,505
Purchases of restricted stock
(5,675
(5,672
Net increase in loans
(32,190
(46,627
Net purchases of premises and equipment
(634
(1,590
Proceeds from sales of other real estate owned and repossessed assets
Net cash used in investing activities
(25,836
(30,710
Financing Activities
Net increase in non-interest bearing deposits
20,976
6,270
Net decrease in interest-bearing deposits
(5,913
(14,492
Net increase in short-term borrowings
8,176
29,890
Cash dividends paid, net of reinvestment
(2,031
(1,927
Proceeds from issuance of common stock
243
270
Net cash provided by financing activities
21,451
20,011
Increase (decrease) in cash and cash equivalents
610
(4,605
Cash and cash equivalents at beginning of year
16,331
Cash and cash equivalents at end of period
11,726
Supplemental Cash Flow Disclosures
Interest paid
4,904
3,593
Income taxes paid
920
Non-cash transactions:
Right-of-use assets obtained in exchange for new operating lease liabilities
501
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements include the accounts of QNB Corp. and its wholly-owned subsidiary, QNB Bank (the “Bank”). The consolidated entity is referred to herein as “QNB” or the “Company”. All significant intercompany accounts and transactions are eliminated in the consolidated financial statements.
These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in QNB's 2018 Annual Report incorporated in the Form 10-K. Operating results for the three- and six-month periods ended June 30, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.
The unaudited consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the results of operations for the period and are of a normal and recurring nature.
Tabular information, other than share and per share data, is presented in thousands of dollars.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from such estimates.
QNB has evaluated events and transactions occurring subsequent to the balance sheet date of June 30, 2019, for items that should potentially be recognized or disclosed in these consolidated financial statements.
2. RECENT ACCOUNTING PRONOUNCEMENTS
QNB adopted Financial Accounting Standards Board (FASB) issued Accounting Statement Update (ASU) 2016-02, Leases (Topic 842) effective January 1, 2019. This new standard on accounting for leases introduced a lessee model that brings most leases on the balance sheet but recognizes expenses in the income statement similar to how items are recorded today. The new standard eliminates the requirement in current generally accepted accounting principles in the United States (U.S. GAAP) for an entity to use bright-line tests in determining lease classification. The ASU also eliminates the current real estate-specific provisions and changes the guidance on sale-leaseback transactions, initial direct costs and lease executory costs for all entities. All entities will classify leases to determine how to recognize the related revenue and expense and this classification will affect amounts that lessors record on the balance sheet.
QNB applied the new standard to all new contracts initiated on or after the effective date; and, for contracts which have remaining obligations as of the effective date. There was no adjustment needed to the opening balance of QNB’s retained earnings account at January 1, 2019. The discount rates used in determining the initial value of the right of use assets were based on the FHLB Amortizing Fixed Loan Rate for the remaining term of each lease at January 1, 2019. These rates ranged from 2.62% to 3.46%. QNB typically enters into lease agreements with an initial term of 5 to 10 years and subsequent additional optional terms in increments of 5 years. The lease agreements also contain termination options. None of the leases contain purchase options and none transfer the ownership of the leased asset. QNB has renewed one operating lease and entered into one new operating lease that both began during the second quarter of 2019. QNB also entered into an operating lease that it anticipates will begin during the fourth quarter of 2019.
The right-of-use assets under the operating leases are included within “Premises and equipment, net” and the operating lease liabilities are included with “Other liabilities” on the Consolidated Balance Sheets. All operating lease costs are included in non-interest expense within “Net occupancy” on the Consolidated Statements of Income. The following table summarized the quantitative attributes of QNB’s operating leases.
For the six months ended
Lease cost:
Operating lease cost
281
Total lease cost
Other information:
Cash paid for amounts included in the measurement of lease liabilities:
Operating cashflows from operating leases
Total cash paid for amounts included in the measurement of lease liabilities
At implementation of new accounting guidance:
Right-of-use assets recorded for operating lease liabilities
2,005
Weighted average remaining lease term:
Operating leases
7.8 years
Weighted average discount rate:
3.16
%
A maturity analysis of the operating lease liabilities and reconciliation of the undiscounted cash flows to the total operating lease liability is as follows:
Operating Leases
July 2019 thru June 2020
July 2020 thru June 2021
July 2021 thru June 2022
371
July 2022 thru June 2023
357
July 2023 thru June 2024
284
July 2024 and thereafter
999
Total undiscounted cashflows
2,908
Total discount on cashflows
(399
Total lease liabilities
2,509
On June 16, 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326). The new guidance requires organizations to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts.
To that end, the new guidance:
•
Eliminates the probable initial recognition threshold in current U.S. GAAP and, instead, reflects an organization’s current estimate of all expected credit losses over the contractual term of its financial assets
Broadens the information an entity can consider when measuring credit losses to include forward-looking information
Increases usefulness of the financial statements by requiring timely inclusion of forecasted information in forming expectations of credit losses
Increases comparability of purchased financial assets with credit deterioration (PCD assets) with other purchased assets that do not have credit deterioration as well as originated assets because credit losses that are expected will be recorded through an allowance for credit losses for all assets
10
Increases users’ understanding of underwriting standards and credit quality trends by requiring additional information about credit quality indicators by year of origination (vintage)
For available-for-sale debt securities, aligns the income statement recognition of credit losses with the reporting period in which changes occur by recording credit losses (and subsequent changes in credit losses) through an allowance rather than a write down
The new guidance affects organizations that hold financial assets and net investments in leases that are not accounted for at fair value with changes in fair value reported in net income. The new guidance affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.
For public business entities that are U.S. Securities and Exchange Commission (SEC) filers, the new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. QNB is evaluating the impact of this new standard on its consolidated financial statements.
3. STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY
QNB sponsors stock-based compensation plans, administered by a Board committee (the Committee), under which both qualified and non-qualified stock options may be granted periodically to certain employees. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period.
Stock-based compensation expense was $33,000 and $36,000 for the three months ended June 30, 2019 and 2018, respectively. Stock-based compensation expense was $60,000 and $58,000 for the six months ended June 30, 2019 and 2018, respectively. As of June 30, 2019, there was approximately $154,000 of unrecognized compensation cost related to unvested share-based compensation award grants that is expected to be recognized over the next 32 months.
Options are granted to certain employees at prices equal to the market value of the stock on the date the options are granted. The 2005 Plan authorized the issuance of 200,000 shares. The time period during which any option is exercisable under the 2005 Plan is determined by the Committee but shall not commence before the expiration of six months after the date of grant or continue beyond the expiration of five years after the date the option is awarded. The granted options vest after a three-year period. As of June 30, 2019, there were 184,200 options granted, 65,850 options forfeited, 103,950 options exercised, and 14,400 options outstanding under this Plan. The 2005 Plan expired on March 15, 2015.
The 2015 Plan authorizes the issuance of 300,000 shares. The terms of the 2015 Plan are identical to the 2005 Plan. There were 98,200 options granted, 2,600 options forfeited, 250 options exercised and 95,350 options outstanding under the 2015 Plan as of June 30, 2019. The 2015 Plan expires on February 24, 2025.
The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. QNB estimated the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of assumptions.
The following assumptions were used in the option pricing model in determining the fair value of options granted during the period:
Risk free interest rate
2.52
2.15
Dividend yield
3.36
1.24
Volatility
16.44
18.12
Expected life (years)
4.17
4.20
The risk-free interest rate was selected based upon yields of U.S. Treasury securities with a term approximating the expected life of the option being valued. Historical information was the basis for the selection of the expected dividend yield, expected volatility and expected lives of the options.
11
The fair market value of options granted in the six months of 2019 and 2018 was $3.96 and $5.29, respectively.
Stock option activity during the six months ended June 30, 2019 and 2018 is as follows:
Number
of options
Weighted
average
exercise
price
remaining
contractual term
(in years)
Aggregate
intrinsic value
Outstanding at December 31, 2018
95,075
35.11
Granted
24,700
38.15
Exercised
(8,525
25.53
Forfeited
(1,500
37.20
Outstanding at June 30, 2019
109,750
36.51
2.84
258
Exercisable at June 30, 2019
36,600
29.95
1.22
Outstanding at December 31, 2017
85,525
30.94
25,000
43.60
(10,000
24.86
(1,600
32.52
Outstanding at June 30, 2018
98,925
34.73
2.99
1,180
Exercisable at June 30, 2018
26,525
27.46
1.14
509
4. EARNINGS PER SHARE & SHARE REPURCHASE PLAN
The following sets forth the computation of basic and diluted earnings per share:
Numerator for basic and diluted earnings per share - net income
Denominator for basic earnings per share - weighted average
shares outstanding
3,494,620
3,460,360
3,490,724
3,456,467
Effect of dilutive securities - employee stock options
7,491
20,952
7,333
20,407
Denominator for diluted earnings per share - adjusted
weighted average shares outstanding
3,502,111
3,481,312
3,498,057
3,476,874
There were 73,150 and 25,000 stock options that were anti-dilutive for the three-month periods ended June 30, 2019 and 2018, respectively. There were 73,150 and 25,000 stock options that were anti-dilutive for the six-month periods ended June 30, 2019 and 2018, respectively. These stock options were not included in the above calculation.
QNB’s current stock repurchase plan was approved by the Board of Directors on January 21, 2008 and subsequently increased on February 9. 2009 and has authorized the repurchase of up to 100,000 shares of its common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. There were no shares repurchased during the six months ended June 30, 2019 and 2018. As of June 30, 2019, 57,883 shares were repurchased under this authorization at an average price of $16.97 and a total cost of $982,000.
12
5. COMPREHENSIVE INCOME (LOSS)
The following shows the components of accumulated other comprehensive income (loss) at June 30, 2019 and December 31, 2018:
June 30,
December 31,
Unrealized net holding losses on available-for-sale
securities
(501
(9,028
Unrealized losses on available-for-sale securities
for which a portion of an other-than-temporary
impairment loss has been recognized in earnings
Accumulated other comprehensive loss
Tax effect
1,896
The following tables present amounts reclassified out of accumulated other comprehensive income (loss) for the three and six months ended June 30, 2019 and 2018:
Amount reclassified from
accumulated other
comprehensive loss
Details about accumulated other comprehensive loss
Affected line item in statement of income
Unrealized net holding gain on available-for-sale
Net gain on sale of investment
Other-than-temporary impairment losses on
investment securities
Net other-than-temporary impairment
losses on investment securities
Total reclass out of accumulated other
comprehensive income (loss), net of tax
Net of tax
comprehensive income
Details about accumulated other comprehensive income
Unrealized net holding (losses) gains on available-for-sale
(39
Total reclass out of accumulated other comprehensive
income (loss), net of tax
(31
13
6. INVESTMENT SECURITIES
Available-For-Sale Securities
The amortized cost and estimated fair values of investment securities available-for-sale at June 30, 2019 and December 31, 2018 were as follows:
Gross
unrealized
Fair
holding
Amortized
value
gains
losses
cost
U.S. Treasury
3,467
U.S. Government agency
67,773
(226
67,991
State and municipal
53,587
704
(26
52,909
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed
136,652
453
(1,182
137,381
Collateralized mortgage obligations (CMOs)
78,009
342
(675
78,342
Pooled trust preferred
108
121
Corporate debt
8,132
126
(12
Total investment debt securities available-for-sale
1,633
(2,134
348,229
68,409
(2,072
70,481
66,313
195
(464
66,582
125,913
79
(4,251
130,085
75,491
87
(2,549
77,953
116
(6
122
7,979
(80
8,026
394
(9,422
353,249
The amortized cost and estimated fair value of securities available-for-sale by contractual maturity at June 30, 2019 are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities are assigned to categories based on contractual maturity except for mortgage-backed securities and CMOs which are based on the estimated average life of these securities and municipal securities that have been pre-refunded.
Fair value
Amortized cost
Due in one year or less
10,069
10,051
Due after one year through five years
270,673
271,831
Due after five years through ten years
41,475
41,297
Due after ten years
25,511
25,050
14
Proceeds from sales of investment securities available-for-sale were approximately $9,591,000 and $1,756,000 for the three months ended June 30, 2019 and 2018, respectively. Proceeds from sales of investment securities available-for-sale were approximately $20,783,000 and $4,159,000 for the six months ended June 30, 2019 and 2018, respectively.
At June 30, 2019 and December 31, 2018, investment securities available-for-sale totaling approximately $202,175,000 and $194,573,000, respectively, were pledged as collateral for repurchase agreements and deposits of public funds.
The following table presents information related to the Company’s gains and losses on the sales of securities available-for-sale, and losses recognized for the other-than-temporary impairment (“OTTI”) of these investments. Gains and losses on available-for-sale securities are computed on the specific identification method and included in non-interest income. Gross realized losses on debt securities are net of other-than-temporary impairment charges:
Gross realized gains
16
Gross realized losses
(16
(75
(22
Other-than-temporary impairment
Total net gains (losses) on AFS securities
The tax expense applicable to the net realized (losses)/gains for the three-month periods ended June 30, 2019 and 2018 was $0 and $1,000, respectively. The tax applicable to the net realized (losses)/gains for the six-month periods ended June 30, 2019 and 2018 were a benefit of $8,000 and an expense of $1,000, respectively.
QNB recognizes OTTI for debt securities classified as available-for-sale in accordance with FASB ASC 320, Investments – Debt and Equity Securities, which requires that we assess whether we intend to sell or it is more likely than not that the Company will be required to sell a security before recovery of its amortized cost basis less any current-period credit losses. For debt securities that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell prior to recovery of our amortized cost basis, the amount of the impairment is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows discounted at the security’s effective yield. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and, therefore, is not required to be recognized as a loss in the statement of income but is recognized in other comprehensive income. QNB believes that we will fully collect the carrying value of securities on which we have recorded a non-credit related impairment in other comprehensive income. No credit impairments were recognized on debt securities during first six months ended June 30, 2019 and 2018, respectively.
The following table indicates the length of time individual debt securities have been in a continuous unrealized loss position at June 30, 2019 and December 31, 2018:
Less than 12 months
12 months or longer
No. of
Unrealized
35
47,769
1,123
1,308
(14
2,431
93
7,100
(35
97,546
(1,147
104,646
49,344
4,006
8,223
(47
200,081
(2,087
208,304
15
51
81
21,657
(204
10,558
32,215
111
12,561
(91
108,802
(4,160
121,363
73
62,467
(2,548
62,900
3,947
34,651
(296
254,299
(9,126
288,950
Management evaluates debt securities, which are comprised of U.S Treasury securities, U.S. Government agencies, state and municipalities, mortgage-backed securities, CMOs and corporate debt securities, for other-than-temporary impairment and considers the current economic conditions, the length of time and the extent to which the fair value has been less than cost, interest rates and the bond rating of each security. The unrealized losses at June 30, 2019 in U.S. Treasury securities, U.S. Government agency securities, state and municipal securities, mortgage-backed securities, CMOs and corporate debt securities are primarily the result of interest rate fluctuations. If held to maturity, these bonds will mature at par, and QNB will not realize a loss. The Company has the intent to hold the securities and does not believe it will be required to sell the securities before recovery occurs.
QNB holds one pooled trust preferred security as of June 30, 2019. This security has a total amortized cost of approximately $121,000 and a fair value of $108,000. The pooled trust preferred security is available-for-sale and is carried at fair value.
Equity Securities
The Company’s investment in equity securities primarily consists of investments with readily determinable fair values in large cap stock companies. Changes in fair value is recorded in unrealized gain/(losses) in non-interest income.
At June 30, 2019 and December 31, 2018, the Company had $6,898,000 and $9,421,000, respectively, in equity securities recorded at fair value. The following is a summary of unrealized and realized gains and losses recognized in net income on equity securities during the three and six months ended June 30, 2019 and 2018:
Net gains (losses) recognized during the period on equity securities
179
85
1,200
Less: Net gains recognized during the period on equity securities sold during the period
629
130
Net unrealized gains (losses) recognized during the reporting period on equity securities still held at the reporting date
Tax expense applicable to the net realized gains for the three months ended June 30, 2019 and June 30, 2018 was $52,000 and $25,000, respectively. Tax applicable to the net realized gains (losses) for the six months ended June 30, 2019 were an expense of $347,000 and for the six months ended June 30, 2018 a benefit of $22,000. Proceeds from sales of investment equity securities were approximately $4,162,000 and $678,000 for the three months ended June 30, 2019 and 2018, respectively. Proceeds from sales of investment equity securities were approximately $4,520,000 and $1,390,000 for the six months ended June 30, 2019 and 2018, respectively.
7. RESTRICTED INVESTMENT IN STOCKS
Restricted investment in stocks includes Federal Home Loan Bank of Pittsburgh (FHLB) with a carrying cost of $1,860,000, Atlantic Community Bankers Bank (ACBB) stock with a carrying cost of $12,000 and VISA Class B stock with a carrying cost of $0 at June 30, 2019. FHLB and ACBB stock was issued to the Bank as a requirement to facilitate the Bank’s participation in borrowing and other banking services. The Bank’s investment in FHLB stock may fluctuate, as it is based on the member banks’ use of FHLB’s services.
The Bank owns 6,502 shares of Visa Class B stock, which was necessary to participate in Visa services in support of the Bank’s credit card, debit card, and related payment programs (permissible activities under banking regulations) as a member institution. Following the resolution of Visa’s covered litigation, shares of Visa’s Class B stock will be converted to Visa Class A shares using a conversion factor (1.6298 as of June 28, 2018), which is periodically adjusted to reflect VISA’s ongoing litigation costs. There is a very limited market for this stock, as only current owners of Class B shares are permitted to transact in Class B. Due to the lack of orderly trades and public information of such trades, Visa Class B does not have a readily determinable fair value.
These restricted investments are carried at cost and evaluated for OTTI periodically. As of June 30, 2019, there was no OTTI associated with these shares.
8. LOANS & ALLOWANCE FOR LOAN LOSSES
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at the principal amount outstanding, net of deferred loan fees and costs. Interest income is accrued on the principal amount outstanding. Loan origination and commitment fees and related direct costs are deferred and amortized to income over the term of the respective loan and loan commitment period as a yield adjustment.
Loans held-for-sale consists of residential mortgage loans that are carried at the lower of aggregate cost or fair value. Net unrealized losses, if any, are recognized through a valuation allowance charged to income. Gains and losses on residential mortgages held-for-sale are included in non-interest income.
QNB maintains an allowance for loan losses, which is intended to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.
The allowance for loan losses is based on management’s continuing review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value) of the impaired loan is lower than the carrying value of that loan. The portion of the allowance that is allocated to internally criticized and non-accrual loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general component covers pools of loans by loan class including commercial loans not considered impaired, as well as smaller balance homogeneous loans, such as residential real estate, home equity and other consumer loans. These pools of loans are evaluated for loss exposure based upon historical loss rates. These loss rates are based on a three year history of charge-offs and are more heavily weighted for recent experience for each of these categories of loans, adjusted for qualitative factors. These qualitative risk factors include:
1.
Lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices.
2.
Effect of external factors, such as legal and regulatory requirements.
3.
National, regional, and local economic and business conditions as well as the condition of various market segments, including the value of underlying collateral for collateral dependent loans.
4.
Nature and volume of the portfolio including growth.
5.
Experience, ability, and depth of lending management and staff.
6.
Volume and severity of past due, classified and nonaccrual loans.
7.
Quality of the Company’s loan review system, and the degree of oversight by the Company’s Board of Directors.
8.
Existence and effect of any concentrations of credit and changes in the level of such concentrations.
17
Each factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation.
An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of uncollectibility. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent firm reviews risk assessment and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments using information available to them at the time of their examination.
Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
Major classes of loans are as follows:
Commercial:
Commercial and industrial
156,307
162,452
Construction
61,323
50,135
Secured by commercial real estate
329,900
308,590
Secured by residential real estate
71,153
68,581
State and political subdivisions
50,184
43,737
Retail:
1-4 family residential mortgages
67,008
67,453
Home equity loans and lines
74,781
77,475
Consumer
6,717
6,785
Total loans
817,373
785,208
Net unearned costs
220
240
Loans secured by commercial real estate include all loans collateralized at least in part by commercial real estate. These loans may not be for the expressed purpose of conducting commercial real estate transactions.
Overdrafts are reclassified as loans and are included in consumer loans above and total loans receivable on the Consolidated Balance Sheets. At June 30, 2019 and December 31, 2018, overdrafts were approximately $132,000 and $183,000, respectively.
QNB generally lends in its trade area which is comprised of Quakertown and the surrounding communities. To a large extent, QNB makes loans collateralized at least in part by real estate. Its lending activities could be affected by changes in the general economy, the regional economy, or real estate values. Other than disclosed in the table above, at June 30, 2019, there was a concentration of loans to lessors of residential buildings and dwellings of 16.2% of total loans and to lessors of nonresidential buildings of 18.7% of total loans,
18
compared with 15.8% and 18.1% of total loans, respectively, at December 31, 2018. These concentrations were primarily within the commercial real estate categories.
The Company engages in a variety of lending activities, including commercial, residential real estate and consumer transactions. The Company focuses its lending activities on individuals, professionals and small to medium sized businesses. Risks associated with lending activities include economic conditions and changes in interest rates, which can adversely impact both the ability of borrowers to repay their loans and the value of the associated collateral.
Commercial and industrial loans, commercial real estate loans, construction loans and residential real estate loans with a business purpose are generally perceived as having more risk of default than residential real estate loans with a personal purpose and consumer loans. These types of loans involve larger loan balances to a single borrower or groups of related borrowers and are more susceptible to a risk of loss during a downturn in the business cycle. These loans may involve greater risk because the availability of funds to repay these loans depends on the successful operation of the borrower’s business. The assets financed are used within the business for its ongoing operation. Repayment of these kinds of loans generally comes from the cash flow of the business or the ongoing conversions of assets, such as accounts receivable and inventory, to cash. Typical collateral for commercial and industrial loans includes the borrower’s accounts receivable, inventory and machinery and equipment. Commercial real estate and residential real estate loans secured for a business purpose are originated primarily within the eastern Pennsylvania market area at conservative loan-to-value ratios and often backed by the individual guarantees of the borrowers or owners. Repayment of this kind of loan is dependent upon either the ongoing cash flow of the borrowing entity or the resale or lease of the subject property. Commercial real estate loans may be affected to a greater extent than residential loans by adverse conditions in real estate markets or the economy because commercial real estate borrowers’ ability to repay their loans depends on successful development of their properties, as well as the factors affecting residential real estate borrowers.
Loans to state and political subdivisions are tax-exempt or taxable loans to municipalities, school districts and housing and industrial development authorities. These loans can be general obligations of the municipality or school district repaid through their taxing authority, revenue obligations repaid through the income generated by the operations of the authority, such as a water or sewer authority, or loans issued to a housing and industrial development agency, for which a private corporation is responsible for payments on the loans.
The Company originates fixed-rate and adjustable-rate real estate-residential mortgage loans for personal purposes that are secured by first liens on the underlying 1-4 family residential properties. Credit risk exposure in this area of lending is minimized by the evaluation of the credit worthiness of the borrower, including debt-to-income ratios, credit scores and adherence to underwriting policies that emphasize conservative loan-to-value ratios of generally no more than 80%. Residential mortgage loans granted in excess of the 80% loan-to-value ratio criterion are generally insured by private mortgage insurance.
The real estate-home equity portfolio consists of fixed-rate home equity loans and variable-rate home equity lines of credit. Risks associated with loans secured by residential properties are generally lower than commercial loans and include general economic risks, such as the strength of the job market, employment stability and the strength of the housing market. Since most loans are secured by a primary or secondary residence, the borrower’s continued employment is the greatest risk to repayment.
The Company offers a variety of loans to individuals for personal and household purposes. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and is more likely to decrease in value than real estate. Credit risk in this portfolio is controlled by conservative underwriting standards that consider debt-to-income levels and the creditworthiness of the borrower and, if secured, collateral values.
The Company employs a ten-grade risk rating system related to the credit quality of commercial loans and loans to state and political subdivisions of which the first six categories are pass categories (credits not adversely rated). The following is a description of the internal risk ratings and the likelihood of loss related to each risk rating.
- Excellent - no apparent risk
- Good - minimal risk
- Acceptable - lower risk
- Acceptable - average risk
19
- Acceptable – higher risk
- Pass watch
- Special Mention - potential weaknesses
- Substandard - well defined weaknesses
- Doubtful - full collection unlikely
- Loss - considered uncollectible
The Company maintains a loan review system, which allows for a periodic review of our loan portfolio and the early identification of potential problem loans. Each loan officer assigns a rating to all loans in the portfolio at the time the loan is originated. Loans with risk ratings of one through five are reviewed annually based on the borrower’s fiscal year. Loans with risk ratings of six are reviewed every six to twelve months based on the dollar amount of the relationship with the borrower. Loans with risk ratings of seven through ten are reviewed at least quarterly, and as often as monthly, at management’s discretion. The Company also utilizes an outside loan review firm to review the portfolio on a semi-annual basis to provide the Board of Directors and senior management an independent review of the Company’s loan portfolio on an ongoing basis. These reviews are designed to recognize deteriorating credits in their earliest stages in an effort to reduce and control risk in the lending function as well as identifying potential shifts in the quality of the loan portfolio. The examinations by the outside loan review firm include the review of lending activities with respect to underwriting and processing new loans, monitoring the risk of existing loans and to provide timely follow-up and corrective action for loans showing signs of deterioration in quality. In addition, the outside firm reviews the methodology for the allowance for loan losses to determine compliance to policy and regulatory guidance.
The following tables present the classes of the loan portfolio summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company’s internal risk rating system as of June 30, 2019 and December 31, 2018:
Pass
Special
mention
Substandard
Doubtful
152,617
3,690
322,077
505
7,318
69,589
1,564
655,790
12,572
668,867
155,219
7,151
297,713
1,259
9,618
66,838
1,570
613,642
1,514
18,339
633,495
20
For retail loans, the Company evaluates credit quality based on the performance of the individual credits. The following tables present the recorded investment in the retail classes of the loan portfolio based on payment activity as of June 30, 2019 and December 31, 2018:
Performing
Non-performing
66,441
567
74,555
226
6,613
104
147,609
897
148,506
66,513
940
77,309
166
6,659
150,481
1,232
151,713
The performance and credit quality of the loan portfolio is also monitored by analyzing the age of the loans receivable as determined by the length of time a recorded payment is past due. The following table presents the classes of the loan portfolio summarized by the past due status as of June 30, 2019 and December 31, 2018:
30-59 days
past due
60-89 days
90 days or
more past
due
Total past
due loans
Current
receivable
2,126
2,418
153,889
366
309
1,811
2,486
327,414
168
399
70,586
393
455
848
66,160
157
364
74,417
23
29
52
6,665
633
1,174
4,928
6,735
810,638
94
141
1,372
1,607
160,845
305
1,029
638
1,972
306,618
24
352
291
667
67,914
544
245
476
1,265
66,188
61
348
77,127
6,703
1,072
2,007
5,941
779,267
21
The following tables disclose the recorded investment in loans receivable that are either on non-accrual status or past due 90 days or more and still accruing interest as of June 30, 2019 and December 31, 2018:
90 days or more past
due (still accruing)
Non-accrual
3,598
2,057
1,116
7,668
3,179
1,965
1,102
7,478
Activity in the allowance for loan losses for the three and six months ended June 30, 2019 and 2018 are as follows:
Three months ended June 30, 2019
Balance,
beginning of
period
Provision for
(credit to)
loan losses
Charge-offs
Recoveries
Balance, end
of period
3,083
3,302
602
675
2,829
84
2,913
743
(5
42
722
190
(67
341
(56
294
80
188
Unallocated
561
(125
9,015
(73
72
9,164
22
Three months ended June 30, 2018
2,840
557
573
278
2,710
835
(72
781
381
(27
311
(23
67
310
(99
211
8,037
8,192
Six months ended June 30, 2019
3,092
192
551
124
2,824
89
754
(59
(36
63
153
497
(64
338
(38
(17
(102
(25
8,834
(155
Six months ended June 30, 2018
2,711
107
2,410
298
816
(55
114
76
444
(7
(158
7,841
(93
As previously discussed, the Company maintains a loan review system, which includes a continuous review of the loan portfolio by internal and external parties to aid in the early identification of potential impaired loans. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining
impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans and loans to state and political subdivisions by using either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential mortgage loans for impairment disclosures, unless such loans are part of a larger relationship that is impaired or are classified as a troubled debt restructuring or on non-accrual.
An allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of the majority of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral.
For commercial loans secured by real estate, estimated fair values are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.
For commercial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable agings or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.
From time to time, QNB may extend, restructure, or otherwise modify the terms of existing loans, on a case-by-case basis, to remain competitive and retain certain customers, as well as assist other customers that may be experiencing financial difficulties. A loan is considered to be a troubled debt restructuring (“TDR”) loan when the Company grants a concession to the borrower because of the borrower’s financial condition that it would not otherwise consider. Such concessions include the reduction of interest rates, forgiveness of principal or interest, or other modifications of interest rates to less than the current market rate for new obligations with similar risk. Loans classified as TDRs are considered non-performing and are also designated as impaired.
The concessions made for TDRs involve lowering the monthly payments on loans through periods of interest only payments, a reduction in interest rate below a market rate or an extension of the term of the loan without a corresponding adjustment to the risk premium reflected in the interest rate, or a combination of these three methods. The restructurings rarely result in the forgiveness of principal or accrued interest. If the borrower has demonstrated performance under the previous terms and our underwriting process shows the borrower has the capacity to continue to perform under the restructured terms, the loan will continue to accrue interest. Non-accruing restructured loans may be returned to accrual status when there has been a sustained period of repayment performance (generally six consecutive months of payments) and both principal and interest are deemed collectible. TDR loans that are in compliance with their modified terms and that yield a market rate may be removed from the TDR status after a period of performance.
Performing TDRs (not reported as non-accrual or past due 90 days or more and still accruing) totaled $2,009,000 and $2,160,000 as of June 30, 2019 and December 31, 2018, respectively. Non-performing TDRs totaled $1,210,000 and $1,317,000 as of June 30, 2019 and December 31, 2018, respectively. All TDRs are included in impaired loans.
The following table illustrates the specific reserve for loan losses allocated to loans modified as TDRs. These specific reserves are included in the allowance for loan losses for loans individually evaluated for impairment.
Unpaid
principal
balance
Related
allowance
TDRs with no specific allowance recorded
2,825
2,513
TDRs with an allowance recorded
387
964
411
3,219
3,477
There were no newly identified TDR during the six months ended June 30, 2019. As of June 30, 2019 and December 31, 2018, QNB had no commitments to lend additional funds to customers with loans whose terms have been modified in troubled debt restructurings. There were $5,000 in net charge-offs during the three and six months ended June 30, 2019, and no charge-offs during the three and six months ended June 30, 2018, resulting from loans previously modified as TDRs.
The following tables present loans, by loan class, modified as TDRs during the three and six months ended June 30, 2019 and 2018. The pre-modification and post-modification outstanding recorded investments disclosed in the tables below, represent carrying amounts immediately prior to the modification and as of the period end indicated.
contracts
Pre-modification
outstanding
recorded
investment
Post-modification
47
There were no loans modified as TDRs within 12 months prior to June 30, 2019 and 2018 for which there was a payment default (60 days or more past due) during the six months ended June 30, 2019 and 2018.
The Company has five mortgage loans secured by residential real estate for which foreclosure proceedings are in process at June 30, 2019. The total recorded investment is $662,000.
The following tables present the balance in the allowance for loan losses at June 30, 2019 and December 31, 2018 disaggregated on the basis of the Company’s impairment method by class of loans receivable along with the balance of loans receivable by class, excluding unearned fees and costs, disaggregated on the basis of the Company’s impairment methodology:
Allowance for Loan Losses
Loans Receivable
Balance
Balance related
to loans
individually
evaluated for
impairment
collectively
1,952
1,350
152,709
139
2,774
3,476
326,424
650
1,733
69,420
430
892
66,116
165
74,616
6,644
2,166
6,562
9,937
807,436
1,461
1,631
7,128
155,324
101
2,723
6,083
302,507
97
657
1,740
66,841
1,268
66,185
333
186
77,289
77
6,708
1,664
6,709
16,482
768,726
26
The following table summarize additional information, in regards to impaired loans by loan portfolio class, as of June 30, 2019 and December 31, 2018:
Recorded
(after
charge-offs)
With no specific allowance recorded:
681
822
4,243
4,525
2,194
2,827
5,012
5,577
1,462
1,639
1,023
1,140
735
763
1,357
271
140
5,310
6,404
11,763
12,873
With an allowance recorded:
2,917
4,247
2,885
4,128
1,282
1,311
1,071
1,095
717
773
162
46
4,627
6,031
4,719
6,042
Total:
5,069
8,653
4,138
6,672
1,950
1,913
925
236
12,435
18,915
27
The following table presents additional information regarding the average recorded investment and interest income recognized on impaired loans:
Six Months Ended June 30,
Average
recognized
3,953
6,208
4,855
68
3,752
1,746
1,696
1,101
1,222
75
83
11,886
98
13,147
9. FAIR VALUE MEASUREMENTS AND DISCLOSURES
FASB ASC 820, Fair Value Measurements and Disclosures, defines fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (fair values are not adjusted for transaction costs). ASC 820 also establishes a framework (fair value hierarchy) for measuring fair value under U.S. GAAP and expands disclosures about fair value measurements.
ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are as follows:
Level 1:
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Level 2:
Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.
Level 3:
Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).
An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
The measurement of fair value should be consistent with one of the following valuation techniques: market approach, income approach, and/or cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering factors specific to the measurement (qualitative and quantitative). Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the security’s relationship to other benchmark quoted securities.
The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis and the fair value measurements by level within the fair value hierarchy as of June 30, 2019:
Quoted prices
in active
markets
for identical
assets
(Level 1)
Significant
other
observable
input
(Level 2)
unobservable
inputs
(Level 3)
Balance at end
Recurring fair value measurements
Equity securities
Available-for-sale securities:
U.S. Treasury securities
U.S. Government agency securities
State and municipal securities
U.S. Government agencies and sponsored
enterprises (GSEs):
Mortgage-backed securities
Pooled trust preferred securities
Corporate debt securities
Total debt securities available-for-sale
347,620
Total recurring fair value measurements
354,626
Nonrecurring fair value measurements
Impaired loans
2,461
Mortgage servicing rights
Total nonrecurring fair value measurements
2,469
There were no transfers in and out of Level 1 and Level 2 fair value measurements during the three or six months ended June 30, 2019. There were also no transfers in or out of level 3 for the same period. There were no losses included in earnings attributable to the change in unrealized gains or losses relating to the available-for-sale securities above with fair value measurements utilizing significant unobservable inputs for the three- or six-month period ended June 30, 2019.
The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis, the fair value measurements by level within the fair value hierarchy as of December 31, 2018:
Debt securities available-for-sale
344,105
353,642
3,055
3,060
The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which QNB has utilized Level 3 inputs to determine fair value:
Quantitative information about Level 3 fair value measurements
Valuation
techniques
Unobservable
Value or range
of values
1,927
Appraisal of collateral
(1)
Appraisal adjustments
(2)
-10.0% to -25.0%
Liquidation expenses
(3)
-10.0
534
Financial statement values for UCC collateral
Financial statement value discounts
(5)
-30.0% to -100.0%
Discounted cash flow
Remaining term
1 - 26 years
Discount rate
12.0% to 12.5%
1,632
-20.0% to -90.0%
1,415
-25.0% to -100.0%
Used commercial vehicle guides
Guide value discounts
(4)
-10%
2 to 26 years
Fair value is primarily determined through appraisals of the underlying collateral by independent parties, which generally includes various level 3 inputs which are not always identifiable.
Appraisals may be adjusted by management for qualitative factors such as economic conditions and the age of the appraisal. The range is presented as a percent of the initial appraised value.
Appraisals and pending agreements of sale are adjusted by management for estimated liquidation expenses. The range is presented as a percent of the initial appraised value.
If lendable value (lower than wholesale) is utilized then no additional discounts are taken. If lendable value is not provided, additional discounts are applied.
Values obtained from financial statements for UCC collateral (fixed assets and inventory) are discounted to estimated realizable liquidation value.
The following table presents additional information about the available-for-sale securities measured at fair value on a recurring basis and for which QNB utilized significant unobservable inputs (Level 3 inputs) to determine fair value for the six months ended June 30, 2019 and 2018:
Fair value measurements
using significant
unobservable inputs
Balance, January 1,
215
Payments received
(119
Total gains or losses (realized/unrealized)
Included in earnings
Included in other comprehensive (loss) income
Transfers in and/or out of Level 3
Balance, June 30,
118
The Level 3 securities consist of one collateralized debt obligation security, the PreTSL security, which is backed by trust preferred securities issued by banks. The market for this security at June 30, 2019 was not active and markets for similar securities also are not active. The new issue market is also inactive and there are currently very few market participants who are willing and or able to transact for these securities.
Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:
The few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at June 30, 2019;
An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates; and
The PreTSL will be classified within Level 3 of the fair value hierarchy because significant adjustments are required to determine fair value at the measurement date.
QNB used an independent third party to value this security using a discounted cash flow analysis. Based on management’s review of the bond’s four underlying issuers, there are no expected credit losses or prepayments; cashflows used were contractual based on the Bloomberg YA screen. The assumed cashflows have been discounted using and estimated market discount rate based on the 30-year swap rate. The 30-year is used as the reference rate since it is indicative of market expectation for short-term rates in the future. This is consistent with the 30-year nature of the PreTSL security, which is priced using the 3-month LIBOR as a reference rate. The discount rate of 5.81% includes the risk-free rate, a credit component and a spread for illiquidity.
The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of QNB’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between QNB’s disclosures and those of other companies may not be meaningful.
The following methods and assumptions were used to estimate the fair values of each major classification of financial instrument and non-financial asset at June 30, 2019 and December 31, 2018:
Cash and cash equivalents, accrued interest receivable and accrued interest payable (carried at cost): The carrying amounts reported in the balance sheet approximate those assets’ fair value.
Investment securities (carried at fair value): The fair value of securities are primarily determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. Level 2 debt securities are valued by a third-party pricing service commonly used in the banking industry. Level 2 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 date, market consensus prepayment speeds, credit information and the security’s terms and conditions, among other things. For certain securities which are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence (Level 3). In the absence of such evidence, management’s best estimate is used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Cash flow models using a present value formula that includes assumptions market participants would use along with indicative exit pricing obtained from broker/dealers (where available) were used to support fair values of certain Level 3 investments.
Restricted investment in stocks (carried at cost): The fair value of stock in Atlantic Community Bankers Bank, the Federal Home Loan Bank and VISA Class B is the carrying amount, based on redemption provisions, and considers the limited marketability of and restrictions on such securities.
Loans Receivable (carried at cost): The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the liquidity, credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.
Impaired Loans (generally carried at fair value): Impaired loans are loans, in which the Company has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.
Mortgage Servicing Rights (carried at lower of cost or fair value): The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The mortgage servicing rights are stratified into tranches based on predominant characteristics, such as interest rate, loan type and investor type. The valuation incorporates assumptions that market participants would use in estimating future net servicing income.
Deposit liabilities (carried at cost): The fair value of deposits with no stated maturity (e.g. demand deposits, interest-bearing demand accounts, money market accounts and savings accounts) are by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amounts). This approach to estimating fair value excludes the significant benefit that results from the low-cost funding provided by such deposit liabilities, as compared to alternative sources of funding. Deposits with a stated maturity (time deposits) have been valued using the present value of cash flows discounted at rates approximating the current market for similar deposits.
Short-term borrowings (carried at cost): The carrying amount of short-term borrowings approximates their fair values.
Off-balance-sheet instruments (disclosed at cost): The fair values for QNB’s off-balance sheet instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.
32
Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in sales transaction on the dates indicated. The estimated fair value amounts have been measured as of the respective period ends and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period end.
The estimated fair values and carrying amounts of the Company’s financial and off-balance sheet instruments are summarized as follows:
Carrying
Quoted
prices in
active
markets for
identical
Financial assets
Cash and cash equivalents
Investment securities:
Equities
Available-for-sale
824,020
440
556
Financial liabilities
Deposits with no stated maturities
796,350
Deposits with stated maturities
234,311
234,083
Off-balance sheet instruments
Commitments to extend credit
Standby letters of credit
771,685
451
604
791,810
223,788
220,876
10. OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS AND GUARANTEES
In the normal course of business there are various legal proceedings, commitments, and contingent liabilities which are not reflected in the consolidated financial statements. Management does not anticipate any material losses as a result of these transactions and activities. They include, among other things, commitments to extend credit and standby letters of credit. The maximum exposure to credit loss, which represents the possibility of sustaining a loss due to the failure of the other parties to a financial instrument to perform according to the terms of the contract, is represented by the contractual amount of these instruments. QNB uses the same lending standards and policies in making credit commitments as it does for on-balance sheet instruments. The activity is controlled through credit approvals, control limits, and monitoring procedures.
A summary of the Company's financial instrument commitments is as follows:
Commitments to extend credit and unused lines of credit
282,695
266,021
16,815
17,269
Total financial instrument commitments
299,510
283,290
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. QNB evaluates each customer’s creditworthiness on a case-by-case basis.
Standby letters of credit are conditional commitments issued by the Company to guarantee the financial or performance obligation of a customer to a third party. QNB’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making conditional obligations as it does for on-balance sheet instruments. Standby letters of credit of $15,746,000 will expire
34
within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. The Company requires collateral and personal guarantees supporting these letters of credit as deemed necessary. Management believes that the proceeds obtained through a liquidation of such collateral and the enforcement of personal guarantees would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The amount of the liability as of June 30, 2019 and December 31, 2018 for guarantees under standby letters of credit issued is not material.
The amount of collateral obtained for letters of credit and commitments to extend credit is based on management’s credit evaluation of the customer. Collateral varies, but may include real estate, accounts receivable, marketable securities, pledged deposits, inventory or equipment.
11. REGULATORY RESTRICTIONS
Dividends payable by QNB Corp. and the Bank are subject to various limitations imposed by statutes, regulations and policies adopted by bank regulatory agencies. Under Federal and Pennsylvania banking law, the Bank is subject to certain restrictions on the amount of dividends that it may declare without prior regulatory approval. Under Federal Reserve regulations, the Bank is limited as to the amount it may lend affiliates, including QNB Corp., unless such loans are collateralized by specific obligations.
Both the Company and the Bank are subject to regulatory capital requirements administered by Federal banking agencies. Failure to meet minimum capital requirements can initiate actions by regulators that could have an effect on the financial statements. Under the framework for prompt corrective action, both the Company and the Bank must meet capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items.
The capital amounts and classification are also subject to qualitative judgments by the regulators. Management believes, as of June 30, 2019, that the Company and the Bank met capital adequacy requirements to which they were subject.
As of the most recent notification, the primary regulator of the Bank considered it to be “well capitalized” under the regulatory framework. There are no conditions or events since that notification that management believes have changed the classification. To be categorized as well capitalized, the Company and the Bank must maintain minimum ratios as set forth in the following table below.
The Company and the Bank’s actual capital amounts and ratios are presented as follows:
Capital levels
Actual
Adequately capitalized
Well capitalized
As of June 30, 2019
Amount
Ratio
Total risk-based capital (to risk-weighted assets):
The Company
125,490
13.42
74,826
8.00
93,533
10.00
Bank
114,572
12.53
73,163
91,454
Tier I capital (to risk-weighted assets):
116,253
12.43
56,120
6.00
105,335
11.52
54,872
Common equity tier 1 capital (to risk-weighted
assets):
42,090
4.50
41,154
59,445
6.50
Tier I capital (to average assets):
9.67
48,095
4.00
8.84
47,667
59,584
5.00
As of December 31, 2018
120,379
13.21%
72,910
91,137
110,508
12.52
70,619
88,273
111,472
12.23
54,682
101,601
11.51
52,964
41,012
39,723
57,378
9.40
47,458
8.64
47,045
58,807
12. REVENUE RECOGNITION FROM CONTRACTS WITH CUSTOMERS
The Company generally fully satisfies its performance obligations on its contracts with customers as services are rendered and the transaction prices are typically fixed; charged either on a periodic basis or based on activity. Because performance obligations are satisfied as services are rendered and the transaction prices are fixed, there is little judgment involved in applying Topic 606 that significantly affects the determination of the amount and timing of revenue from contracts with customers. The main types of revenue contracts included in non-interest income within the consolidated statements of operations are as follows:
Fees for services to customers—fees include service charges on deposits which are included as liabilities in the consolidated statement of financial position and consist of transaction-based fees, stop payment fees, Automated Clearing House (ACH) fees, account maintenance fees, and overdraft services fees for various retail and business checking customers. These fees are charged as earned on the day of the transaction or within the month of the service, with the exception of Enhanced Account Analysis Fees, which are calculated on the previous month’s activity and assessed on the following month. The Enhanced Account Analysis Fees are currently being accrued; the revenue is currently being recorded in the month it is earned. Service charges on deposits are withdrawn directly from the customer’s account balance.
ATM and debit card – fees are recognized at the time the transaction is executed as that is the point in time the Company fulfills the customer’s request.
Retail brokerage and advisory—fee income and related expenses are accrued monthly to properly record the revenues in the month they are earned. Advisory fees are collected in advance on a quarterly basis. These advisory fees are recorded in the first month of the quarter for which the service is being performed. Fees that are transaction based are recognized at the point in time that the transaction is executed (i.e. trade date).
Merchant – QNB earns interchange fees from credit/debit cardholder transactions conducted through VISA/MasterCard payment networks. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized monthly, concurrently with the transaction processing services provided to the cardholder within the month.
Other—includes credit card fees, sales of checks to depositors, miscellaneous fees and gain/losses on sale of OREO.
Credit card fees are recognized monthly, concurrently with the transaction processing services provided to the cardholder within the month.
Sales of checks to depositors are commissions earned from a third-party who provides checks to QNB’s customers. There is a pre-paid incentive with the third party which is recognized over the term of the contract. Other commissions on the sales of checks are recorded weekly.
Miscellaneous fees, such as wire, cashier check and garnishment fees, are charged as earned on the day of the transaction.
Gain (loss) on sales of OREO – QNB records a gain or loss from the sale of OREO when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. When the QNB finances the sale of OREO to the buyer, QNB assesses whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction price is probable. Once these criteria are met, the OREO asset is derecognized and the gain or loss on sale is recorded upon the transfer of control of the property to the buyer. In determining the gain or loss on the sale, QNB adjusts the transaction prices and related gain (loss) on sale if a significant financing component is present.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
QNB Corp. is a bank holding company headquartered in Quakertown, Pennsylvania. QNB Corp., through its wholly-owned subsidiary, the Bank, has been serving the residents and businesses of upper Bucks, northern Montgomery and southern Lehigh counties in Pennsylvania since 1877. Due to its limited geographic area, growth is pursued through expansion of existing customer relationships and building new relationships by stressing a consistent high level of service at all points of contact. The Bank is a locally managed community bank that provides a full range of commercial and retail banking and retail brokerage services. The consolidated entity is referred to herein as “QNB” or the “Company”.
Tabular information presented throughout management’s discussion and analysis, other than share and per share data, is presented in thousands of dollars.
FORWARD-LOOKING STATEMENTS
In addition to historical information, this document contains forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference.
Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, and including the risk factors identified in Item 1A of QNB’s 2018 Form 10-K, could affect the future financial results of QNB Corp. and its subsidiary and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include, but are not limited, to the following:
Volatility in interest rates and shape of the yield curve;
Credit risk;
Liquidity risk;
Operating, legal and regulatory risks;
Economic, political and competitive forces affecting QNB’s business; and
The risk that the analysis of these risks and forces could be incorrect, and/or that the strategies developed to address them could be unsuccessful.
QNB cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which change over time, and QNB assumes no duty to update forward-looking statements. Management cautions readers not to place undue reliance on any forward-looking statements. These statements speak only as of the date of this report on Form 10-Q, even if subsequently made available by QNB on its website or otherwise, and they advise readers that various factors, including those described above, could affect QNB’s financial performance and could cause actual results or circumstances for future periods to differ materially from those anticipated or projected. Except as required by law, QNB does not undertake, and specifically disclaims 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.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of QNB, which are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) and predominant practices within the banking industry. The preparation of these consolidated financial statements requires QNB to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. QNB evaluates estimates on an on-going basis, including those related to the determination of the allowance for loan losses, the determination of the valuation of other real estate owned and foreclosed assets, other-than-temporary impairments on investment securities, the valuation of deferred tax assets, stock-based compensation and income taxes. QNB bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Other-Than-Temporary Investment Security Impairment
Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, it indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. For equity securities that do not have readily-determinable fair values, once a decline in value is determined to be other-than-temporary, the value of the equity security is reduced and a corresponding charge to earnings is recognized. There were no other-than-temporary impairment charges recorded during the three or six months ended June 30, 2019 and 2018, respectively.
The Company follows accounting guidance related to the recognition and presentation of other-than-temporary impairment that specifies (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more likely than not the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income. There were no credit-related other-than-temporary impairment charges in the three or six months ended June 30, 2019 or 2018, respectively.
The determination of the allowance for loan losses involves a higher degree of judgment and complexity than the Company’s other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a level believed by management to be sufficient to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.
The allowance for loan losses is based on management’s continual review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. The portion of the allowance that is allocated to impaired loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral or present value of future estimated cash flows. The general reserves are based on the composition and risk characteristics of the loan portfolio, including the nature of the loan portfolio, credit concentration trends, delinquency and loss experience, as well as other qualitative factors such as current economic trends.
Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of collection. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent loan review group tests risk assessments and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, increases to the allowance may be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
Foreclosed Assets
Assets acquired through, or in lieu of, loan foreclosure are held-for-sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses and changes in the valuation allowance are included in net expenses from foreclosed assets.
Stock-Based Compensation
QNB sponsors stock-based compensation plans, administered by a Board committee, under which both qualified and non-qualified stock options may be granted periodically to certain employees. QNB accounts for all awards granted under stock-based compensation plans in accordance with ASC 718, Compensation-Stock Compensation. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. QNB estimates the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature.
Income Taxes
QNB accounts for income taxes under the asset/liability method in accordance with income tax accounting guidance, ASC 740, Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Because the judgment about the level of future taxable income is dependent on matters that may, at least in part, be beyond QNB’s control, it is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.
RESULTS OF OPERATIONS - OVERVIEW
QNB reported net income for the second quarter of 2019 of $3,143,000, or $0.90 per share on a diluted basis, compared to net income of $2,862,000, or $0.82 per share on a diluted basis, for the same period in 2018. For the six-month period ended June 30, 2019, QNB reported net income of $6,522,000, or $1.86 per share on a diluted basis, compared to net income of $5,797,000, or $1.67 per share on a diluted basis, for the same period in 2018.
Net income expressed as an annualized rate of return on average assets and average shareholders’ equity was 1.05% and 10.91%, respectively, for the quarter ended June 30, 2019 compared with 0.98% and 10.70%, respectively, for the quarter ended June 30, 2018. For the six months ended June 30, 2019, the annualized rate of return on average assets and average shareholders’ equity was 1.10% and 11.49%, respectively, compared with 1.00% and 11.02%, for the same period in 2018.
Total assets as of June 30, 2019 were $1,212,005,000, compared with $1,175,452,000 at December 31, 2018. Loans receivable at June 30, 2019 were $817,593,000, compared with $785,448,000 at December 31, 2018, an increase of $32,145,000, or 4.1%, with commercial lending as the largest contributor to the growth. Total deposits of $1,030,661,000 at June 30, 2019 increased $15,063,000, or 1.5%, compared with total deposits of $1,015,598,000 at December 31, 2018.
Results for the three and six months ended June 30, 2019 include the following significant components:
Net interest income increased $411,000, or 4.7%, to $9,111,000 and $456,000, or 2.6%, to $17,947,000 for the three and six months ended June 30, 2019, respectively.
Net interest margin on a tax-equivalent basis increased five basis points for the quarter and one basis point year-to-date, to 3.20% and 3.19%, respectively.
QNB recorded $150,000 in provision for loan losses for the quarter and $375,000 for the six months ended June 30, 2019, compared with $187,000 and $375,000 for the same periods in 2018, respectively.
40
Non-interest income increased $200,000, or 13.8%, to $1,654,000 for the second quarter and $1,442,000, or 57.2%, for the six months ended June 30, 2019 compared with the same periods in 2018.
Non-interest expense increased $260,000, or 4.0%, to $6,793,000 for the second quarter and $806,000, or 6.3%, to $13,517,000 for the six months ended June 30, 2019, compared to the same periods in 2018.
Total non-performing loans were $9,677,000, or 1.18% of loans receivable at June 30, 2019, compared to $9,638,000, or 1.23% of loans receivable at December 31, 2018. Loans on non-accrual status were $7,668,000 at June 30, 2019 compared with $7,478,000 at December 31, 2018. Net charge-offs for the six months ended June 30, 2019 were $45,000, compared with $24,000 for the same period in 2018.
These items, as well as others, will be explained more thoroughly in the next sections.
NET INTEREST INCOME
QNB earns its net income primarily through the Bank. Net interest income, or the spread between the interest, dividends and fees earned on loans and investment securities and the expense incurred on deposits and other interest-bearing liabilities, is the primary source of operating income for QNB. Management seeks to achieve sustainable and consistent earnings growth while maintaining adequate levels of capital and liquidity and limiting its exposure to credit and interest rate risk levels approved by the Board of Directors.
The following table presents the adjustment to convert net interest income to net interest income on a fully taxable-equivalent basis for the three- and six-month periods ended June 30, 2019 and 2018.
Tax-equivalent adjustment
402
Net interest income (fully taxable-equivalent)
9,307
8,901
18,340
17,893
Net interest income is the primary source of operating income for QNB. Net interest income is interest income, dividends, and fees on earning assets, less interest expense incurred for funding sources. Earning assets primarily include loans, investment securities, interest bearing balances at the Federal Reserve Bank (Fed) and Federal funds sold. Sources used to fund these assets include deposits and borrowed funds. Net interest income is affected by changes in interest rates, the volume and mix of earning assets and interest-bearing liabilities, and the amount of earning assets funded by non-interest bearing deposits.
For purposes of this discussion, interest income and the average yield earned on loans and investment securities are adjusted to a tax-equivalent basis as detailed in the tables that appear above. This adjustment to interest income is made for analysis purposes only. Interest income is increased by the amount of savings of Federal income taxes, which QNB realizes by investing in certain tax-exempt state and municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more easily compared.
The net interest rate spread is the difference between average rates received on earning assets and average rates paid on interest-bearing liabilities, while the net interest rate margin, which includes interest-free sources of funds, is net interest income expressed as a percentage of average interest-earning assets. The Asset/Liability and Investment Management Committee works to manage and maximize the net interest margin for the Company.
Average Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent Basis)
Three Months Ended
June 30, 2018
Rate
Interest
Investment securities (AFS & Equity):
1,935
2.51
0.00
U.S. Government agencies
71,972
1.83
329
72,476
1.79
324
53,791
3.60
484
71,528
3.26
Mortgage-backed and CMOs
213,688
2.22
1,186
212,076
2.12
1,124
4.95
123
4.53
8,020
3.76
6,538
2.39
8,308
10,109
2.87
Total investment securities
357,836
2.41
2,152
372,850
2.30
2,145
Loans:
Commercial real estate
460,836
4.85
5,575
427,120
4.61
Residential real estate
67,168
3.98
669
60,830
3.82
580
Home equity loans
68,254
4.72
803
66,298
4.46
736
154,000
5.63
2,161
155,505
4.98
1,930
Consumer loans
6,886
6.06
7,105
5.95
106
Tax-exempt loans
48,429
3.41
40,686
3.21
325
Total loans, net of unearned income*
805,573
4.84
9,723
757,544
4.54
8,581
Other earning assets
2,945
4.51
2,890
5.12
Total earning assets
1,166,354
4.10
11,908
1,133,284
3.81
10,763
12,815
11,657
(9,107
(8,103
32,344
29,545
1,202,406
1,166,383
Liabilities and Shareholders' Equity
Interest-bearing deposits:
213,308
0.48
186,532
0.23
Municipals
104,912
2.03
530
99,001
1.33
328
93,890
0.97
77,903
241,445
263,365
0.56
121,752
1.58
121,392
1.25
107,585
1.91
105,353
Total interest-bearing deposits
882,892
1.09
2,405
853,546
0.78
1,661
57,907
1.36
67,841
1.19
Total interest-bearing liabilities
940,799
1.11
921,387
0.81
Non-interest-bearing deposits
139,033
133,454
7,023
4,241
Shareholders' equity
115,551
107,301
Net interest rate spread
3.00
Margin/net interest income
3.20
3.15
Six Months Ended
973
71,231
1.81
646
72,475
649
58,475
3.50
1,024
73,127
3.27
1,196
211,205
2.21
2,339
215,753
2.11
2,274
5.04
4.07
8,022
3.77
151
7,290
9,203
3.06
9,231
2.91
359,231
2.40
4,314
378,055
4,340
452,524
4.82
10,822
424,032
4.65
9,768
67,350
3.95
1,329
58,958
3.84
1,132
68,805
4.73
1,613
66,253
4.35
1,430
156,417
5.52
4,283
155,068
5.08
3,904
6,901
6.13
210
7,010
5.89
45,720
3.37
39,567
3.23
634
797,717
4.81
19,020
750,888
4.59
17,073
2,595
4.66
4,223
2.86
1,159,543
23,394
1,133,166
21,473
12,235
11,486
(9,011
(8,086
32,165
28,790
1,194,932
1,165,356
210,876
0.47
490
183,323
0.22
203
98,965
2.02
991
100,775
1.21
607
100,736
1.03
79,938
0.30
244,612
261,266
0.54
119,567
1.51
122,641
105,473
106,555
1.54
880,229
1.07
4,668
854,498
0.76
3,200
58,542
69,637
1.10
938,771
924,135
134,802
130,835
6,925
4,313
114,434
106,073
2.98
3.04
3.19
3.18
Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 21 percent for three and six months ended June 30, 2019 and 2018.
Non-accrual loans are included in earning assets.
* Includes loans held-for-sale
43
Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated to changes in volume.
Three months ended
Six months ended
June 30, 2019 compared
to June 30, 2018
Due to change in:
Change
Volume
Interest income:
(11
(100
(145
45
(172
(240
(48
113
Total Investment securities (AFS & Equity)
(142
149
(293
267
671
1,054
656
398
197
183
55
128
231
(21
252
86
129
Total Loans
1,142
507
635
1,947
1,000
947
1,145
365
780
1,921
684
1,237
Interest expense:
134
287
256
202
384
396
392
362
100
(18
159
90
158
(9
167
744
1,468
1,490
(29
(61
739
741
1,474
(83
1,557
406
367
447
767
(320
Net Interest Income and Net Interest Margin – Quarterly Comparison
Average earning assets for the second quarter of 2019 were $1,166,354,000, an increase of $33,070,000, or 2.9%, from the second quarter of 2018, with average loans increasing $48,029,000, or 6.3%, and average investment securities decreasing $15,014,000, or 4.0%, over the same period. Growth in the loan portfolio supports interest income and the net interest margin as loans generally earn a higher yield than investment securities. Average loans as a percent of average earning assets were 69.1% for the second quarter of 2019, compared with 66.8% for the second quarter of 2018. On the funding side, average deposits increased $34,925,000, or 3.5%, to $1,021,925,000 for the second quarter of 2019 primarily due to growth in interest bearing demand and money market accounts. Customers continue to reinvest funds into non-time deposits, as the yield in time deposits remains low and customers prefer to keep their funds liquid to capitalize on rising rates. Average borrowed funds for the second quarter of 2019 decreased $9,934,000, to $57,907,000, which consisted of average commercial repurchase agreements of $39,311,000 and average overnight borrowings of
$18,596,000. For the same period in 2018, borrowings consisted of average commercial repurchase agreements of $37,484,000 and average overnight borrowings of $30,357,000.
The net interest margin for the second quarter of 2019 was 3.20% compared to 3.15%, for the same period in 2018. While competition for quality loans in our local market continues to exert pressure on the net interest margin, increases in the prime rate during 2018 have provided increased interest income and competitive pricing pressure on deposits.
The Rate-Volume Analysis tables, as presented on a tax-equivalent basis, highlight the impact of changing rates and volumes on interest income and interest expense. Total interest income on a tax-equivalent basis increased $1,145,000, or 10.6%, to $11,908,000 for the second quarter of 2019; total interest expense increased $739,000, or 39.7%, to $2,601,000. Increased yield on earnings assets and growth in earning assets contributed to the increase in interest income. All categories of interest-bearing deposits experienced higher rates in the second quarter of 2019 compared to second quarter of 2018, due to rate increases for municipal deposits indexed to Fed Funds, and a 10-basis point rate increase to the eSavings and Rewards checking products and a five- to ten-basis point increase in the top tiers of the Money Market product since June 30, 2018.
The yield on earning assets on a tax-equivalent basis increased 29 basis points from 3.81% for the second quarter of 2018, to 4.10% for the second quarter of 2019. The cost of interest-bearing liabilities was 1.11% for the second quarter ended June 30, 2019, compared with 0.81% for the same period in 2018.
Interest income on investment securities (available-for-sale and equity) increased $7,000 when comparing the quarters ended June 30, 2019 and 2018. The average yield on the investment portfolio was 2.41% for the second quarter of 2019 compared with 2.30% for the second quarter of 2018. Proceeds from sales, payments, calls and maturities, net of purchases, were utilized to grow the loan portfolio at higher yields than the investment portfolio with any excess funds reinvested in higher yielding investments.
Income on U.S. Treasury securities increased $12,000, due to volume as proceeds from sales of equities were invested in U.S. Treasuries. Income on U.S. Government agency securities increased $5,000 as the rate increased four-basis points.
Interest income on tax-exempt municipal securities declined due to a $17,737,000 decrease in average balances. This was partially offset by a 34-basis point increase in yield. Proceeds from matured, called and sold municipal securities were invested in slightly higher yielding municipal securities and used to grow the loan portfolio. Typically, QNB purchases municipal bonds with 10-15 year maturities with call dates between 2-5 years.
Interest income on mortgage-backed securities and CMOs increased $62,000 with a ten-basis point increase in average yield and a $1,612,000 increase in average balances. This portfolio generally provides higher yields relative to agency bonds and also provides monthly cash flow which can be used for liquidity purposes or can be reinvested as interest rates increase. Since most of these securities were purchased at a premium, any prepayments result in a shorter amortization period of this premium and therefore a reduction in income.
Interest income on corporate debt securities increased $36,000 due to an increase in rate of 137 basis points and an increase in volume of $1,482,000.
Income on loans increased $1,142,000 to $9,723,000 when comparing the second quarters of 2019 and 2018, with a 6.3% growth in average balances contributing an increase in interest income of $507,000. The yield on loans, at 4.84%, was 30 basis points higher than the second quarter of 2018, contributing to a $635,000 increase in interest income. Despite increases in the prime rate in June, September and December of 2018, competitive pressures compressed the yields on new loans being originated. Mitigating competitive pricing, variable rate loans have repriced higher.
The largest category of the loan portfolio is commercial real estate loans. This category of loans includes commercial purpose loans secured by either commercial properties such as office buildings, factories, warehouses, medical facilities and retail establishments, or residential real estate, usually the residence of the business owner. The category also includes construction and land development loans. Income on commercial real estate loans increased $671,000 when comparing the second quarters of 2019 and 2018, primarily due to the 7.9% increase in average balances. Average balances increased $33,716,000, to $460,836,000 for the quarter ended June 30, 2019 compared with the same quarter in 2018. The yield on commercial real estate loans increased 24 basis points from 4.61% in 2018 to 4.85% in 2019.
Income on commercial and industrial loans increased $231,000 when comparing the second quarters of 2019 and 2018. The average yield on these loans increased 66 basis points to 5.63% resulting in an increase in income of $252,000; this was partially offset by a
decrease in average balances of $1,505,000, or 1.0%, to $154,000,000 for the second quarter of 2019 resulting in a $21,000 decrease in income. Many of the loans in this category are indexed to the prime interest rate, which increased by 50 basis points since June 30, 2018.
Tax-exempt loan income was $411,000 for the second quarter of 2019, an increase of $86,000 from the same period in 2018. Average balances increased $7,743,000, or 19.0%, to $48,429,000 for the second quarter of 2019, resulting in an increase of $62,000 in income. The yield on municipal loans increased 20 basis points, to 3.41% for the second quarter of 2019, compared with the same period in 2018, resulting in an increase of $24,000 in interest income.
QNB desires to become the “local consumer lender of choice” and to effect this QNB refocused its retail lending efforts, adding new product offerings and increasing marketing and promotion. The positive impact of this focus has been year-over-year growth in balances in overall retail lending: residential mortgage, home equity and consumer loans. Average residential mortgage loans secured by first lien 1-4 family residential mortgages increased by $6,338,000, or 10.4%, to $67,168,000 for the second quarter of 2019 compared to the same period in 2018. Over this same timeframe, the average yield on the portfolio increased 16 basis points to 3.98% for the second quarter of 2019. The combined result was an increase in interest income of $89,000. Average home equity loans increased by $1,956,000, or 3.0%, to $68,254,000 and the average yield increased 26 basis points to 4.72% resulting in a combined increase in interest income of $67,000. The yield on the consumer portfolio increased 11 basis points to 6.06% for the second quarter of 2019 offset by a slight decrease in average balances resulting in a combined $2,000 decrease in interest income.
Earning assets are funded by deposits and borrowed funds. Interest expense increased $739,000, when comparing the second quarter of 2019 to the same period in 2018. The growth in average deposits continues to be centered in accounts with greater liquidity, such as non-interest and interest-bearing demand, and money market deposits. Average non-interest-bearing demand accounts increased $5,579,000, or 4.2%, to $139,033,000 for the second quarter of 2019. QNB has been successful in increasing both personal and business checking accounts. Average interest-bearing demand accounts increased $26,776,000, or 14.4%, to $213,308,000 for the second quarter of 2019. Interest expense on interest-bearing demand accounts increased $150,000 to $258,000 for the same period, as the average rate paid increased 25 basis points to 0.48% for the second quarter of 2019. Included in this category is QNB-Rewards checking, a higher-rate checking account product that pays 1.35% on balances up to $25,000 and 0.40% for balances over $25,000. In order to receive the high rate a customer must receive an electronic statement, have one direct deposit or other ACH transaction and have at least 12 check card purchase transactions post and clear per statement cycle. For the second quarter of 2019, the average balance in this product was $60,519,000 and the related interest expense was $101,000 for an average yield of 0.67%. In comparison, the average balance of the QNB-Rewards accounts for the second quarter of 2018 was $56,627,000 with a related interest expense of $85,000 and an average rate paid of 0.60%. This product also generates fee income through the use of the check card.
Interest expense on municipal interest-bearing demand accounts increased $202,000 to $530,000 for the second quarter of 2019. The average interest rate paid on municipal interest-bearing demand accounts increased 70 basis points to 2.03% for the second quarter of 2019 and average balances increased $5,911,000, or 6.0%, to $104,912,000. Many of these accounts are indexed to the Federal funds rate with rate floors between 0.25% and 0.50%; therefore the increases in the Federal funds rate affected the yield of these deposits. Municipal deposits are seasonal in nature and are received during the second and third quarters as tax receipts are collected and are withdrawn over the course of the next year.
Average money market accounts increased $15,987,000, or 20.5%, to $93,890,000 for the second quarter of 2019 compared with the same period in 2018. Interest expense on money market accounts increased $165,000 to $227,000, and the average interest rate paid on money market accounts increased 65 basis points to 0.97% for the second quarter of 2019. Most of the balances in this category are in a product that pays a tiered rate based on account balances.
Interest expense on savings accounts increased $28,000 when comparing the second quarter of 2019 to the second quarter of 2018, and the average rate increased 10 basis points to 0.66% when comparing both periods. When comparing these same periods, average savings accounts decreased $21,920,000, or 8.3%, to $241,445,000 for the second quarter of 2019 primarily due to decreases in the e-Savings product. QNB’s online e-Savings product is the largest category of savings deposits, with average balances for the second quarter of 2019 of $170,291,000 compared to $190,063,000 in the same period of 2018. The average yield paid on these accounts was 0.86% for the second quarter of 2019 and 0.71% for the same period in 2018. Traditional statement savings accounts, passbook savings and club accounts are also included in the savings category and average balances in these types of savings accounts decreased $2,148,000 when comparing the second quarter of 2019 average to the same period in 2018.
Interest expense on time deposits totaled $993,000 for the second quarter of 2019 compared to $794,000 in 2018. Average total time deposits increased $2,592,000 to $229,337,000 for the second quarter of 2019. As with fixed-rate loans and investment securities, these deposits reprice over time and, therefore, have less of an immediate impact on costs in either a rising or falling rate environment, however, the maturity and repricing characteristics of time deposits tend to be shorter. The average rate paid on total time deposits increased 34 basis points from 1.40% to 1.74% when comparing the second quarter of 2018 to the same period in 2019.
Approximately $130,351,000, or 56%, of time deposits at June 30, 2019 will mature over the next 12 months. The average rate paid on these time deposits is approximately 1.69%. The yield on the time deposit portfolio may change slightly in the next quarter as short-term time deposits reprice. However, given the short-term nature of these deposits, interest expense may increase if short-term time deposit rates were to increase suddenly or if customers select higher paying time deposits.
Short-term borrowings are primarily comprised of sweep accounts structured as repurchase agreements with our commercial customers and overnight FHLB borrowings. Interest expense on short-term borrowings decreased $5,000 for the second quarter of 2019 to $196,000 when compared to the same period in 2018. When comparing these same periods, average balances decreased from $67,841,000 to $57,907,000 due to a decrease in average FHLB borrowings of $11,761,000, with a 63-basis point increase in rate, and an increase in repurchase agreement average balances of $1,827,000, with a rate increase of 24 basis points.
Net Interest Income and Net Interest Margin – Six-Month Comparison
For the six-month period ending June 30, 2019 average earning assets increased $26,377,000, or 2.3%, to $1,159,543,000, with average loans increasing 6.2% and average investment securities decreasing 5.0%. Average total deposits increased $29,698,000, or 3.0%, to $1,015,031,000 for the six-month period ended June 30, 2019 compared to the same period in 2018. The net interest margin on a tax-equivalent basis was 3.19% for the six-month period ended June 30, 2019, a one-basis point increase from the same period in 2018.
Total interest income on a tax-equivalent basis increased $1,921,000, or 8.9%, from $21,473,000 to $23,394,000, when comparing the six-month periods ended June 30, 2018 and June 30, 2019 due to the additional interest income generated from the growth in earning assets combined with the impact of improved yields on those assets. Interest income increased $684,000 as a result of volume increases, and $1,237,000 as a result of better yields. The analysis of the six-month comparison periods is similar to what was described in the quarterly analysis.
The yield on earning assets increased from 3.82% to 4.07% for the six-month periods with the yield on loans up 22 basis points to 4.81%. QNB continues to experience pressure on yields due to historically low levels of interest rates over the past several years and competitive pressures on loan pricing. The yield on investments increased 10 basis points from 2.30% to 2.40% when comparing the six-month periods.
Total interest expense increased $1,474,000 for the six-month period ended June 30, 2019 compared with the same period in 2018, attributable to the shift of deposits into higher-earning interest-bearing DDA, as well as rate increases in the eSavings, Rewards checking, and municipal deposits, which are correlated to changes in the Fed Funds target rate. The average rate paid on interest bearing deposits increased 31 basis points to 1.07% for the six-month period ended June 30, 2019 versus the first half of 2018. QNB funded growth in loans with net proceeds from investments and growth in deposits; QNB was therefore able to reduce its short-term cash needs resulting in decreased Federal Home Loan Bank borrowings in the first half of 2019 compared with the same period in 2018. The average balance of total short-term borrowing decreased $11,095,000 whereas the average borrowing rate increased 23 basis points resulting in a net increase in interest expense of $6,000. The yield on interest-bearing liabilities rose 31 basis points to 1.09% for the first half of 2019.
PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES
The provision for loan losses represents management's determination of the amount necessary to be charged to operations to bring the allowance for loan losses to a level that represents management’s best estimate of the known and inherent losses in the existing loan portfolio. Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. The determination of an appropriate level for the allowance for loan losses is based upon an analysis of the risks inherent in QNB’s loan portfolio. Management, in determining the allowance for loan losses, makes significant estimates and assumptions. Since the allowance for loan losses is dependent, to a great extent, on conditions that may be beyond QNB’s control, it is at least reasonably possible that management’s
estimates of the allowance for loan losses and actual results could differ. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for losses on loans. Such agencies may require QNB to recognize changes to the allowance based on their judgments about information available to them at the time of their examination. Actual loan losses, net of recoveries, serve to reduce the allowance.
Management closely monitors the quality of its loan portfolio and performs a quarterly analysis of the appropriateness of the allowance for loan losses. This analysis considers several relevant factors including: specific impairment reserves, historical loan loss experience, general economic conditions, levels of and trends in delinquent and non-performing loans, levels of classified loans, trends in the growth rate of loans and concentrations of credit.
Based on this analysis, QNB recorded $150,000 and $375,000 in provision for loan losses in the three and six months ended June 30, 2019, respectively, compared with $187,000 and $375,000 for the same periods in 2018. QNB's allowance for loan losses of $9,164,000 represents 1.12% of loans receivable at June 30, 2019 compared with an allowance for loan losses of $8,834,000, or 1.12% of loans receivable, at December 31, 2018, and $8,192,000, or 1.05% of loans receivable at June 30, 2018. Management believes the allowance for loan losses at June 30, 2019 is adequate as of that date based on its analysis of known and inherent losses in the portfolio.
Net charge-offs were $1,000 and $45,000 compared for the three and six months ended June 30, 2019, respectively, to net charge-offs of $32,000 and $24,000 for the same periods in 2018. Charge-offs of approximately $155,000 during the six months ended June 30, 2019 consisted of commercial loans secured by residential real estate of $36,000, overdraft charge-offs of $40,000, a home equity line of $16,000, student loans of $57,000 and other consumer loans of $6,000. These were partially offset by $110,000 in recoveries comprising $94,000 in repayments from borrowers of previously charged-off credits, and $16,000 related to overdraft recoveries. Annualized net charge-offs as a percentage of average loans receivable were 0% and 0.01% for the three and six months ended June 30, 2019, respectively, compared with annualized charge-offs as a percentage of average loans receivable were 0.02% and 0.01% for the same period in 2018, respectively.
Non-performing assets were $9,677,000 at June 30, 2019 compared to $9,638,000 as of December 31, 2018 and $7,987,000 as of June 30, 2018. Total non-performing loans, which represent loans on non-accrual status, loans past due 90 days or more and still accruing interest and restructured loans, were 1.18% of loans receivable at June 30, 2019 compared with 1.23% of loans receivable at December 31, 2018 and 1.02% at June 30, 2018. In cases where there is a collateral shortfall on non-accrual loans, specific impairment reserves have been established based on updated collateral values even if the borrower continues to pay in accordance with the terms of the agreement. At June 30, 2019, $2,172,000, or approximately 28% of the loans classified as non-accrual are current or past due less than 30 days. Loans classified as substandard or doubtful totaled $12,572,000, a decrease of $5,767,000, or 31.4%, from the $18,339,000 reported at December 31, 2018 and a decrease of $5,627,000, or 30.9, from the $18,199,000 reported at June 30, 2018.
QNB had no loans past due 90 days or more and still accruing interest at June 30, 2019 or December 31, 2018, and $23,000 at June 30, 2018. Total loans 30 days or more past due, which includes non-accrual loans by actual number of days delinquent, represented 0.82% of loans receivable at June 30, 2019 compared with 0.76% at December 31, 2018 and 0.59% at June 30, 2018.
Troubled debt restructured loans, not classified as non-accrual loans or loans past due 90 days or more and accruing, were $2,009,000 at June 30, 2019, compared with $2,160,000 at December 31, 2018, and $1,233,000 at June 30, 2018. There were no newly identified troubled debt restructuring in the six months ended June 30, 2019. QNB had no other real estate owned or repossessed assets as of June 30, 2019, December 31, 2018, or June 30, 2018.
A loan is considered impaired, based on current information and events, if it is probable that QNB will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case-by-case basis, taking into consideration all the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent.
The following table shows detailed information and ratios pertaining to the Company’s loan and asset quality:
Non-accrual loans
6,731
Loans past due 90 days or more and still accruing interest
Troubled debt restructured loans (not already included above)
2,009
2,160
1,233
Total non-performing loans
9,677
9,638
7,987
Total non-performing assets
Total loans (excluding loans held-for-sale):
Average total loans (YTD)
797,681
766,692
750,828
779,886
Allowance for loan losses to:
Non-performing loans
94.70
91.66
102.57
Total loans (excluding held-for-sale)
1.12
1.05
Average total loans
1.15
Non-performing loans / total loans (excluding held-for-sale)
1.18
1.23
1.02
Non-performing assets / total assets
0.80
0.68
An analysis of net loan recoveries for the three and six months ended June 30, 2019 compared to 2018 is as follows:
Net charge-offs/(recoveries)
Net annualized charge-offs/(recoveries) to:
0.02
0.01
Average total loans excluding held-for-sale
0.04
1.57
0.99
0.59
At June 30, 2019 and December 31, 2018, the recorded investment in loans for which impairment has been identified totaled $9,937,000 and $16,482,000 of which $5,310,000 and $11,763,000, respectively, required no specific allowance for loan loss. The recorded investment in impaired loans requiring an allowance for loan losses was $4,627,000 and $4,719,000 at June 30, 2019 and December 31, 2018, respectively, and the related allowance for loan losses associated with these loans was $2,166,000 and $1,664,000, respectively. Most of the loans that have been identified as impaired are collateral-dependent. See Note 8 to the Notes to Consolidated Financial Statements for additional detail of impaired loans.
NON-INTEREST INCOME
Non-Interest Income Comparison
Change from
prior year
Percent
Net gain on sales of investment securities
536
N/M
457
(446
776
3.4
-1.7
6.6
7.9
26.7
66
31.7
1.4
0.7
20.7
11.5
(24.3
11.4
15.3
20.2
200
13.8
1,442
57.2
Quarter to Quarter Comparison
Total non-interest income for the second quarter of 2019 was $1,654,000, an increase of $200,000, compared to $1,454,000 for the second quarter of 2018. Excluding net gains and net unrealized gains (losses) on investment securities and the gain on sale of loans for both periods, total non-interest income was $1,447,000 and $1,328,000 for the quarters ended June 30, 2019 and 2018, respectively.
Net gains on sales investment securities increased $536,000 from $48,000 in second quarter of 2018 to $584,000 in second quarter of 2019. Gain on investments are primarily derived from sale of equity securities. Net gains on sales of equity securities were $584,000 for the second quarter of 2019 compared to $44,000 for the same period in 2018. During the second quarter of 2019, unrealized losses of $405,000 were recorded compared to unrealized gains of $41,000 in the same period of 2018.
QNB originates residential mortgage loans for sale in the secondary market. Net gain on sale of loans decreased $9,000 when comparing the two periods. The net gain on residential mortgage sales is directly related to the volume of mortgages sold and the timing of the sales relative to the interest rate environment. Residential mortgage loans to be sold are identified at origination. Proceeds from the sale of residential mortgages were $1,189,000 and $1,344,000 for the second quarters of 2019 and 2018, respectively.
Fees for services to customers increased $14,000, or 3.4%, to $422,000 for the second quarter of 2019, due primarily to an increase in net overdraft income. ATM and debit card income increased $32,000, or 6.6%, to $519,000 for the second quarter of 2019, compared to the same period in 2018, due to increases in card-based transactions and expansion of checking account households.
QNB provides securities and advisory services under the name QNB Financial Services. Retail brokerage and advisory fees increased $28,000, or 26.7%, to $133,000 for the second quarter of 2019 compared to the same period in 2018. During 2018, there was a transition to move toward advanced advisory fees based on assets under management in lieu of fees per transaction. Advisory fees increased $32,000, or 41.6% comparing second quarters of 2019 and 2018, partially offset by a decline in transaction-based fees of $4,000.
50
Other non-interest income increased $27,000, or 15.3%. Other non-interest income includes a $58,000 deferred gain on the sale of a bank-financed other real estate owned property and $18,000 broker-dealer conversion cost reimbursement in the second quarter of 2019. Other non-interest income for the second quarter of 2018 included a sales tax refund of $53,000.
Six-Month Comparison
Total non-interest income for the six-month periods ended June 30, 2019 and 2018 was $3,963,000 and $2,521,000, respectively, an increase of $1,442,000, or 57.2%. Excluding net gains and unrealized gain and losses on investment securities and loans for both periods total non-interest income was $2,753,000 and $2,549,000, respectively, an increase of $204,000.
Net investment securities gains increased $457,000 to $590,000 for the six months ended June 30, 2019 compared to $133,000 for the comparable six months in 2018. Market conditions in the equities market for the six months ended June 30, 2019 versus the same period in 2018 resulted in greater opportunities for profitable sales. Under ASU 2016-01, QNB recorded unrealized gains of $571,000 compared to unrealized losses of $205,000 on equity securities for the six months ended June 30, 2019 and 2018, respectively.
Net gains on sales of loans increased to $49,000 from $44,000, when comparing the six months ended June 30, 2019 to the same period in 2018. Proceeds from the sale of residential mortgages were $1,864,000 and $1,949,000 for the six-month periods ended June 30, 2019 and 2018, respectively.
ATM and debit card and merchant income increased $72,000 and $18,000, respectively, for the first six months of 2019 compared to 2018, for reasons detailed in the quarterly comparison.
Retail brokerage and advisory increased $66,000, or 31.7%, to $274,000 for the six months ended June 30, 2019 compared to the same period in 2018; advisory fees increased $86,000, or 58.9% partially offset by a decline in transaction-based fees of $20,000.
Other non-interest income increased $61,000, or 20.2%. Other non-interest income included a $58,000 deferred gain on the sale of a bank-financed other real estate owned property and $47,000 broker-dealer conversion cost reimbursement in the second quarter of 2019. Other non-interest income for the second quarter of 2018 included a sales tax refund of $53,000.
NON-INTEREST EXPENSE
Non-Interest Expense Comparison
163
4.5
8.6
12.9
10.0
5.0
9.3
19.0
(5.8
Third-party services
(60
(11.9
(30
(3.3
(12.1
(0.8
26.2
12.8
(7.5
(17.4
2.6
7.2
260
4.0
806
6.3
Total non-interest expense was $6,793,000 for the second quarter of 2019, an increase of $260,000, or 4.0%, compared to the second quarter of 2018.
Salaries and benefits comprise the largest component of non-interest expense. QNB monitors, through the use of various surveys, the competitive salary and benefit information in its markets and makes adjustments when appropriate. Salaries and benefits expense increased $163,000, or 4.5%, to $3,790,000 when comparing the two quarters. Salary expense and related payroll taxes increased
$288,000, or 9.6%, to $3,277,000 during the second quarter 2019 compared to the same period in 2018. Medical premiums, net of employee contributions decreased $161,000 to $223,000 when comparing the two quarters due to a reduction in medical claims. Retirement plan expense and post-retirement life insurance benefit expense increased $27,000, and $14,000, respectively during the same period.
Net occupancy and furniture and equipment expenses increased $58,000, or 12.9%, and $28,000, or 5.0%, respectively. This is due primarily to increased rent, building repairs and maintenance, depreciation of furniture and equipment and software maintenance expense of $19,000, $42,000, $36,000, and $25,000, respectively, offset in part by decreased software amortization, and equipment maintenance expense of $7,000 and $23,000, respectively, when comparing the two periods. Marketing expense increased $42,000, or 19.0%, to $263,000 for the quarter ended June 30, 2019 due to the timing of sponsorships and donations.
Third party services are comprised of professional services, including legal, accounting, auditing and consulting services, as well as fees paid to outside vendors for support services of day-to-day operations. These support services include correspondent banking services, IT services, statement printing and mailing, investment security safekeeping and supply management services. Third party services expense decreased $60,000 when comparing the two periods, due primarily to reduced consulting fees. Telephone and postage and supplies expenses decreased $21,000, or 12.1%, due to usage. State taxes increased $43,000 due to timing of tax credits received in 2019 versus 2019. FDIC insurance premiums decreased $11,000, or 7.5%. The FDIC assessment had included an assessment to pay the interest on FICO bonds since the 1990’s. FICO bonds were issued in the late 1980’s to recapitalize the former Federal Savings & Loan Insurance Corporation. The last of these bonds will mature in September 2019 and the last FICO assessment was collected on the March 29, 2019 assessment invoice.
Total non-interest expense was $13,517,000 for the six-month period ended June 30, 2019, an increase of $806,000, or 6.3%, compared to the six months ended June 30, 2018.
Salaries and benefits expense increased $599,000 to $7,571,000 for the six months ended June 30, 2019 compared to the same period in 2018, for the same reasons described in the quarter comparison. Salary and related payroll tax expense increased $563,000, or 9.6%, during the period, to $6,403,000 while medical premiums, net of employee contributions, decreased $26,000, to $607,000.
Net occupancy and furniture and equipment expense increased $190,000, or 9.6%, to $2,159,000, and third-party services decreased $30,000, or 3.3%, to $886,000 for the six months ended June 30, 2019, for the same reasons described in the quarter comparison.
Telephone, postage and supplies expenses decreased slightly in the first six months of 2019 compared to 2018, FDIC insurance premiums decreased $56,000 and marketing decreased $31,000, due to the reasons described in the quarter comparison.
INCOME TAXES
QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of June 30, 2019, QNB’s net deferred tax asset was $1,528,000. The primary components of deferred taxes are deferred tax assets of $1,924,000 relating to the allowance for loan losses and $105,000 related to unrealized losses on available for sale securities. As of December 31, 2018, QNB’s net deferred tax asset was $3,724,000. The decrease in the balance of net deferred tax assets when comparing June 30, 2019 to December 31, 2018 is due to lower unrealized losses on available for sale securities.
The realizability of deferred tax assets is dependent upon a variety of factors, including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. Based upon these and other factors, management believes it is more likely than not that QNB will realize the benefits of these remaining deferred tax assets.
Applicable income tax expense was $679,000 for the quarter and $1,496,000 for the six months ended June 30, 2019, compared to $572,000 and $1,129,000 for the same periods in 2018. The effective tax rate for second quarter and year-to-date 2019 was 17.8% and 18.7%, respectively, compared with 16.7% and 16.3% for the same periods in 2018. The increase in effective tax rate in 2019 is due to the state income tax provision at the parent company related to the increase in realized gains on the equities portfolio and the reduction in tax-exempt net interest income.
FINANCIAL CONDITION ANALYSIS
Financial service organizations are challenged to demonstrate they can generate sustainable and consistent earnings growth in a dynamic operating environment. Rate competition for quality loans is anticipated to continue through 2019. It is also anticipated that the rate competition for attracting and retaining deposits may continue in 2019, which could result in a lower net interest margin and a decline in net interest income.
QNB’s primary business is accepting deposits and making loans to meet the credit needs of the communities it serves. Loans are the most significant component of earning assets and growth in loans to small businesses and residents of these communities has been a primary focus of QNB. Inherent within the lending function is the evaluation and acceptance of credit risk and interest rate risk. QNB manages credit risk associated with its lending activities through portfolio diversification, underwriting policies and procedures and loan monitoring practices. QNB is committed to make credit available to its customers.
Total assets at June 30, 2019 were $1,212,005,000 compared with $1,175,452,000 at December 31, 2018. Cash and cash equivalents increased $610,000 from $13,458,000 at December 31, 2018 to $14,068,000 at June 30, 2019, due primarily to growth in deposit balances and paydowns of amortizing mortgage-backed securities during the six months ended June 30, 2019.
The composition of the investment portfolio is essentially unchanged since December 31, 2018; however, QNB traded out lower-yielding municipal bonds for higher yielding mortgage-backed bonds. The fixed-income securities portfolio represents a significant portion of QNB’s earning assets and is also a primary tool in liquidity and asset/liability management. QNB actively manages its fixed income portfolio to take advantage of changes in the shape of the yield curve and changes in spread relationships in different sectors and for liquidity purposes. Management continually reviews strategies that will result in an increase in the yield or improvement in the structure of the investment portfolio, including monitoring credit and concentration risk in the portfolio. QNB owns one CDO in the form of a pooled trust preferred security, with a fair value of $108,000. PreTSL IV represents the senior-most obligation of the trust.
Loans receivable grew $32,145,000, or 4.1%, with commercial loans increasing $35,372,000, or 5.6%, to $668,867,000 at June 30, 2019, compared with $633,495,000 at year-end 2018. Retail loan balances at $148,506,000 declined $3,207,000 comparing June 30, 2019 to December 31, 2018.
Deposits grew $15,063,000, or 1.5%, from December 31, 2018 to June 30, 2019. Non-interest-bearing demand deposits grew $20,976,000, or 16.3%, to $149,591,000 at June 30, 2019 compared with $128,615,000 at year-end 2018, primarily due to growth in business deposits and is partially offset by decreases in commercial sweep accounts in short-term borrowings. Interest-bearing demand balances, excluding municipal deposits, grew $5,837,000, or 2.8%, to $216,788,000, with the commercial checking product providing the majority of the growth. The $29,764,000 decline in savings was partially offset by growth in time deposits as balances were moved to higher-yielding accounts. Total time deposits increased $10,523,000 from December 31, 2018 to June 30, 2019. Municipal deposit balances increased $7,228,000, or 7.7%, to $100,929,000. Municipal deposits can be volatile depending on the timing of deposits and withdrawals, and the cash flow needs of the school districts or municipalities. It is anticipated that total deposits will decrease as tax money received from the local school districts during second and third quarters flows out for the subsequent twelve months as the schools use the funds for operations. These deposits provide incremental income as they are invested in short-term investment securities but will further reduce the net interest margin as the spread earned is significantly less than the current net interest margin.
Short-term borrowings increased 16.1%, from $50,872,000 at December 31, 2018 to $59,048,000 at June 30, 2019. Commercial sweep accounts decreased $7,683,000, as these funds may be volatile based on businesses’ receipt and disbursement of funds and is offset by increases in business non-interest-bearing demand accounts. Overnight borrowings from FHLB increased $15,859,000 to $19,724,000 supporting loan growth.
LIQUIDITY
Liquidity represents an institution’s ability to generate cash or otherwise obtain funds at reasonable rates to satisfy demand for loans and deposit withdrawals. QNB attempts to manage its mix of cash and interest-bearing balances, Federal funds sold and investment securities to match the volatility, seasonality, interest sensitivity and growth trends of its loans and deposits. The Company manages its liquidity risk by measuring and monitoring its liquidity sources and estimated funding needs. Liquidity is provided from asset sources through repayments and maturities of loans and investment securities. The portfolio of investment securities classified as available for sale and QNB's policy of selling certain residential mortgage originations in the secondary market also provide sources of liquidity. Core deposits and cash management repurchase agreements have historically been the most significant funding source for
QNB. These deposits and repurchase agreements are generated from a base of consumers, businesses and public funds primarily located in the Company’s market area.
Additional sources of liquidity are provided by the Bank’s membership in the FHLB. At June 30, 2019, the Bank had a maximum borrowing capacity with the FHLB of approximately $308,720,000, net of the $19,724,000 in overnight borrowings and a $350,000 letter of credit at June 30, 2019. The maximum borrowing depends upon qualifying collateral assets and the Bank’s asset quality and capital adequacy. In addition, the Bank maintains unsecured Federal funds lines with three correspondent banks totaling $51,000,000. At June 30, there were no outstanding borrowings under these lines. During the six months ended June 30, 2019, the Bank borrowed from the FHLB to fund short-term liquidity needs. Future availability under these lines is subject to the policies of the granting banks and may be withdrawn.
Liquid sources of funds, including cash, available-for-sale and equity investment securities, and loans held-for-sale have increased $1,594,000 since December 31, 2018, totaling $368,694,000 at June 30, 2019. Growth in deposits since year-end 2018 has been used to fund loans. Management expects these liquid sources will be adequate to meet normal fluctuations in loan demand or deposit withdrawals. The investment portfolio is expected to continue to provide sufficient liquidity, even in a rising rate environment, as municipal bonds are called or mature and cash flow on mortgage-backed and CMO securities continues to be steady.
Approximately $202,175,000 and $194,573,000 of available-for-sale debt securities at June 30, 2019 and December 31, 2018, respectively, were pledged as collateral for repurchase agreements and deposits of public funds. The level of pledged securities corresponds with the municipal deposit and repurchase agreement balances.
QNB is a member of the Certificate of Deposit Account Registry Services (CDARS) program offered by the Promontory Interfinancial Network, LLC. CDARS is a funding and liquidity management tool used by banks to access funds and manage their balance sheet. It enables financial institutions to provide customers with full FDIC insurance on time deposits over $250,000 that are placed in the program. QNB also has available Insured Cash Sweep (ICS), another program through Promontory Interfinancial Network, LLC, which is a product similar to CDARS, but one that provides liquidity like a money market or savings account.
CAPITAL ADEQUACY
A strong capital position is fundamental to support continued growth and profitability and to serve the needs of depositors. QNB's shareholders' equity at June 30, 2019 was $115,878,000, or 9.56% of total assets, compared with shareholders' equity of $104,348,000, or 8.88% of total assets, at December 31, 2018. Shareholders’ equity at June 30, 2019 and December 31, 2018 included a negative adjustment of $396,000 and $7,132,000, respectively, related to unrealized holding losses, net of taxes, on investment securities available-for-sale. Without these adjustments, shareholders' equity to total assets would have been 9.59% and 9.43% at June 30, 2019 and December 31, 2018, respectively.
Average shareholders' equity and average total assets were $114,434,000 and $1,194,932,000 for the six months ended June 30, 2019, an increase of 7.9% and 2.5%, respectively, from the averages for the six months ended June 30, 2018. The ratio of average total equity to average total assets was 9.58% for the six months ended June 30, 2019 compared to 9.10% for the same period in 2018.
Retained earnings at June 30, 2019 were impacted by six months of net income totaling $6,522,000 partially offset by dividends declared and paid of $2,305,000 for the same period. QNB offers a Dividend Reinvestment and Stock Purchase Plan (the “Plan”) to provide participants a convenient and economical method for investing cash dividends paid on the Company’s common stock in additional shares at a discount. The Plan also allows participants to make additional cash purchases of stock at a discount. Stock purchases under the Plan contributed $433,000 to capital during the six months ended June 30, 2019.
The Board of Directors has authorized the repurchase of up to 100,000 shares of its common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. As of June 30, 2019, 57,883 shares were repurchased under this authorization at an average price of $16.97 and a total cost of $982,000. There have been no additional shares repurchased under the plan since the first quarter of 2009.
QNB and the Bank are subject to various regulatory capital requirements as issued by Federal regulatory authorities. Regulatory capital is defined in terms of Tier 1 capital and Tier 2 capital. Risk-based capital ratios are expressed as a percentage of risk-weighted assets. Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet arrangements, such as letters of credit and loan commitments, based on associated risk. The final rules implementing the Basel Committee on Banking
Supervision’s capital guidelines for U.S. banks (Basel III) became effective for QNB on January 1, 2015, with full compliance with all of the final rule’s requirements phased in over a multi-year schedule, and were fully phased-in January 1, 2019.
Under the final rules, minimum requirements increased for both the quantity and quality of capital. The rules included a new common equity Tier 1 capital to risk-weighted assets minimum ratio of 4.5%, raised the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0%, required a minimum ratio of Total Capital to risk-weighted assets of 8.0%, and required a minimum Tier 1 leverage ratio of 4.0%. A new capital conservation buffer, comprised of common equity Tier 1 capital, is also established above the regulatory minimum capital requirements. This capital conservation buffer was phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, and increased each subsequent year by an additional 0.625% until reaching its final level of 2.5% on January 1, 2019. Strict eligibility criteria for regulatory capital instruments were also implemented. The final rules also revised the definition and calculation of Tier 1 capital, Total Capital, and risk-weighted assets. QNB and the Bank have sufficient capital to meet minimum regulatory capital requirements plus the fully phased-in capital conservation buffer.
The following table sets forth consolidated information for QNB:
Capital Analysis
Regulatory Capital
Net unrealized securities losses, net of tax
7,132
Deferred tax assets on net operating loss
Disallowed intangible assets
(8
Common equity tier I capital
Tier I capital
Allowable portion: Allowance for loan losses and reserve
for unfunded commitments
9,237
8,907
Total regulatory capital
Risk-weighted assets
935,331
911,374
Quarterly average assets for leverage capital purposes
1,202,385
1,186,448
Capital Ratios
Common equity tier I capital / risk-weighted assets
Tier I capital / risk-weighted assets
Total regulatory capital / risk-weighted assets
13.21
Tier I capital / average assets (leverage ratio)
At June 30, 2019, common equity Tier I, Tier I capital, and total regulatory capital ratios increased from December 31, 2018, due to increased regulatory capital and improved credit quality. The Company remains well-capitalized by all applicable regulatory requirements as of June 30, 2019.
MARKET RISK MANAGEMENT
Market risk reflects the risk of economic loss resulting from changes in interest rates and market prices. QNB’s primary market risk exposure is interest rate risk and liquidity risk. QNB’s liquidity position was discussed in a prior section.
QNB’s largest source of revenue is net interest income, which is subject to changes in market interest rates. Interest rate risk management seeks to minimize the effect of interest rate changes on net interest margins and interest rate spreads and to provide growth in net interest income through periods of changing interest rates. QNB’s Asset/Liability and Investment Management Committee (ALCO) is responsible for managing interest rate risk and for evaluating the impact of changing interest rate conditions on net interest income.
QNB uses computer simulation analysis to measure the sensitivity of projected earnings to changes in interest rates. Simulation considers current balance sheet volumes and the scheduled repricing dates, instrument level optionality, and maturities of assets and liabilities. It incorporates assumptions for growth, changes in the mix of assets and liabilities, prepayments, and average rates earned and paid. Based on this information, management uses the model to project net interest income under multiple interest rate scenarios.
A balance sheet is considered liability sensitive when its liabilities (deposits and borrowings) reprice faster or than its earning assets (loans and securities). A liability sensitive balance sheet will produce relatively less net interest income when interest rates rise and more net interest income when they decline. Based on our simulation analysis, management believes QNB’s interest sensitivity position at June 30, 2019 is liability sensitive. Management expects that market interest decline rates will in the next 12 months, based on the economic environment and policy of the Board of Governors of the Federal Reserve System.
The following table shows the estimated impact of changes in interest rates on net interest income as of June 30, 2019 and 2018 assuming instantaneous rate shocks, and consistent levels of assets and liabilities. Net interest income for the subsequent twelve months is projected to decrease when interest rates are higher than current rates.
Estimated Change in Net Interest Income
Changes in Interest rates
(in basis points)
+300
-3.56
-10.08
+200
-1.98
-6.60
+100
-0.58
-3.15
-100
-3.30
-0.02
-200
-10.14
-7.98
Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results. Assets and liabilities may react differently than projected to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates. Interest rate shifts may not be parallel.
Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect QNB’s interest rate sensitivity position. Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt.
QNB is not subject to foreign currency exchange or commodity price risk. At June 30, 2019, QNB did not have any hedging transactions in place such as interest rate swaps, caps or floors.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The information required in response to this item is set forth in Item 2, above.
ITEM 4. CONTROLS AND PROCEDURES
We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the consolidated financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report. No changes were made to our internal control over financial reporting during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
No material proceedings.
Item 1A. Risk Factors
There were no material changes to the Risk Factors described in Item 1A in QNB’s Annual Report on Form 10-K for the period ended December 31, 2018.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
QNB did not repurchase any shares of its common stock during the quarter ended June 30, 2019. The following provides certain information relating to QNB's stock repurchase plan.
Period
Total Number of
Shares Purchased
Average Price
Paid per Share
Purchased as
Part of Publicly
Announced
Plan
Maximum
Shares that
may yet be
Purchased
Under the Plan
April 1, 2019 through April 30, 2019
42,117
May 1, 2019 through May 31, 2019
June 1, 2019 through June 30, 2019
Transactions are reported as of settlement dates.
QNB’s current stock repurchase plan was approved by its Board of Directors and announced on January 24, 2008 and subsequently increased on February 9, 2009.
The total number of shares approved for repurchase under QNB’s current stock repurchase plan is 100,000.
QNB’s current stock repurchase plan has no expiration date.
QNB has no stock repurchase plan that it has determined to terminate or under which it does not intend to make further purchases.
Item 3. Default Upon Senior Securities
None.
Item 4. Mine Safety Disclosures
Item 5. Other Information
Item 6. Exhibits
Exhibit 3.1
Articles of Incorporation of Registrant, as amended. (Incorporated by reference to Exhibit 3(i) of Registrant’s Annual Report on Form 10-K, SEC File No. 0-17706, filed with the Commission on March 13, 2015).
Exhibit 3.2
Bylaws of Registrant, as amended. (Incorporated by reference to Exhibit 3(ii) of Registrant’s Annual Report on Form 10-K, SEC File No. 0-17706, filed with the Commission on March 13, 2015).
Exhibit 31.1
Section 302 Certification of Chief Executive Officer
Exhibit 31.2
Section 302 Certification of Chief Financial Officer
Exhibit 32.1
Section 906 Certification of Chief Executive Officer
Exhibit 32.2
Section 906 Certification of Chief Financial Officer
The following Exhibits are being furnished* as part of this report:
No.
Description
101.INS
XBRL Instance Document.*
101.SCH
XBRL Taxonomy Extension Schema Document.*
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document.*
101.LAB
XBRL Taxonomy Extension Label Linkbase Document.*
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document.*
101.DEF
XBRL Taxonomy Extension Definitions Linkbase Document.*
*
These interactive data files are being furnished as part of this Quarterly Report, and, in accordance with Rule 402 of Regulation S-T, shall not be deemed filed for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under those sections.
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.
Date: August 7, 2019
By:
/s/ David W. Freeman
David W. Freeman
Chief Executive Officer
/s/ Janice McCracken Erkes
Janice McCracken Erkes
Chief Financial Officer
/s/ Mary E. Liddle
Mary E. Liddle
Chief Accounting Officer, QNB Bank