ARROW FINANCIAL CORP (AROW) FY 2022 MD&A

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Selected Quarterly Information

Dollars in thousands, except per share amounts

Share and per share amounts have been restated for the September 2022 3% stock dividend

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Selected Twelve-Month Information

Dollars in thousands, except per share amounts

Share and per share amounts have been restated for the September 2022 3% stock dividend

*See "Use of Non-GAAP Financial Measures" on page 4.

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Arrow Financial Corporation

Reconciliation of Non-GAAP Financial Information

(Dollars In Thousands, Except Per Share Amounts)

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CRITICAL ACCOUNTING ESTIMATES

The significant accounting policies, as described in Note 2 - Summary of Significant Accounting Policies to the Consolidated Financial Statements are essential in understanding the Management Discussion and Analysis. Many of the significant accounting policies require complex judgments to estimate the values of assets and liabilities. Arrow has procedures and processes in place to facilitate making these judgments. The more judgmental estimates are summarized in the following discussion. In many cases, there are numerous alternative judgments that could be used in the process of determining the inputs to the models. Where alternatives exist, Arrow has used the factors that are believed to represent the most reasonable value in developing the inputs. Actual performance that differs from estimates of the key variables could impact the results of operations.

Allowance for credit losses: The allowance for credit losses consists of the allowance for credit losses and the allowance for losses on unfunded commitments. Arrow adopted on January 1, 2021, Accounting Standards Updates (‘‘ASU’’) 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (‘‘CECL’’) and its related amendments. The CECL approach requires an estimate of the credit losses expected over the life of an exposure (or pool of exposures). The estimate of expected credit losses under the CECL approach is based on relevant information about past events, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amounts. Historical loss experience is generally the starting point for estimating expected credit losses. Arrow then considers whether the historical loss experience should be adjusted for asset-specific risk characteristics or current conditions at the reporting date that did not exist over the period from which historical experience was used. Finally, Arrow considers forecasts about future economic conditions that are reasonable and supportable. The allowance for losses on unfunded commitments represents the expected credit losses on off-balance sheet commitments such as unfunded commitments to extend credit and standby letters of credit. However, a liability is not recognized for commitments unconditionally cancellable by Arrow. The allowance for losses on unfunded commitments is determined by estimating future draws and applying the expected loss rates on those draws. Arrow considers the accounting policy relating to the allowance for credit losses to be a critical accounting estimate given the uncertainty in evaluating the level of the allowance required to cover Arrow's estimate of all expected credit losses over the expected contractual life of our loan portfolio. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the then-existing loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for credit losses in those future periods. While management’s current evaluation of the allowance for credit losses indicates that the allowance is appropriate at this time, the allowance may need to be increased in the future due to changes in conditions or assumptions. The impact of utilizing the CECL approach to calculate the reserve for credit losses will be significantly influenced by the composition, characteristics and quality of our loan portfolio, as well as the prevailing economic conditions and forecasts utilized. Material changes to these and other relevant factors may result in greater volatility to the reserve for credit losses, and therefore, greater volatility to our reported earnings. Arrow's policies on the allowance for credit losses, pension accounting and provision for income taxes are disclosed in Note 2 to the consolidated financial statements of this Form 10-K.

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A. OVERVIEW

The following discussion and analysis focuses on and reviews Arrow's results of operations for each of the years in the three-year period ended December 31, 2022 and the financial condition as of December 31, 2022 and 2021.  The discussion below should be read in conjunction with the selected quarterly and annual information set forth above and the Consolidated Financial Statements and other financial data presented elsewhere in this Report.  When necessary, prior-year financial information has been reclassified to conform to the current-year presentation.

Summary of 2022 Financial Results: For the year ended December 31, 2022, net income was $48.8 million, down 2.1% from $49.9 million for 2021. The decrease from the prior year was primarily the result of an increase in net interest income of $8.0 million, offset by a $4.5 million increase in the provision for credit loss, a decrease in Paycheck Protection Program (PPP) revenue earned of $6.2 million and a $2.3 million decrease in the gain on the sale of loans.

Diluted EPS was $2.95 for 2022, down 2.1% from $3.01 in 2021. Return on average equity (ROE) and return on average assets (ROA) were 13.55% and 1.21%, respectively, as compared to 14.09% and 1.28%, respectively, for 2021.

Net interest income for the year ended December 31, 2022 was $118.3 million, an increase of $8.0 million, or 7.2%, from the prior year. Interest and fees on loans were $113.0 million, an increase of 7.6% from the $105.0 million for the year ended December 31, 2021. Interest and fees related to PPP loans, included in the $113.0 million, were $1.6 million. In 2021, $7.8 million of income was earned on PPP loans. Interest expense for the year ended December 31, 2022 was $11.3 million. This is an increase of $6.1 million, or 117.7%, from the $5.2 million in expense for the prior-year period.

Net interest margin was 3.03% for the year ended December 31, 2022, as compared to 2.97% for the year ended December 31, 2021. In the fourth quarter of 2022, the net interest margin was 3.08%, as compared to 2.77% for the fourth quarter of 2021. The increase in net interest margin was due to a variety of factors, including higher market rates impacting asset yields and a reduction in cash balances. Net interest margin in 2022, excluding PPP income, increased to 3.00% from 2.84% in the prior year. The cost of interest-bearing liabilities increased primarily due to the repricing of time deposits and municipal deposits.

For 2022, the provision for credit losses related to the loan portfolio was $4.8 million, compared to $272 thousand in 2021. The key drivers affecting the provision were strong loan growth, increase in net charge-offs and a deterioration in forecasted economic conditions.

Noninterest income was $30.9 million for the year ended December 31, 2022, a decrease of 4.5%, as compared to $32.4 million for the year ended December 31, 2021. Income from fiduciary activities in 2022 was $9.7 million, a decrease of $431 thousand from 2021, primarily driven by market conditions. Fees and other services to customers increased $164 thousand to $11.6 million in 2022. Gain on sales of loans decreased $2.3 million from 2021 to $83 thousand in 2022. Other operating income increased $814 thousand from 2021, due to gains related to other investments and bank-owned life insurance proceeds.

Noninterest expense for the year ended December 31, 2022 increased by $3.5 million, or 4.5%, to $81.5 million, as compared to $78.0 million in 2021. The largest component of noninterest expense is salaries and benefits paid to our employees, which totaled $47.0 million in 2022. Salaries and benefits increased $2.2 million, or 4.9%, from the prior year. Technology and equipment expense was $16.1 million, an increase of $1.2 million or 8.4%, from the prior year, reflects our continued commitment to innovation. Noninterest expense for the fourth quarter of 2022 decreased $68 thousand, or 0.3%, as compared to the fourth quarter of 2021.

The provision for income taxes for 2022 was $14.1 million, compared to $14.5 million for 2021. The effective income tax rates for 2022 and 2021 were 22.4% and 22.6%, respectively.

Total assets were $3.97 billion at December 31, 2022, a decrease of $58.4 million, or 1.5%, compared to December 31, 2021. Total cash and cash equivalents were $64.7 million at December 31, 2022, a decrease of $393.0 million, or 85.9%, compared to December 31, 2021. Total investments were $757.1 million at December 31, 2022, a decrease of $5.9 million, or 0.8%, compared to December 31, 2021. In 2022, the rising interest rate environment resulted in an increase of unrealized losses versus the prior year.

At December 31, 2022, total loan balances reached $3.0 billion, up $315 million, or 11.8%, from the prior-year level. Loan growth for the fourth quarter was $58.4 million. The consumer loan portfolio grew by $144.6 million, or 15.7%, over the balance at December 31, 2021, primarily as a result of continued strength in the indirect automobile lending program. The residential real estate loan portfolio increased $124.8 million, or 13.2%, from the prior year. Commercial loans, including commercial real estate, increased $45.9 million, or 5.7%, over the balances at December 31, 2021.

The allowance for credit losses was $30.0 million at December 31, 2022, an increase of $2.7 million from December 31, 2021. The allowance for credit losses represents 1.00% of loans outstanding, a decrease from 1.02% at year-end 2021. When expressed as a percentage of nonperforming loans, the allowance for credit loss coverage ratio was 250.0% at year-end 2022 as compared to 233.9% at year-end 2021. Asset quality remained solid at December 31, 2022. Net loan losses, expressed as an annualized percentage of average loans outstanding, were 0.08% for the year ended December 31, 2022, as compared to 0.03% for the prior year. Nonperforming assets of $12.6 million at December 31, 2022, represented 0.32% of period-end assets, compared to $11.8 million or 0.29% at December 31, 2021.

At December 31, 2022, total deposit balances were $3.5 billion, a decrease of $52.1 million, or 1.5%, from the prior-year level. Non-municipal deposits decreased by $26.6 million and municipal deposits decreased by $25.5 million as compared to December 31, 2021. Noninterest-bearing deposits grew by $26.6 million, or 3.3%, during 2022, and represented 23.9% of total deposits at year-end, as compared to the prior-year level of 22.8%. At December 31, 2022, total time deposits decreased $5.1 million from the prior-year level. Deposits decreased in the fourth quarter by $296.7 million. Non-municipal and municipal deposits decreased by $149.0 million and $147.7 million, respectively in the fourth quarter. The decline in deposits was primarily the result of increased consumer spending, pressure from competitive rate pricing and seasonality of municipal deposits.

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Total borrowings were $74.8 million at December 31, 2022, an increase of $9.8 million, or 15.1%, compared to December 31, 2021.

Total shareholders’ equity was $353.5 million at period-end, a decrease of $17.6 million, or 4.8%, from the year-end 2021 balance. Arrow's regulatory capital ratios remained strong in 2022. At December 31, 2022, Arrow's Common Equity Tier 1 Capital Ratio was 13.32% and Total Risk-Based Capital Ratio was 15.11%. The capital ratios of Arrow and both its subsidiary banks continued to significantly exceed the “well capitalized” regulatory standards.

In 2022, Arrow upgraded its core banking system. The system upgrade reflects the strategic focus on a strong technology foundation and this investment paves the way for customer-facing enhancements and more efficient and improved internal operations as Arrow continues to work toward fully leveraging the capabilities of the new bank core system. In connection with the conversion, we have encountered, and are continuing to experience, operational and other issues, certain of which have required substantial time and resources to address, and which have had a negative impact on our operations and business and have contributed to material weaknesses in the Company’s internal controls described in Part II, Item 9A, Controls and Procedures. Additionally in 2022, Arrow further optimized its branch network with the December consolidation of Glens Falls National Bank's Aviation Road Office into nearby Queensbury locations. Meanwhile, construction on the downtown Glens Falls headquarters advanced; once completed later in 2023, the energy-efficient space will improve both the employee and customer experience.

The changes in net income, net interest income and net interest margin between the current and prior year are discussed in detail under the heading "Results of Operations," beginning on page 30.

Regulatory Capital and Decrease in Stockholders' Equity: As of December 31, 2022, Arrow continued to exceed all required minimum capital ratios under the current bank regulatory capital rules as implemented under Dodd-Frank (the "Capital Rules") at both the holding company and bank levels.  At that date, both subsidiary banks, as well as the holding company, continued to qualify as "well-capitalized" under the capital classification guidelines as defined by the Capital Rules.  Because of continued profitability and strong asset quality, the regulatory capital levels throughout recent years have consistently remained well in excess of the various required regulatory minimums in effect from time to time, as they do at present.

In 2020, federal bank regulators introduced an optional simplified measure of capital adequacy for qualifying community banking organizations (CBLR).  A qualifying community banking organization that opts into the CBLR framework and meets all the requirements under the CBLR framework will be considered to have met the well-capitalized ratio requirements under the “prompt corrective action” regulations and will not be required to report or calculate risk-based capital ratios.

The CBLR final rule became effective as of January 1, 2020, and Arrow and both subsidiary banks have opted out of utilizing the CBLR framework. Therefore, the Capital Rules promulgated under Dodd-Frank will remain applicable to Arrow and both subsidiary banks.

Total stockholders' equity was $353.5 million at December 31, 2022, a decrease of $17.6 million, or 4.8%, from December 31, 2021. The components of the change in stockholders' equity since year-end 2021 are presented in the Consolidated Statement of Changes in Stockholders' Equity on page 59. Total book value per share decreased by 4.9% over the prior year level. At December 31, 2022, tangible book value per share, a non-GAAP financial measure calculated based on tangible book value (total stockholders' equity minus intangible assets including goodwill) was $19.95, a decrease of $1.08, or 5.1%, over the December 31, 2021 amount. The net decrease in total stockholders' equity during 2022 principally reflected the following factors: (i) $48.8 million of net income for the year, plus (ii) $2.0 million of equity related to various stock-based compensation plans, plus (iii) $1.9 million of equity resulting from the dividend reinvestment plan, reduced by (iv) other comprehensive loss of $50.0 million, (v) cash dividends of $17.4 million and (vi) repurchases of common stock of $2.9 million. As of December 31, 2022, Arrow's closing stock price was $33.90, resulting in a trading multiple of 1.70 to Arrow's tangible book value. The Board of Directors declared and Arrow paid a cash dividend of $0.262 per share for the first three quarters of 2022, as adjusted for a 3% stock dividend distributed September 23, 2022, a cash dividend of $0.27 per share for the fourth quarter of 2022, and declared a $0.27 per share cash dividend for the first quarter of 2023.

Loan quality: Nonperforming loans were $12.0 million at December 31, 2022, an increase of $319 thousand, or 2.7%, from year-end 2021. The ratio of nonperforming loans to period-end loans at December 31, 2022 was 0.40%, a decrease from 0.44% at December 31, 2021 and higher than Arrow's peer group ratio of 0.38% at September 30, 2022. Loans charged-off (net of recoveries) against the allowance for credit losses was $2.1 million for 2022, an increase of $1.2 million from 2021. The ratio of net charge-offs to average loans was 0.08% for 2022 and 0.03% for 2021, compared to the peer group ratio of 0.04% for the period ended September 30, 2022. At December 31, 2022, the allowance for credit losses was $30.0 million, representing 1.00% of total loans, a decrease of 2 basis points from the December 31, 2021 ratio.

Loan Segments: As of December 31, 2022, total loans grew $315.3 million, or 11.8%, as compared to the balance at December 31, 2021.

◦    Commercial and Commercial Real Estate Loans: Combined, these loans comprised 28.4% of the total loan portfolio at period-end. Commercial property values in Arrow's region have largely remained stable, however, there remains uncertainty surrounding market conditions due to the inflation and the rising interest rate environment. Appraisals on nonperforming and watched CRE loan properties are updated as deemed necessary, usually when the loan is downgraded or when there has been significant market deterioration since the last appraisal.

◦    Consumer Loans: These loans (primarily automobile loans) comprised approximately 35.7% of the total loan portfolio at period-end. Consumer automobile loans at December 31, 2022, were $1.1 billion, or 99.6% of this portfolio segment. The vast majority of automobile loans are initiated through the purchase of vehicles by consumers with automobile

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dealers. Although previous supply chain constraints have lessened, inflation and higher rates may limit the potential growth in this category.

◦    Residential Real Estate Loans: These loans, including home equity loans, made up 35.9% of the total loan portfolio at period-end. Demand for residential real estate has continued but weakened as interest rates have increased. Arrow originated nearly all of the residential real estate loans currently held in the loan portfolio and applies conservative underwriting standards to loan originations. Arrow typically sells a portion of residential real estate mortgage originations into the secondary market. The ratio of the sales of originations to total originations tends to fluctuate from period to period based on market conditions and other factors. Since the second half 2021, sales have decreased as a result of the strategic decision to grow the residential loan portfolio. The rate at which mortgage loan originations are sold in future periods will depend on various circumstances, including prevailing mortgage rates, other lending opportunities, capital and liquidity needs, and the availability of a market for such transactions.

Liquidity and access to credit markets: Arrow did not experience any liquidity problems or special concerns in recent years or in 2022. Arrow’s liquidity position should provide the Company with the necessary flexibility to address any unexpected near-term disruptions.  Interest-bearing cash balances at December 31, 2022 were $32.8 million which represents a significant decline as compared to $430.7 million at December 31, 2021.  In the fourth quarter, deposits declined as the result of increased consumer spending, pressure from competitive rate pricing and seasonality of municipal deposits. Deposit balances nonetheless provided an abundance of liquidity to fund Arrow's asset growth. Additionally, contingent lines of credit are also available. Operating collateralized lines of credit are established and available through the FHLBNY and FRB, totaling $1.3 billion. The terms of Arrow's lines of credit have not changed significantly in recent periods (see the general liquidity discussion on page 46). Historically, Arrow has principally relied on asset-based liquidity (i.e., funds in overnight investments and cash flow from maturing investments and loans) with liability-based liquidity as a secondary source of funds (the main liability-based sources are an overnight borrowing arrangement with correspondent banks, an arrangement for overnight borrowing and term credit advances from the FHLBNY, and an additional arrangement for short-term advances at the Federal Reserve Bank discount window). Regular liquidity stress tests and tests of the contingent liquidity plan are performed to ensure that an adequate amount of available funds can be generated to meet a wide variety of potential liquidity crises.

Reference Rate Reform: On March 5, 2021, the ICE Benchmark Administration (the IBA), the administrator of LIBOR, and the United Kingdom’s Financial Conduct Authority, the regulatory supervisor for the IBA, announced certain future dates that LIBOR settings will cease to be provided by any administrator. In addition, regulators have issued statements indicating that financial institutions should not issue new LIBOR-based financial instruments after January 1, 2022. To prepare for the upcoming cessation of LIBOR, Arrow established a committee in 2020 comprised of Bank Management to prepare for the discontinuance of LIBOR, which is widely used to reprice floating rate financial instruments. Based on a review of existing floating rate financial instruments, Management has determined that the financial products tied to LIBOR will not be subject to cessation until June 30, 2023. This review also identified that only a few legacy contracts do not include appropriate fallback language. On March 15, 2022, the “Adjustable Interest Rate (LIBOR) Act” was enacted by Congress. The law provides basic framework for addressing the discontinuation of U.S. Dollar LIBOR under federal law. The law establishes a clear uniform process, on a nationwide basis, for replacing LIBOR in existing contracts that do not provide for the use of a clearly defined or practicable replacement benchmark rate (so-called “tough legacy” contracts), without affecting the ability of parties to use any appropriate benchmark rate in new contracts. In December 2022, the Federal Reserve Board adopted a final rule implementing the Adjustable Interest Rate (LIBOR) Act, which was effective February 27, 2023. Arrow no longer issues new LIBOR-based financial instruments. Furthermore, U.S. Dollar LIBOR indices utilized by Arrow's existing financial instruments shall cease on or before June 30, 2023. On January 1, 2022, Arrow designated SOFR as the replacement index for financial instruments previously tied to LIBOR.

Visa Class B Common Stock: Arrow's subsidiary bank, Glens Falls National, like other Visa member banks, bears some indirect contingent liability for Visa's direct liability arising out of certain antitrust claims involving merchant discounts to the extent that Visa's liability might exceed the amount funded in its litigation escrow account. On December 13, 2019, the Court granted final approval to a settlement in this class action lawsuit. On January 3, 2020 an appeal of the final-approved order was filed with the court. On December 16, 2021, the second circuit court of appeals set oral arguments regarding objections to final approval of the settlement for March 16, 2022. On March 16, 2022, the Second Circuit Court of Appeals heard oral arguments regarding objections to final approval of the settlement. It is currently unknown when the appeal will be decided. When the appeals process is resolved and assuming the balance in the litigation escrow account is sufficient to cover the litigation claims and related expenses, Arrow could potentially realize a gain on the receipt of Visa Class A common stock. At December 31, 2022, Glens Falls National held 27,771 shares of Visa Class B common stock, and utilizing the conversion ratio to Class A common stock at that time, these Class B shares would convert to approximately 44,000 shares of Visa Class A common stock. Since the litigation settlement is not certain, Arrow has not recognized any economic value for these shares.

B. RESULTS OF OPERATIONS

The following analysis of net interest income, the provision for credit losses, noninterest income, noninterest expense and income taxes, highlights the factors that had the greatest impact on the results of operations for December 31, 2022 and the prior two years. For a comparison of the years ended December 31, 2020 and 2021, see Part II. Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in our Form 10-K for the year ended December 31, 2021.

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I. NET INTEREST INCOME

Net interest income represents the difference between interest, dividends and fees earned on loans, securities and other earning assets and interest paid on deposits and other sources of funds.  Changes in net interest income result from changes in the level and mix of earning assets and sources of funds (volume) and changes in the yields earned and interest rates paid (rate). Net interest margin is the ratio of net interest income to average earning assets.  Net interest income may also be described as the product of average earning assets and the net interest margin.

CHANGE IN NET INTEREST INCOME

(Dollars In Thousands) (GAAP Basis)

Net interest income was $118.3 million in 2022, an increase of $8.0 million, or 7.2%, from the $110.4 million in 2021.  This is in comparison with the increase of $11.2 million, or 11.2%, from 2020 to 2021.  Factors contributing to the year-to-year changes in net interest income over the three-year period are discussed in the following portions of this Section B.I.

The following tables reflect the components of net interest income for years ended December 31, 2022, 2021 and 2020: (i) average balances of assets, liabilities and stockholders' equity, (ii) interest and dividend income earned on earning assets and interest expense incurred on interest-bearing liabilities, (iii) average yields earned on earning assets and average rates paid on interest-bearing liabilities, (iv) the net interest spread (average yield less average cost) and (v) the net interest margin (yield) on earning assets. The yield on securities available-for-sale is based on the amortized cost of the securities. Nonaccrual loans are included in average loans.

Average Consolidated Balance Sheets and Net Interest Income Analysis

(GAAP basis)

(Dollars in Thousands)

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Changes between periods are attributed to movement in either the average daily balances or average rates for both earning assets and interest-bearing liabilities.  Changes attributable to both volume and rate have been allocated proportionately between the categories.

Net Interest Income Rate and Volume Analysis

(Dollars in Thousands) (GAAP basis)

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NET INTEREST MARGIN

Arrow's earnings are derived predominantly from net interest income, which is interest income, net of interest expense. Changes in balance sheet composition, including interest-earning assets, deposits, and borrowings, combined with changes in market interest rates, impact net interest income. Net interest margin is net interest income divided by average interest-earning assets. Interest-earning assets and funding sources are managed, including noninterest and interest-bearing liabilities, in order to maximize this margin.

2022 Compared to 2021: Net interest income increased $8.0 million, or 7.2%, to $118.3 million for the year ended December 31, 2022 from $110.4 million for the year ended December 31, 2021. Interest and fees on loans were $113.0 million, an increase of 7.6% from the $105.0 million for the year ended December 31, 2021. Interest and fees related to PPP loans, included in the $113.0 million, were $1.6 million. In 2021, $7.8 million of income was earned on PPP loans. The net interest margin was 3.03% for the year ended December 31, 2022 as compared to 2.97% for the year ended December 31, 2021.

Income on investment securities increased $3.6 million, or 35.7%, between the years ended December 31, 2022 and December 31, 2021. The average balances for fully taxable securities were higher for the year, with yield increasing by 22 basis points. The average balances for securities exempt from federal taxes were lower for the year, with yield decreasing by 5 basis points.

Interest income from loans increased $8.0 million, or 7.6%, to $113.0 million for the year ended December 31, 2022 from $105.0 million for the year ended December 31, 2021. The loan portfolio yield increased 3 basis points in 2022, to 4.00%. Average loan balances increased by $184.4 million, a 7.0% increase over 2021 average balances. Within the loan portfolio, the three principal segments are residential real estate loans, consumer loans (primarily through the indirect automobile lending program) and commercial loans. The consumer loan portfolio grew by $144.6 million, or 15.7%, over the balance at December 31, 2021. The residential real estate loan portfolio increased $124.8 million, or 13.2% from the prior year. Commercial loans, including commercial real estate, increased $45.9 million, or 5.7%, over the balances at December 31, 2021.

Total interest expense on interest-bearing liabilities increased $6.1 million, or 117.7%, to $11.3 million for the year ended December 31, 2022 from $5.2 million for the year ended December 31, 2021. Average interest bearing deposit balances increased by $123.8 million and the total cost of interest-bearing deposits increased to 22 basis points from 13 basis points. In addition, average demand deposits, which are non-interest bearing, increased by $47.5 million.

II. PROVISION FOR CREDIT LOSSES AND ALLOWANCE FOR CREDIT LOSSES

Arrow considers the accounting policy relating to the allowance for credit losses to be a critical accounting policy, given the uncertainty involved in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio, and the material effect that such judgments may have on the results of operations.  The provision for credit losses for 2022 was $4.8 million, compared to the $0.3 million provision for 2021. The analysis of the method employed for determining the amount of the credit loss provision is explained in detail in Notes 2, Summary of Significant Accounting Policies, and 5, Loans, to the Consolidated Financial Statements.

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SUMMARY OF THE ALLOWANCE AND PROVISION FOR CREDIT LOSSES

(Dollars In Thousands) (Loans, Net of Unearned Income)

ALLOCATION OF THE ALLOWANCE FOR CREDIT LOSSES

(Dollars in Thousands)

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Arrow adopted CECL on January 1, 2021. The CECL approach requires an estimate of the credit losses expected over the life of a loan (or pool of loans). It replaced the incurred loss approach’s threshold that required the recognition of a credit loss when it was probable that a loss event was incurred. The allowance for credit losses is a valuation account that is deducted from, or added to, the loans’ amortized cost basis to present the net, lifetime amount expected to be collected on the loans. Loan losses are charged off against the allowance when Arrow believes a loan balance is confirmed to be uncollectible. Expected recoveries do not exceed the aggregate of amounts previously charged off and expected to be charged off.

Management estimates the allowance using relevant available information from internal and external sources related to past events, current conditions, and a reasonable and supportable single economic forecast. Historical credit loss experience provides the basis for the estimation of expected credit losses. Arrow's historical loss experience was supplemented with peer information when there was insufficient loss data for Arrow. Peer selection was based on a review of institutions with comparable loss experience as well as loan yield, bank size, portfolio concentration and geography. Adjustments to historical loss information are made for differences in current loan-specific risk characteristics such as differences in credit concentrations, delinquency level, collateral values and underwriting standards as well as changes in economic conditions or other relevant factors. Management judgment is required at each point in the measurement process.

Portfolio segment is defined as the level at which an entity develops and documents a systematic methodology to determine its allowance for credit losses. Upon adoption of CECL, Management revised the manner in which loans were pooled for similar risk characteristics. Management developed portfolio segments for estimating loss based on type of borrower and collateral as follows:

Commercial Loans

Commercial Real Estate Loans

Consumer Loans

Residential Loans

Further details related to loan portfolio segments are included in Note 5, Loans, to the Consolidated Financial Statements.

Historical credit loss experience for both Arrow and segment-specific peers provides the basis for the estimation of expected credit losses. Arrow utilized regression analyses of peer data, of which Arrow is included, where observed credit losses and selected economic factors were utilized to determine suitable loss drivers for modeling lifetime probability of default (PD) rates. Arrow uses the discounted cash flow (DCF) method to estimate expected credit losses for the commercial, commercial real estate, and residential segments. For each of these loan segments, Arrow generates cash flow projections at the instrument level wherein payment expectations are adjusted for estimated prepayment speed, curtailments, time to recovery, PD, and segment-specific loss given default (LGD) risk factors. The modeling of expected prepayment speeds, curtailment rates, and time to recovery are based on historical internal data and adjusted, if necessary, based on the reasonable and supportable forecast of economic conditions.

For the loan segments utilizing the DCF method, (commercial, commercial real estate, and residential) Management utilizes externally developed economic forecast of the following economic factors as loss drivers: national unemployment, gross domestic product and home price index (HPI). The economic forecast is applied over a reasonable and supportable forecast period. Arrow utilizes a six quarter reasonable and supportable forecast period with an eight quarter reversion to the historic mean on a straight-line basis.

The combination of adjustments for credit expectations (default and loss) and timing expectations (prepayment, curtailment, and time to recovery) produces an expected cash flow stream at the instrument level. Instrument effective yield is calculated, net of the impacts of prepayment assumptions, and the instrument expected cash flows are then discounted at that effective yield to produce an instrument-level net present value of expected cash flows (NPV). An allowance for credit loss is established for the difference between the instrument’s NPV and amortized cost basis. The contractual term excludes expected extensions, renewals, and modifications unless either of the following applies: Management has a reasonable expectation at the reporting date that a troubled debt restructuring (TDR) will be executed with an individual borrower or the extension or renewal options are included in the original or modified contract at the reporting date and are not unconditionally cancellable by Arrow.

Arrow uses the vintage analysis method to estimate expected credit losses for the consumer loan segment. The vintage method was selected since the loans within the consumer loan segment are homogeneous, not just by risk characteristic, but by loan structure. Under the vintage analysis method, a loss rate is calculated based on the quarterly net charge-offs to the outstanding loan balance for each vintage year over the lookback period. Once this periodic loss rate is calculated for each quarter in the lookback period, the periodic rates are averaged into the loss rate. The loss rate is then applied to the outstanding loan balances based on the loan's vintage year. Arrow maintains, over the life of the loan, the loss curve by vintage year. If estimated losses computed by the vintage method need to be adjusted based on current conditions and the reasonable and supportable economic forecast, these adjustments would be incorporated over a six quarter reasonable and supportable forecast period, reverting to historical losses using a straight-line method over an eight quarter period. Based on current conditions, and the reasonable and supportable economic forecast, no adjustments are currently required.

The vintage and DCF models also consider the need to qualitatively adjust expected loss estimates for information not already captured in the quantitative loss estimation process. Qualitative considerations include limitations inherent in the quantitative model; trends experienced in nonperforming and delinquent loans; changes in value of underlying collateral; changes in lending policies and procedures; nature and composition of loans; portfolio concentrations that may affect loss experience across one or more components or the portfolio; the experience, ability and depth of lending management and staff; Arrow's credit review system; and the effect of external factors such as competition, legal and regulatory requirements. These

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qualitative factor adjustments may increase or decrease Arrow's estimate of expected credit losses so that the allowance for credit loss is reflective of the estimate of lifetime losses that exist in the loan portfolio at the balance sheet date.

The change in methodology from incurred loss to the expected loss over the life of the loan also impacted the allocation of the allowance for credit losses. The vintage approach combined with a shorter life of loan decreased the allowance needed for consumer loans. Residential real estate loans, due to their longer life of loan, have a higher allocation of the allowance of credit loans as compared to the incurred loss methodology.

Arrow's allowance for credit losses was $30.0 million at December 31, 2022, which represented 1.00% of loans outstanding, a decrease from 1.02% at year-end 2021.

See Note 5, Loans, to the Consolidated Financial Statements for the complete methodology used to calculate the provision for credit losses.

III. NONINTEREST INCOME

The majority of the noninterest income constitutes fee income from services, principally fees and commissions from fiduciary services, deposit account service charges, insurance commissions, net gains (losses) on securities transactions, net gains on sales of loans and other recurring fee income.

ANALYSIS OF NONINTEREST INCOME

(Dollars In Thousands)

2022 Compared to 2021:  Total noninterest income in 2022 was $30.9 million, a decrease of $1.5 million, or 4.5%, from total noninterest income of $32.4 million for 2021. Income from fiduciary activities decreased $431 thousand from 2021 to 2022. The decrease was primarily driven by market conditions. Assets under trust administration and investment management at December 31, 2022 were $1.61 billion, a decrease of $245.0 million, or 13.2%, from the prior year-end balance of $1.85 billion. Fees for other services to customers were $11.6 million for 2022, an increase of $164 thousand as compared to 2021. Insurance commissions were flat to the previous year. Net gain on securities in 2022, consisting of a change in the fair value of equity investments, was $427 thousand as compared to a loss of $111 thousand in 2021.

Net gains on the sales of loans decreased in 2022 to $83 thousand, from $2.4 million in 2021. Sales decreased primarily as a result of the strategic decision in the second half of 2021 to retain more newly originated residential real estate loans. The rate at which mortgage loan originations are sold in future periods will depend on various circumstances, including prevailing mortgage rates, other lending opportunities, capital and liquidity needs, and the availability of a market for such transactions. Therefore, Arrow is unable to predict what the retention rate of such loans in future periods may be. Servicing rights are generally retained for loans originated and sold, which also generates additional noninterest income in subsequent periods (fees for other services to customers).

Other operating income increased by $814 thousand, or 45.9% between the two years primarily due to gains on other assets of $421 thousand as well as proceeds received related to bank owned life insurance of $383 thousand.

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IV. NONINTEREST EXPENSE

Noninterest expense is the measure of the delivery cost of services, products and business activities of a company.  The key components of noninterest expense are presented in the following table.

ANALYSIS OF NONINTEREST EXPENSE

(Dollars In Thousands)

2022 compared to 2021:  Noninterest expenses for 2022 were $81.5 million, an increase of $3.5 million, or 4.5%, from 2021.  For 2022, the efficiency ratio was 54.26%. This ratio, which is a commonly used non-GAAP financial measure in the banking industry, is a comparative measure of a financial institution's operating efficiency. The efficiency ratio (a ratio where lower is better), as defined by Arrow, is the ratio of operating noninterest expense (excluding intangible asset amortization) to net interest income (on a tax-equivalent basis) plus operating noninterest income (excluding net securities gains or losses). See the discussion of the efficiency ratio in this Report under the heading “Use of Non-GAAP Financial Measures.”

Salaries and employee benefits expense increased $2.2 million or 4.9%, from 2021. Included within salaries and benefits was a $1.5 million reclassification between salaries and employee benefits and other operating expenses. Under ASU 2017-07 (Compensation-Retirement Benefits), interest cost, expected return on plan assets, amortization of prior service cost and amortization of net loss are required to be reclassified out of salaries and employee benefits. The reclassification was $1.7 million in 2021. Salaries and benefits were also impacted by increased benefit costs and incentive payments.

Technology expenses increased $1.2 million, or 8.4%, from 2021 due to the investment in upgrading the core banking system. The expense reflects the strategic focus on a strong technology foundation and paves the way for customer-facing enhancements and more efficient and improved internal operations.

Other operating expense decreased $476 thousand, or 4.2%, from 2021. The decrease is the result of the expense for estimated credit losses on off-balance sheet credit exposures of $685 thousand for 2021 as compared to $22 thousand in the current year.

V. INCOME TAXES

The following table sets forth the provision for income taxes and effective tax rates for the periods presented.

INCOME TAXES AND EFFECTIVE RATES

(Dollars In Thousands)

The provisions for federal and state income taxes amounted to $14.1 million for 2022, $14.5 million for 2021, and $11.0 million for 2020. The effective income tax rates for 2022, 2021 and 2020 were 22.4%, 22.6% and 21.3%, respectively. The effective tax rate was essentially flat between 2022 and 2021. The increase in 2021 as compared to 2020 was primarily due to the reduction of tax exempt investments held and the related investment income, combined with the increase in the New York State corporate tax rate which was effective January 1, 2021.

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C. FINANCIAL CONDITION

I. INVESTMENT PORTFOLIO

During 2022 and 2021, Arrow held no trading securities.

The available-for-sale securities portfolio, held-to-maturity securities portfolio and the equity securities portfolio are further detailed below.

The table below presents the changes in the period-end balances for available-for-sale, held-to-maturity and equity securities from December 31, 2021 to December 31, 2022 (in thousands):

The table below presents the weighted average yield for available-for-sale and held-to-maturity securities as of December 31, 2022 (in thousands).

For the years above, Arrow held no investment securities in the securities portfolio that consisted of or included, directly or indirectly, obligations of foreign governments or government agencies of foreign issuers.

In the periods referenced above, mortgage-backed securities consisted solely of mortgage pass-through securities and collateralized mortgage obligations (CMOs) issued or guaranteed by U.S. federal agencies or by government-sponsored enterprises (GSEs). Mortgage pass-through securities provide to the investor monthly portions of principal and interest pursuant to the contractual obligations of the underlying mortgages. CMOs are pools of mortgage-backed securities, the repayments on which have generally been separated into two or more components (tranches), where each tranche has a separate estimated life and yield. Arrow's practice has been to purchase pass-through securities and CMOs that are issued or guaranteed by U.S. federal agencies or GSEs, and the tranches of CMOs purchased are generally those having shorter average lives and/or

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durations. Lower market interest rates and/or payment deferrals on underlying loans that make up mortgage-backed security collateral may impact cashflows.

In the periods referenced above, U.S. Government & Agency Obligations consisted solely of agency bonds issued by GSEs. These securities generally pay fixed semi-annual coupons with principle payments at maturity. For some, callable options are included that may impact the timing of these principal payments. Arrow's practice has been to purchase Agency securities that are issued or guaranteed by GSEs with limited embedded optionality (call features). Final maturities are generally less than 5 years.

The yields on obligations of states and municipalities exempt from federal taxation were computed on a tax-equivalent basis. The yields on other debt securities shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the amortized cost of the securities at December 31, 2022.

Arrow evaluates available-for-sale debt securities in unrealized loss positions at each measurement date to determine whether the decline in the fair value below the amortized cost basis (impairment) is due to credit-related factors or non-credit related factors. Any impairment that is not credit related is recognized in other comprehensive income, net of applicable taxes. Credit-related impairment is recognized within the allowance for credit losses on the balance sheet, limited to the amount by which the amortized cost basis exceeds the fair value, with a corresponding adjustment to earnings via credit loss expense. Arrow determined that at December 31, 2022, gross unrealized losses, $65.6 million, were primarily attributable to changes in interest rates, relative to when the investment securities were purchased, and not due to the credit quality of the investment securities. In 2022, the rising interest rate environment resulted in an increase in unrealized losses versus the comparable prior period. Arrow does not intend to sell, nor is it more likely than not that Arrow will be required to sell any securities before recovery of its amortized cost basis, which may be at maturity. Therefore, Arrow carried no allowance for credit loss at December 31, 2022 and there was no credit loss expense recognized by Arrow with respect to the securities portfolio during the year ended December 31, 2022.

At December 31, 2022 and 2021, the weighted average maturity was 4.2 and 4.0 years, respectively, for debt securities in the available-for-sale portfolio.

For further information regarding the portfolio of securities available-for-sale, see Note 4, Investment Securities, to the Consolidated Financial Statements.

Securities Held-to-Maturity:

The following table sets forth the carrying value of the portfolio of securities held-to-maturity at December 31 of each of the last two years.

SECURITIES HELD-TO-MATURITY

(Dollars In Thousands)

Arrow's held-to-maturity debt securities are comprised of GSEs and state and municipal obligations. GSE securities carry the explicit and/or implicit guarantee of the U.S. government, are widely recognized as “risk free,” and have a long history of zero credit loss. Arrow performs an analysis of the credit worthiness of municipal obligations to determine if a security is of investment grade. The analysis may include, but may not solely rely upon credit analysis conducted by external credit rating agencies. Arrow determined that the expected credit loss on its held to maturity debt portfolio was immaterial and, therefore, no allowance for credit loss was recorded as of December 31, 2022.

At December 31, 2022 and 2021, the weighted average maturity was 1.9 and 2.0 years, respectively, for the debt securities in the held-to-maturity portfolio.

For additional information regarding the fair value of the portfolio of securities held-to-maturity at December 31, 2022, see Note 4, Investment Securities, to the Consolidated Financial Statements.

EQUITY SECURITIES

(Dollars In Thousands)

The following table is the schedule of Equity Securities at December 31 of each of the last two years.

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II. LOAN PORTFOLIO

The amounts and respective percentages of loans outstanding represented by each principal category on the dates indicated were as follows:

a. Types of Loans

(Dollars In Thousands)

Commercial and Commercial Real Estate Loans: Commercial and commercial real estate loans in the loan portfolio were extended to businesses or borrowers primarily located in Arrow's regional markets. A portion of the loans in the commercial portfolio have variable rates tied to market indices, such as Prime, LIBOR, SOFR or FHLBNY. PPP loans were previously included within the commercial loan portfolio. There were no PPP loans outstanding as of December 31, 2022.

Consumer Loans: At December 31, 2022, consumer loans (primarily automobile loans originated through dealerships located in New York and Vermont) continue to be a significant component of Arrow's business, comprising approximately one third of the total loan portfolio.

Consumer loan originations have remained strong in 2022, with origination volume for the last three years at $572.3 million, $452.1 million and $386.4 million for 2022, 2021 and 2020, respectively.

For credit quality purposes, Arrow assigns potential automobile loan customers into one of four tiers, ranging from lower to higher quality in terms of anticipated credit risk. Arrow's experienced lending staff not only utilizes credit evaluation software tools but also reviews and evaluates each loan individually prior to the loan being funded. Arrow believes that this disciplined approach to evaluating risk has contributed to maintaining the strong credit quality in this portfolio.

Residential Real Estate Loans: Gross originations for residential real estate loans (including refinancings of mortgage loans) were $217.5 million, $244.5 million and $250.1 million for the years 2022, 2021, and 2020, respectively.

Demand for residential real estate has continued but weakened as interest rates have increased. New origination activity has benefited from the higher rates. A continuous elevated rate environment may impact future demand. Arrow continues to sell portions of these originations in the secondary market. Sales decreased during 2021 and were minimal in 2022 as the result of the strategic decision to grow the residential loan portfolio. The rate at which mortgage loan originations are sold in future periods will depend on a variety of factors, including demand for residential mortgages in our operating markets, market conditions for mortgage sales and strategic balance sheet and interest-rate risk management decisions.

The following table indicates the changing mix in the loan portfolio by including the quarterly average balances for the significant loan segments for the past five quarters.  The remaining quarter-by-quarter tables present the percentage of total loans represented by each category and the annualized yield of each category.

LOAN PORTFOLIO

Quarterly Average Loan Balances

(Dollars In Thousands)

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Percentage of Total Quarterly Average Loans

Quarterly Yield on Loans

The average yield on the loan portfolio increased from 3.82% for the fourth quarter of 2021 to 4.13% for the fourth quarter of 2022. The current raising rate environment prevailed for much of 2022, which impacted new loan yields for both fixed and variable rate loans.

PPP Loans

Arrow originated over $234.2 million of PPP loans in 2020 and 2021. Arrow completed the PPP program in 2022.

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The following table indicates the respective maturities and interest rate structure of commercial loans and commercial real estate construction loans at December 31, 2022.  For purposes of determining relevant maturities, loans are assumed to mature at (but not before) their scheduled repayment dates as required by contractual terms.  Demand loans and overdrafts are included in the “Within 1 Year” maturity category.  Most of the commercial construction loans are made with a commitment for permanent financing, whether extended by us or unrelated third parties.  The maturity distribution below reflects the final maturity of the permanent financing.

b. Maturities and Sensitivities of Loans to Changes in Interest Rates

(Dollars in Thousands)

The table below shows the maturity of loans outstanding as of December 31, 2022. Also provided are the amounts due after one year, classified according to fixed interest rates and variable interest rates (in thousands):

COMMITMENTS AND LINES OF CREDIT

Stand-by letters of credit represent extensions of credit granted in the normal course of business, which are not reflected in the financial statements at a given date because the commitments are not funded at that time.  As of December 31, 2022, the total contingent liability for standby letters of credit amounted to $3.6 million.  In addition to these instruments, there are lines of credit to customers, including home equity lines of credit, commitments for residential and commercial construction loans and other personal and commercial lines of credit, which also may be unfunded or only partially funded from time-to-time. Commercial lines, generally issued for a period of one year, are usually extended to provide for the working capital requirements of the borrower. At December 31, 2022, outstanding unfunded loan commitments in the aggregate amount were approximately $424.2 million compared to $402.3 million at December 31, 2021.

c. Risk Elements

1. Nonaccrual, Past Due and Restructured Loans

The amounts of nonaccrual, past due and restructured loans at year-end for each of the past two years are presented in the table on page 33 under the heading "Summary of the Allowance and Provision for Credit Losses."

Loans are placed on nonaccrual status either due to the delinquency status of principal and/or interest or a judgment by Management that the full repayment of principal and interest is unlikely. Unless already placed on nonaccrual status, loans secured by home equity lines of credit are put on nonaccrual status when 120 days past due and residential real estate loans are put on nonaccrual status when 150 days past due. Commercial and commercial real estate loans are evaluated on a loan-by-loan basis and are placed on nonaccrual status when 90 days past due if the full collection of principal and interest is uncertain. Under the Uniform Retail Credit Classification and Account Management Policy established by banking regulators, fixed-maturity consumer loans not secured by real estate must generally be charged-off no later than when 120 days past due. Loans secured with non-real estate collateral in the process of collection are charged-down to the value of the collateral, less cost to sell.  Arrow had no material commitments to lend additional funds on outstanding nonaccrual loans at December 31, 2022.  Loans past due 90 days or more and still accruing interest are those loans which were contractually past due 90 days or more but because of expected repayments, were still accruing interest.

The balance of loans 30-89 days past due and still accruing interest totaled $20.4 million at December 31, 2022 and represented 0.68% of loans outstanding at that date, as compared to approximately $12.2 million, or 0.46% of loans outstanding at December 31, 2021. These non-current loans at December 31, 2022 were composed of approximately $18.2 million of consumer loans (principally indirect automobile loans), $1.8 million of residential real estate loans and $0.4 million of commercial and commercial real estate loans.

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The method for measuring all other loans is described in detail in Note 2, Summary of Significant Accounting Policies, and Note 5, Loans, to the Consolidated Financial Statements.

Note 5, Loans, to the Consolidated Financial Statements contains detailed information on modified loans and impaired loans.

2. Potential Problem Loans

On at least a quarterly basis, the internal credit quality rating is re-evaluated for commercial loans that are either past due or fully performing but exhibit certain characteristics that could reflect well-defined weaknesses.  Loans are placed on nonaccrual status when the likely amount of future principal and interest payments are expected to be less than the contractual amounts, even if such loans are not past due.

Periodically, Arrow reviews the loan portfolio for evidence of potential problem loans.  Potential problem loans are loans that are currently performing in accordance with contractual terms, but where known information about possible credit problems of the borrower may jeopardize loan repayment and result in a non-performing loan.  In the credit monitoring program, Arrow treats loans that are classified as substandard but continue to accrue interest as potential problem loans.  At December 31, 2022, Arrow identified 52 commercial loans totaling $41.7 million as potential problem loans.  At December 31, 2021, Arrow identified 56 commercial loans totaling $37.5 million as potential problem loans.  For these loans, although positive factors such as payment history, value of supporting collateral, and/or personal or government guarantees led Arrow to conclude that accounting for them as non-performing at year-end was not warranted, other factors, specifically, certain risk factors related to the loan or the borrower justified concerns that they may become nonperforming at some point in the future.

3. Foreign Outstandings - None

4. Loan Concentrations

The loan portfolio is well diversified.  There are no concentrations of credit that exceed 10% of the portfolio, other than the general categories reported in the preceding Section C.II.a. of this Item 7, beginning on page 40.  For further discussion, see Note 1, Risks and Uncertainties, to the Consolidated Financial Statements.

5. Other Real Estate Owned and Repossessed Assets

Other real estate owned ("OREO") primarily consists of real property acquired in foreclosure.  OREO is carried at fair value less estimated cost to sell. Arrow establishes allowances for OREO losses, which are determined and monitored on a property-by-property basis and reflect the ongoing estimate of the property's estimated fair value less costs to sell. All Repossessed Assets for each of the five years in the table below consist of motor vehicles.

The following table summarizes changes in the net carrying amount of OREO and the number of properties for each of the periods presented. At December 31, 2022, Arrow had no OREO.

III. SUMMARY OF CREDIT LOSS EXPERIENCE

The information required in this section is presented in the discussion of the "Provision for Credit Losses and Allowance for Credit Losses" in Part II Item 7, Section B.II. beginning on page 33 of this Report, including:

•Charge-offs and Recoveries by loan type

•Factors that led to the amount of the Provision for Credit Losses

•Allocation of the Allowance for Credit Losses by loan type

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The percent of loans in each loan category is presented in the table of loan types in the preceding section on page 40 of this Report.

IV. DEPOSITS

The following table sets forth the average balances of and average rates paid on deposits for the periods indicated.

AVERAGE DEPOSIT BALANCES

(Dollars In Thousands)

Average total deposit balances increased by $171.3 million, or 5.0% in 2022, mainly in the demand deposit, checking and savings deposit categories.

Arrow used reciprocal deposits for a select group of municipalities to reduce the amount of investment securities required to be pledged as collateral for municipal deposits where municipal deposits in excess of the FDIC insurance coverage limits were transferred to other participating banks, divided into portions so as to qualify such transferred deposits for FDIC insurance coverage at each transferee bank. In return, reciprocal amounts are transferred to Arrow in equal amounts of deposits from the participant banks. The balances of reciprocal deposits were $520.6 million and $529.8 million at December 31, 2022 and 2021, respectively.

The following tables presents the quarterly average balance by deposit type for each of the most recent five quarters.

DEPOSIT PORTFOLIO

Quarterly Average Deposit Balances

(Dollars In Thousands)

The above tables provide information on trends in the balance and mix of the deposit portfolio by presenting, for each of the last five quarters, the quarterly average balances by deposit type. Time deposits over $250,000 and other time deposits have decreased for the four quarters leading into the fourth quarter of 2022. In the current quarter, the overall balance of time deposits has increased as the result of a strategic initiative to grow certificate of deposit balances. Despite the increase in the average deposit balance from the third to fourth quarter of 2022, deposits decreased from September 30, 2022 to December 31, 2022. The decrease in deposits was primarily the result of both increased consumer spending and pressure from competitive rate pricing.

In general, there is a seasonal pattern to municipal deposits which dip to a low point in August each year.  Account balances tend to increase throughout the fall and into early winter from tax deposits, flatten out after the beginning of the ensuing calendar year, and increase again at the end of March from the electronic deposit of NYS Aid payments to school districts.  In addition to seasonal behavior, the likelihood of downward trajectory of municipal balances may be the result of record high balances that

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included American Rescue Plan and other COVID-19 pandemic response stimulus as well as increasing competition in the current rate environment.

The total quarterly average balances as a percentage of total deposits are illustrated in the table below.

The total quarterly interest cost of deposits, by type of deposit and in total, for each of the most recent five quarters is set forth in the table below:

The cost of deposits began to increase in the second quarter of 2022, and accelerated in the third and fourth quarters. The Federal Funds rate increased throughout 2022 and is anticipated to continue into 2023. Arrow believes it is well positioned for a variety of rate environments.

The maturities of time deposits of $250,000 or more at December 31, 2022 are presented below.  (Dollars In Thousands)

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V. SHORT-TERM BORROWINGS (Dollars in Thousands)