CITIZENS & NORTHERN CORP (CZNC) FY 2022 MD&A

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements in this section and elsewhere in this Annual Report on Form 10-K are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, "should", “likely”, "expect", “plan”, "anticipate", “target”, “forecast”, and “goal”. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management’s control and could cause results to differ materially from those expressed or implied by such forward-looking statements. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following:

●changes in general economic conditions

●the Corporation’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses

●legislative or regulatory changes

●downturn in demand for loan, deposit and other financial services in the Corporation’s market area

●increased competition from other banks and non-bank providers of financial services

●changes in accounting principles, or the application of generally accepted accounting principles

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.

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EARNINGS OVERVIEW

2022 vs. 2021

Net income for the year ended December 31, 2022 was $26,618,000, or $1.71 per diluted share as compared to 2021 net income of $30,554,000 or $1.92 per share. Significant variances were as follows:

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2021 vs. 2020

Net income for the year ended December 31, 2021 was $30,554,000, or $1.92 per diluted share as compared to 2020 net income of $19,222,000 or $1.30 per share. Effective July 1, 2020, the Corporation acquired Covenant Financial, Inc. (“Covenant”). In 2020, the Corporation incurred pre-tax merger-related expenses related to the Covenant transaction of $7.7 million. In the fourth quarter 2020, the Corporation incurred a pre-tax loss of $1.6 million on prepayment of long-term borrowings (Federal Home Loan Bank of Pittsburgh advances) with outstanding balances totaling $48.0 million. The borrowings included several advances maturing in 2022 through 2024 with a weighted-average interest rate of 1.77% and a weighted-average duration of 2.3 years. Excluding the impact of merger-related expenses and loss on prepayment of borrowings, adjusted (non-U.S. GAAP) earnings for 2020 would be $26,648,000 or $1.80 per share.

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The following table provides a reconciliation of the Corporation’s 2021 and 2020 earnings results under U.S. generally accepted accounting principles (U.S. GAAP) to comparative non-U.S. GAAP results excluding merger-related expenses and loss on prepayment of borrowings. Management believes disclosure of 2021 and 2020 earnings results, adjusted to exclude the impact of these items, provides useful information to investors for comparative purposes.

RECONCILIATION OF NET INCOME AND

DILUTED EARNINGS PER SHARE TO NON-U.S.

GAAP MEASURE

(Dollars In Thousands, Except Per Share Data)

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(1) Income tax has been allocated based on a marginal income tax rate of 21%. The effect on the income tax provision is adjusted for the estimated nondeductible portion of the expenses.

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Other significant variances were as follows:

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More detailed information concerning the Corporation’s earnings results are provided in other sections of Management’s Discussion and Analysis.

ACQUISITION OF COVENANT FINANCIAL, INC.

The Corporation’s acquisition of Covenant was completed July 1, 2020. Covenant was the parent company of Covenant Bank, which operated banking offices in Bucks and Chester Counties of Pennsylvania. Pursuant to the transaction, Covenant merged with and into the Corporation and Covenant Bank merged with and into C&N Bank. Total purchase consideration was $63.3 million, including common stock with a fair value of $41.6 million and cash of $21.7 million. The acquisition of Covenant followed the acquisition of Monument Bancorp, Inc. (“Monument”) on April 1, 2019. Monument was the parent company of Monument Bank, with banking and lending offices in Bucks County, Pennsylvania. The total transaction value of the Monument acquisition was $42.7 million.

In connection with the Covenant acquisition, effective July 1, 2020, the Corporation recorded goodwill of $24.1 million and a core deposit intangible asset of $3.1 million. Assets acquired included loans valued at $464.2 million, cash and due from banks of $97.8 million, bank-owned life insurance valued at $11.2 million and securities valued at $10.8 million. Liabilities assumed included deposits valued at $481.8 million, borrowings valued at $64.0 million and subordinated debt valued at $10.1 million. The assets purchased and liabilities assumed in the acquisition were recorded at their preliminary estimated fair values at the time of closing subject to adjustment for up to one year subsequent to the acquisition. There were no adjustments to the fair values of assets acquired and liabilities assumed in the Covenant acquisition subsequent to December 31, 2020.

CRITICAL ACCOUNTING POLICIES

The presentation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.

Allowance for Loan Losses – A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. The Corporation maintains an allowance for loan losses that represents management’s estimate of the losses inherent in the loan portfolio as of the balance sheet date and recorded as a reduction of the investment in loans. Management believes the allowance for loan losses is adequate and reasonable. Notes 1 and 8 to the consolidated financial statements provide an overview of the process management uses for evaluating and determining the allowance for loan losses, and additional discussion of the allowance for loan losses is provided in a separate section later in Management’s Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

As described more fully in Note 2 to the consolidated financial statements, effective January 1, 2023, the Corporation is adopting Accounting Standards Update (ASU) 2016-13, Financial Instruments-Credit Losses (Topic 326), as modified by subsequent ASUs, the required change in accounting for credit losses on loans receivable from an incurred loss methodology to an expected credit loss methodology commonly referred to as “CECL.”  Upon adoption of CECL, the allowance for credit losses will be based on the Corporation’s historical loan loss experience, borrower characteristics, forecasts of future economic conditions and other relevant

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factors. The Corporation will also apply qualitative factors to account for information that may not be reflected in quantitatively derived results or other relevant factors to ensure the allowance reflects management’s best estimate of current expected credit losses.

Fair Value of Available-For-Sale Debt Securities – Another material estimate is the calculation of fair values of the Corporation’s debt securities. For most of the Corporation’s debt securities, the Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services.

NET INTEREST INCOME

The Corporation’s primary source of operating income is net interest income, which is equal to the difference between the amounts of interest income and interest expense. Tables I, II and III include information regarding the Corporation’s net interest income in 2022, 2021 and 2020. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. The Corporation believes presentation of net interest income on a fully taxable-equivalent basis provides investors with meaningful information for purposes of comparing returns on tax-exempt securities and loans with returns on taxable securities and loans. Accordingly, the net interest income amounts reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the tables.

2022 vs. 2021

Fully taxable equivalent net interest income was $84,354,000 in 2022, $5,280,000 (6.7%) higher than in 2021. Interest income was $8,237,000 higher in 2022 as compared to 2021; interest expense was higher by $2,957,000 in comparing the same periods. As presented in Table II, the Net Interest Margin was 3.77% in 2022, as compared to 3.69% in 2021, and the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) increased slightly to 3.57% in 2022 from 3.55% in 2021. The average yield on earning assets of 4.19% was 0.20% higher in 2022 as compared to 2021, and the average rate on interest bearing liabilities of 0.62% was 0.18% higher in 2022 as compared to 2021. Table III shows that, in the aggregate, rising interest rates in 2022 had a positive impact on net interest income as the portion of the increase attributable to changes in rate was $4,976,000.

Income from purchase accounting-related adjustments in 2022 had a positive effect on net interest income of $1,621,000, including an increase in income on loans of $1,216,000 and a net reduction in interest expense on time deposits and borrowed funds totaling $405,000. The positive impact of purchase accounting-related adjustments to the net interest margin was 0.07% in 2022. In comparison, the net positive impact of purchase accounting-related adjustments was $2,659,000, with a positive impact on the net interest margin of 0.13% in 2021.

INTEREST INCOME AND EARNING ASSETS

Interest income totaled $93,873,000 in 2022, an increase of $8,237,000, or 9.6% from 2021.

Interest income from available-for-sale debt securities, on a fully taxable-equivalent basis, increased $3,610,000 in 2022 as compared to 2021, as the average balance (at amortized cost) of available-for-sale debt securities increased $168.2 million as indicated in Table II. The average yield on available-for-sale debt securities was 2.16% for 2022, down slightly from 2.17% in 2021.

Interest and fees from loans receivable increased $4,289,000 in 2022 as compared to 2021. Total interest and fees from loans excluding PPP loans increased $9,861,000 in 2022 as compared to 2021. Interest and fees on PPP loans totaled $958,000 in 2022, a decrease of $5,572,000 from 2021, as previously deferred fees were recognized in income upon the SBA’s repayment of loans based on forgiveness of the underlying borrowers. In 2022, total interest and fees on loans included $1,852,000 from repayments received on purchased credit impaired loans in excess of previous carrying amounts as compared to income from similar repayments of $231,000 in 2021.

Average outstanding loans receivable increased $31,338,000 (2.0%) to $1,628,094,000 in 2022 from $1,596,756,000 in 2021, despite a reduction in average PPP loans of $89,246,000. Average total loans outstanding, excluding PPP loans, increased $120,584,000 (8.0%).

The fully taxable equivalent yield on loans in 2022 was 4.98% compared to 4.81% in 2021. The average yield on loans included the positive impact of the income on PCI loans in 2022. The comparatively high yield on PPP loans provided a benefit to the margin in both

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periods through the higher volume resulted in a larger benefit in 2021. Excluding PPP loans and income from excess repayments on purchased credit impaired loans, the adjusted yield on loans was 4.83% in 2022, up from the similarly adjusted yield of 4.67% in 2021.

Income from interest-bearing due from banks totaled $645,000 in 2022, an increase of $327,000 from the total for 2021. The average yield on interest-bearing due from banks was 1.25% in 2022 and 0.20% in 2021. The average balance of interest-bearing due from banks was $51,407,000 in 2022 as compared to $156,152,000 in 2021. The average balance of interest-bearing due from banks fell to 2.3% of average earning assets in 2022 from 7.3% in 2021 as excess funds were invested in securities and loans. Within this category, the largest asset balance in 2022 and 2021 has been interest-bearing deposits held with the Federal Reserve.

INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES

Interest expense increased $2,957,000, or 45.1%, to $9,519,000 in 2022 from $6,562,000 in 2021. Interest expense on deposits increased $2,100,000. Table II shows the average rate on interest-bearing deposits increased to 0.46% in 2022 from 0.33% in 2021 reflecting the impact of increases in market rates in 2022.

Average total deposits (interest-bearing and noninterest-bearing) increased $75,012,000 (3.9%) to $1,980,412,000 in 2022 from $1,905,400 in 2021. Average time deposits decreased $42,552,000, while the average total balance of other categories increased $117,564,000, or 7.5%. The increase in average deposits includes the impact of growth in commercial deposits, reflecting higher average balances maintained and new business.

Interest expense on short-term borrowings in 2022 was $429,000 as compared to $23,000 in 2021. The average balance of short-term borrowings increased to $21,766,000 in 2022 from $6,269,000 in 2021. The average rate on short-term borrowings was 1.97% in 2022 compared to 0.37% in 2021.

Interest expense on long-term borrowings (FHLB advances) increased $497,000 to $896,000 in 2022 from $399,000 in 2021. The average balance of long-term borrowings was $40,194,000 in 2022, down from an average balance of $44,026,000 in 2021. Borrowings are classified as long-term within the Tables based on their term at origination or assumption in business combinations. The average rate on long-term borrowings was 2.23% in 2022 compared to 0.91% in 2021.

Interest expense on senior notes issued in May 2021 totaled $477,000 in 2022 as compared to $293,000 in 2021. The average balance of the senior notes increased to $14,733,000 in 2022 from $9,129,000 in 2021. The average rate on senior notes was 3.24% in 2022 and 3.21% in 2021.

Interest expense on subordinated debt decreased $230,000 to $1,079,000 in 2022 from $1,309,000 in 2021. The average balance of subordinated debt decreased slightly to $27,116,000 in 2022 from $27,399,000 in 2021. The average rate on subordinated debt decreased to 3.98% in 2022 from 4.78% in 2021 including the net impact of a new issue of subordinated debt of $24,437,000, net, at an effective rate of 3.74% in May 2021 and the redemption of subordinated notes totaling $8,000,000 in the second quarter 2021 and $8,500,000 in the second quarter 2022.

2021 vs. 2020

Fully taxable equivalent net interest income was $79,074,000 in 2021, $10,529,000 (15.4%) higher than in 2020. Interest income was $7,496,000 higher in 2021 as compared to 2020; interest expense was lower by $3,033,000 in comparing the same periods. As presented in Table II, the Net Interest Margin was 3.69% in 2021, unchanged from 2020, and the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) increased to 3.55% in 2021 from 3.49% in 2020. The overall increase in net interest income resulted mainly from the acquisition of Covenant in the third quarter 2020 and income from the PPP loan program.

Income from purchase accounting adjustments in 2021 had a positive effect on net interest income in 2021 of $2,659,000, including an increase in income on loans of $1,289,000 and net reductions in interest expense on time deposits and borrowed funds totaling $1,370,000. In comparison, the net positive impact on net interest income of purchase accounting adjustments was $3,272,000 in 2020. The net positive impact to the net interest margin from purchase accounting adjustments was 0.13% in 2021 and 0.18% in 2020.

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INTEREST INCOME AND EARNING ASSETS

Interest income totaled $85,636,000 in 2021, an increase of 9.6% from 2020. Interest and fees on loans receivable increased $7,175,000, or 10.3%, to $76,781,000 in 2021 from $69,606,000 in 2020. Interest and fees on PPP loans totaled $6,530,000 in 2021, an increase of $3,606,000 over the total in 2020. Table III shows the increase in interest on loans including $8,016,000 attributable to an increase in volume and a decrease of $841,000 related to a decrease in average yield.

The average balance of loans receivable increased $151,658,000 (10.5%) to $1,596,756,000 in 2021 from $1,445,098,000 in 2020. The increase in average loans outstanding includes the effect of loans acquired from Covenant, effective July 1, 2020.

The fully taxable equivalent yield on loans in 2021 was 4.81% compared to 4.82% in 2020. In 2021, rates on variable rate loans and rates on most new loan originations decreased, and prepayments of loans increased, consistent with falling market interest rates throughout most of 2020 and 2021. Further, yields on loans acquired from Covenant on July 1, 2020 were recorded at then-current market yields, which were lower than the Corporation’s average portfolio yield before the acquisition. The overall yield on loans in 2021 included a benefit from the acceleration of fees recognized on PPP loans as repayments have been received from the SBA. As shown in Table II, in 2021, the average balance of 1st Draw PPP loans was $44,735,000 with an average yield of 7.77% and the average balance of 2nd Draw PPP loans was $52,917,000 with an average yield of 5.77%.

Interest income on available-for-sale debt securities totaled $8,471,000 in 2021, an increase of $268,000 from the total for 2020. As indicated in Table II, average available-for-sale debt securities (at amortized cost) totaled $390,163,000 in 2021, an increase of $61,718,000 (18.8%) from 2020. The average yield on available-for-sale debt securities decreased to 2.17% in 2021 from 2.50% in 2020, reflecting acceleration of calls and prepayments of amortizing securities and purchases of lower-yielding securities at recent, lower market rates.

Interest income from interest-bearing deposits in banks totaled $318,000 in 2021, an increase of $67,000 from the total for 2020. The most significant categories of assets within this category include interest-bearing balances held with the Federal Reserve and investments in certificates of deposit issued by other banks. The average balance increased $75,565,000, as increases in deposits and funds from loan repayments outpaced uses of funds for loan originations, purchases of securities and repayments of borrowings. The average balance of interest-bearing due from banks was 7.3% of average earning assets in 2021 as compared to 4.3% in 2020. The average yield on interest-bearing due from banks fell to 0.20% in 2021 from 0.31% in 2020, due to a decrease in market rates.

INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES

Interest expense decreased $3,033,000, or 31.6%, to $6,562,000 in 2021 from $9,595,000 in 2020. Table II shows that the overall cost of funds on interest-bearing liabilities decreased to 0.44% in 2021 from 0.72% in 2020.

Total average deposit balances (interest-bearing and noninterest-bearing) increased $318,991,000 to $1,905,400,000 in 2021 from $1,586,409,000 in 2020. The increase in average deposits includes the impact of the Covenant acquisition. The average rate on interest-bearing deposits decreased to 0.33% in 2021 from 0.60% in 2020. The decrease in average rate on deposits includes a decrease of 0.54% on time deposits. The average balance of time deposits fell to 17.2% of average total deposits in 2021 from 25.1% in 2020, further contributing to the reduction in average rate on deposits.

Interest expense on short-term borrowings decreased $344,000 to $23,000 in 2021 from $367,000 in 2020. The average balance of short-term borrowings decreased to $6,269,000 in 2021 from $34,212,000 in 2020. The average rate on short-term borrowings decreased to 0.37% in 2021 from 1.07% in 2020.

Interest expense on long-term borrowings (FHLB advances) decreased $892,000 to $399,000 in 2021 from $1,291,000 in 2020. The average balance of long-term borrowings was $44,026,000 in 2021, down from an average balance of $83,500,000 in 2020. The average rate on long-term borrowings was 0.91% in 2021 compared to 1.55% in 2020. The reduction in both average balance and rate reflects the prepayment of borrowings of $48,036,000 in December 2020.

Interest expense on senior notes issued in May 2021 totaled $293,000 in 2021. The average balance of the senior notes was $9,129,000 in 2021 with an average rate of 3.21%.

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Interest expense on subordinated debt increased $603,000 to $1,309,000 in 2021 from $706,000 in 2020. The average balance of subordinated debt increased to $27,399,000 in 2021 from $11,553,000 in 2020 reflecting the net impact of subordinated debt agreements assumed in the Covenant transaction of $10,091,000 in July 2020, the new issue of subordinated debt of $24,437,000, net, in May 2021 and the redemption of subordinated notes totaling $8,000,000 in June 2021. The average rate on subordinated debt decreased to 4.78% in 2021 from 6.11% in 2020.

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TABLE I - ANALYSIS OF INTEREST INCOME AND EXPENSE

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TABLE II - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES

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TABLE III -  ANALYSIS OF VOLUME AND RATE CHANGES

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NONINTEREST INCOME

TABLE IV - COMPARISON OF NONINTEREST INCOME

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NONINTEREST EXPENSE

TABLE V - COMPARISON OF NONINTEREST EXPENSE

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Additional detailed information concerning fluctuations in the Corporation’s earnings results and other financial information are provided in other sections of Management’s Discussion and Analysis.

INCOME TAXES

The effective income tax rate was 17.7% of pre-tax income in 2022, down from 18.9% in 2021 and up from 17.2% in 2020. The Corporation’s effective tax rates differed from the federal statutory rate of 21% mainly because of the effects of tax-exempt interest income. The lower effective income tax rate in 2022 as compared to 2021 includes the impact of higher tax-exempt interest as a percentage of pre-tax income, a larger permanent difference (deduction) related to restricted stock compensation and the benefit of a $340,000 reduction in expense from the reversal of tax penalties being non-deductible. The higher effective income tax rate in 2021 as compared to 2020 resulted mainly from a reduction in the proportion of tax-exempt interest income to total pre-tax income.

The Corporation recognizes deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax basis of assets and liabilities. At December 31, 2022, the net deferred tax asset was $20,884,000, up from the balance at December 31, 2021 of $5,887,000. The most significant change in temporary difference components was an increase of $14,669,000 in the net deferred tax asset related to the unrealized loss on available-for-sale debt securities resulting from increases in interest rates.

The Corporation regularly reviews deferred tax assets for recoverability based on history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income, including taxable income in prior carryback years, as well as future taxable income. Further, the value of the benefit from realization of deferred tax assets would be impacted if income tax rates were changed from currently enacted levels.

Management believes the recorded net deferred tax asset at December 31, 2022 is fully realizable; however, if management determines the Corporation will be unable to realize all or part of the net deferred tax asset, the Corporation would adjust the deferred tax asset, which would negatively impact earnings.

Additional information related to income taxes is presented in Note 14 to the consolidated financial statements.

SECURITIES

Management continually evaluates several objectives in determining the size, securities mix and other characteristics of the available-for-sale debt securities (investment) portfolio. Key objectives include supporting liquidity needs, maximizing return on earning assets within reasonable risk parameters and providing a means to hedge the Corporation’s overall asset-sensitive interest rate risk exposure, while maintaining high credit quality.

Table VI shows the composition of the available-for-sale debt securities portfolio at December 31, 2022, 2021 and 2020. The total amortized cost of available-for-sale debt securities increased $50,202,000 to $561,794,000 at December 31, 2022 from $511,592,000 at December 31, 2021. The increase in 2022 followed an increase of $177,040,000 at December 31, 2021 as compared to December 31,

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2020. The increase in the amortized cost basis of the securities portfolio resulted from management’s decision to invest excess funds available from the growth in deposits and net loan repayments throughout most of 2020, 2021 and the first quarter 2022.

At December 31, 2022, the largest categories of securities held as a percentage of total amortized cost, were as follows: (1) tax-exempt and taxable municipal bonds, 38.2%; (2) residential mortgage-backed securities issued or guaranteed by U.S. Government agencies or sponsored agencies, including pass-through securities and collateralized mortgage obligations, 28.1%; and (3) commercial mortgage-backed securities issued or guaranteed by U.S. Government sponsored agencies, 16.3%.

The composition of the available-for-sale debt securities portfolio at December 31, 2022, December 31, 2021 and December 31, 2020 is as follows:

TABLE VI - INVESTMENT SECURITIES

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(a) Source: Treasury.gov (Daily Treasury Par Yield Curve Rates)

As reflected in the table above, the fair value of available-for-sale securities as of December 31, 2022 was lower than the amortized cost basis by $63,761,000, or 11.3%. In comparison, the aggregate unrealized gain position was $6,087,000 (1.2%) at December 31, 2021 and $14,780,000 (4.4%) at December 31, 2020. The unrealized decrease in fair value of the portfolio in 2022 and in 2021 resulted from an increase in interest rates. As shown above, the market yield on the 5-year U.S. Treasury Note was 2.73% higher at December 31, 2022 in comparison to December 31, 2021, and 3.63% higher than at December 31, 2020.

Management reviewed the Corporation’s holdings as of December 31, 2022 and concluded there were no credit-related declines in fair value and that the unrealized losses on all of the securities in an unrealized loss position are considered temporary. In assessing whether there were other-than-temporary impairment losses, management considered (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value, and (4) whether the Corporation intends to sell the security or if it is more likely than not that the Corporation will be required to sell the security before the recovery of its amortized cost basis.

Additional information regarding the potential impact of interest rate changes on all of the Corporation’s financial instruments is provided in Item 7A, Quantitative and Qualitative Disclosures about Market Risk.

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The following table presents the contractual maturities and the weighted-average yields (calculated based on amortized cost) of investment securities as of December 31, 2022. Yields on tax-exempt securities are presented on a fully taxable-equivalent basis. For callable securities, yields on securities purchased at a discount are based on yield-to-maturity, while yields on securities purchased at a premium are based on yield to the first call date. Yields on mortgage-backed securities are estimated and include the effects of prepayment assumptions. Actual maturities may differ from contractual maturities because counterparties may have the right to call or prepay obligations with or without call or prepayment penalties.

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The Corporation’s mortgage-backed securities and collateralized mortgage obligations have stated maturities that may differ from actual maturities due to borrowers’ ability to prepay obligations. Cash flows from such investments are dependent upon the performance of the underlying mortgage loans and are generally influenced by the level of interest rates. As rates increase, cash flows generally decrease as prepayments on the underlying mortgage loans decrease. As rates decrease, cash flows generally increase as prepayments increase due to increased refinance activity and other factors. In the table above, the entire balances and weighted-average rates for mortgage-backed securities and collateralized mortgage obligations are shown in one period.

FINANCIAL CONDITION

This section includes information regarding the Corporation’s lending activities or other significant changes or exposures that are not otherwise addressed in Management’s Discussion and Analysis. Significant changes in the average balances of the Corporation’s earning assets and interest-bearing liabilities are described in the Net Interest Income section of Management’s Discussion and Analysis. Other significant balance sheet items, including securities, the allowance for loan losses and stockholders’ equity, are discussed in separate sections of Management’s Discussion and Analysis. There are no significant concerns that have arisen related to the Corporation’s off-balance sheet loan commitments or outstanding letters of credit at December 31, 2022, and management does not expect the amount of purchases of bank premises and equipment to have a material, detrimental effect on the Corporation’s financial condition in 2023.

Table VII shows the composition of the loan portfolio at year-end from 2018 through 2022. The significant loan growth in 2019 and 2020 reflects the impact of acquisitions. After a reduction in outstanding loans at December 31, 2021 as compared to a year earlier, loan growth was robust in 2022 as the recorded investment in commercial loans was up $133,127,000 (13.6%), and residential mortgage loans were up $39,760,000 (7.0%), from year-end 2021. The volume of residential mortgage loans originated and sold into the secondary market fell significantly in 2022 as higher interest rates dampened market activity. In 2022, a substantial portion of new mortgage loans the Corporation originated were 5/1, 7/1 and 10/1 adjustable rate loans that were retained for investment on the balance sheet. At December 31, 2022, commercial loans represented approximately 64% of the portfolio while residential mortgage loans totaled 35% of the portfolio.

While the Corporation’s lending activities are primarily concentrated in its market areas, a portion of the Corporation’s commercial loan segment consists of participation loans. Participation loans represent portions of larger commercial transactions for which other

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institutions are the “lead banks”. Although not the lead bank, the Corporation conducts detailed underwriting and monitoring of participation loan opportunities. Participation loans are included in the “Commercial and industrial”, “Commercial loans secured by real estate”, “Political subdivisions” and “Other commercial” classes in the loan tables presented in this Form 10-K. Total participation loans outstanding amounted to $44,723,000 at December 31, 2022, down from $54,372,000 at December 31, 2021. As described in more detail in the Provision and Allowance for Loan Losses section of Management’s Discussion and Analysis, the Corporation recorded partial charge-offs totaling $3,942,000 on a commercial real estate secured participation loan with a recorded investment of $2,654,000 at December 31, 2022. At December 31, 2022, the balance of participation loans outstanding includes a total of $13,563,000 to businesses located outside of the Corporation’s market areas. Also, included within participation loans are “leveraged loans,” meaning loans to businesses with minimal tangible book equity and for which the extent of collateral available is limited, though typically at the time of origination the businesses have demonstrated strong cash flow performance in their recent histories. Leveraged participation loans totaled $2,370,000 at December 31, 2022 and $7,469,000 at December 31, 2021.

The Corporation originates and sells residential mortgage loans to the secondary market through the MPF Xtra program administered by the Federal Home Loan Banks of Pittsburgh and Chicago. Residential mortgages originated and sold through the MPF Xtra program consist primarily of conforming, prime loans sold to the Federal National Mortgage Association (Fannie Mae), a quasi-government entity. The Corporation also originates and sells residential mortgage loans to the secondary market through the MPF Original program, administered by the Federal Home Loan Banks of Pittsburgh and Chicago. Residential mortgages originated and sold through the MPF Original program consist primarily of conforming, prime loans sold to the Federal Home Loan Bank of Pittsburgh. The Corporation also may originate and sell larger-balance, nonconforming mortgages under the MPF Direct Program. The Corporation does not retain servicing rights for loans sold under the MPF Direct Program. Through December 31, 2022, the Corporation’s activity under the MPF Direct Program has been minimal.

For loan sales originated under the MPF programs, the Corporation provides customary representations and warranties to investors that specify, among other things, that the loans have been underwritten to the standards established by the investor. The Corporation may be required to repurchase a loan and reimburse a portion of fees received or reimburse the investor for a credit loss incurred on a loan, if it is determined that the representations and warranties have not been met. Such repurchases or reimbursements generally result from an underwriting or documentation deficiency. At December 31, 2022, the total outstanding balance of loans the Corporation has repurchased as a result of identified instances of noncompliance amounted to $1,515,000, and the corresponding total outstanding balance of repurchased loans at December 31, 2021 was $1,571,000.

At December 31, 2022, outstanding balances of loans sold and serviced through the MPF Xtra and Original programs totaled $325,677,000, including loans sold through the MPF Xtra program of $155,506,000 and loans sold through the Original program of $170,171,000. At December 31, 2021, outstanding balances of loans sold and serviced through the two programs totaled $334,741,000, including loans sold through the MPF Xtra program of $165,668,000 and loans sold through the Original Program of $169,073,000. Based on the fairly limited volume of required repurchases to date, no allowance has been established for representation and warranty exposures as of December 31, 2022 and December 31, 2021.

For loans sold under the Original program, the Corporation provides a credit enhancement whereby the Corporation would assume credit losses in excess of a defined First Loss Account (“FLA”) balance, up to specified amounts. The FLA is funded by the Federal Home Loan Bank of Pittsburgh based on a percentage of the outstanding balance of loans sold. At December 31, 2022, the Corporation’s maximum credit enhancement obligation under the MPF Original Program was $6,392,000, and the Corporation has recorded a related allowance for credit losses in the amount of $425,000 which is included in accrued interest and other liabilities in the accompanying consolidated balance sheets. At December 31, 2021, the Corporation’s maximum credit enhancement obligation under the MPF Original Program was $8,656,000, and the related allowance for credit losses was $635,000. Income related to providing the credit enhancement (included in other noninterest income in the consolidated statements of income) totaled $292,000 in 2022, $348,000 in 2021 and $227,000 in 2020. A credit for losses related to the credit enhancement obligation (included in other noninterest expense in the consolidated statements of income) of $172,000 was recorded in 2022 as compared to a provision for losses of $135,000 in 2021 and $167,000 in 2020. The Corporation does not provide a credit enhancement for loans sold through the Xtra program.

The Corporation is a participating SBA lender. Under the terms of its arrangements with the SBA, the Corporation may originate loans to commercial borrowers, with full-or-partial guarantees by the SBA, subject to the SBA’s underwriting and documentation requirements. Pursuant to an acquisition, the Corporation acquired loans with partial SBA guarantees, or in some cases, loans where the SBA-guaranteed portion of the loans had been sold back to the SBA subject to ongoing compliance with SBA underwriting and documentation requirements. As part of its due diligence, the Corporation reviewed all the purchased loans originated through the

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various SBA loan programs as of July 1, 2020 and recorded an allowance for SBA claim adjustments. Determination of the allowance was subjective in nature and was based on the Corporation’s assessment of the credit quality of the loans and the quality of the documentation supporting compliance with SBA requirements. The Corporation’s total exposure related to SBA guarantees on purchased loans was $4,847,000 at December 31, 2022 and $12,856,000 at December 31, 2021 with an allowance for SBA claim adjustments (included in accrued interest and other liabilities in the consolidated balance sheets) of $90,000 at December 31, 2022 and $457,000 at December 31, 2021. In 2022, the Corporation recorded a reduction in other noninterest expense of $367,000 representing amounts realized on SBA claims in excess of prior estimates, as compared to reductions of $236,000 in 2021 and $70,000 in 2020.

TABLE VII – Five-year Summary of Loans by Type

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TABLE VIII – LOAN MATURITY DISTRIBUTION

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PROVISION AND ALLOWANCE FOR LOAN LOSSES

The Corporation maintains an allowance for loan losses that represents management’s estimate of the losses inherent in the loan portfolio as of the balance sheet date and recorded as a reduction of the investment in loans. Notes 1 and 8 to the consolidated financial statements provide an overview of the process management uses for evaluating and determining the allowance for loan losses.

While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

The allowance for loan losses was $16,615,000 at December 31, 2022, up from $13,537,000 at December 31, 2021. Table X shows total specific allowances on impaired loans of $453,000 at December 31, 2022, down from $740,000 at December 31, 2021. Table X also shows the increase in the allowance in 2022 is mainly related to commercial loans, as the collectively evaluated portion of the allowance related to the commercial segment increased to $10,845,000 at December 31, 2022 from $7,553,000 at December 31, 2021. Table X also shows that the allowance has increased at each year-end from 2018 through 2022, reflecting the impact of loan growth and other factors, though the total specific allowance on individually impaired loans has decreased each year.

Table XI shows the allowance for loan losses totaled 0.95% of gross loans outstanding at December 31, 2022, up from 0.87% at December 31, 2021. This ratio declined in 2019 and again in 2020 when loans acquired in business combinations were recorded at their initial fair values, including an estimated adjustment for credit losses, with no allowance initially recorded on those loans. Accordingly, the allowance as a percentage of loans dipped from 1.12% at December 31, 2018 to 0.83% at December 31, 2019 following the Monument acquisition and then to 0.69% at December 31, 2020 following the Covenant acquisition. Table XI also shows that the total of the allowance and the credit adjustment on purchased non-impaired loans, as a percentage of total loans plus the credit adjustment, was 1.06% at December 31, 2022, in line with ratios from the previous years.

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The provision (credit) for loan losses by segment for 2022, 2021 and 2020 is as follows:

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The provision for loan losses is further detailed as follows:

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Commercial segment

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Residential mortgage segment

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Consumer segment

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Total – All segments

In 2022, the provision includes the impact of partial charge-offs totaling $3,942,000 on a commercial real estate secured participation loan to a borrower in the health care industry. The charge-offs resulted from the borrower’s default due to deterioration in financial performance. The recorded investment in the loan at December 31, 2022 (principal balance, net of partial charge-offs) was $2,654,000

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based on a settlement agreement reached with the borrower. At March 7, 2023, after the impact of payments received pursuant to the settlement agreement, the recorded investment in the loan was $474,000. The 2022 provision also includes $1,269,000 related to a net increase in historical loss factors, most of which resulted from the partial charge-offs just described. Further, the 2022 provision includes $3,974,000 attributable to increases in loan volume resulting from significant loan growth, particularly for the commercial segment, as well as an increase in the collectively determined portion of the allowance related to management’s updated assessment of purchased performing loans. In 2022, changes in qualitative factors resulted in a reduction in the provision of $2,207,000, including reductions of $1,229,000 related to the commercial segment and $965,000 related to the residential mortgage segment. The reduction in the provision from changes in qualitative factors reflects management’s assessment that despite concerns that have arisen related to a limited number of commercial loans, the overall credit quality of the portfolio has been improving over the past several quarters.

In the tables immediately above, the portion of the net change in the collectively determined allowance attributable to loan growth was determined by applying the historical loss experience and qualitative factors used in the allowance calculation at the end of the preceding period to the net increase or reduction in loans outstanding (excluding loans specifically evaluated for impairment) for the period.

The effect on the provision of changes in historical loss experience and qualitative factors, as shown in the tables above, was determined by: (1) calculating the net change in each factor used in determining the allowance at the end of the period as compared to the preceding period, and (2) applying the net change in each factor to the outstanding balance of loans at the end of the preceding period (excluding loans specifically evaluated for impairment).

In 2022, net charge-offs were $4,177,000, including recoveries of $68,000 and charge-offs of $4,245,000. Table XII shows the average rate of net charge-offs as a percentage of loans was 0.26% in 2022, up from the annual average rates for the previous 4 years ranging from a high of 0.16% in 2020 to a low of 0.02% in 2018 and the 5-year average of 0.13%.

Table XI presents information related to past due and impaired loans, and loans that have been modified under terms that are considered TDRs. At December 31, 2022, impaired loans totaled $19,358,000, up from $15,734,000 at December 31, 2021. Similarly, total nonperforming loans of $25,322,000 at December 31, 2022 was up from $21,218,000 at December 31, 2021. At December 31, 2022, advances to a commercial borrower under lines of credit totaling $10,799,000 were classified as impaired and nonaccrual. Based on an estimate of the liquidation value of business assets that collateralize the lines of credit, there was no specific allowance recorded on these advances at December 31, 2022. Total nonperforming loans as a percentage of outstanding loans was 1.46% at December 31, 2022, up from 1.36% at December 31, 2021, and nonperforming assets as a percentage of total assets was 1.04% at December 31, 2022, up from 0.94% at December 31, 2021. Table XI presents data at the end of each of the years ended December 31, 2018 through 2022. Table XI shows that the year-end ratio of total nonperforming loans as a percentage of loans ranged from a low of 0.88% in 2019 to a high of 1.94% in 2018 and the ratio of total nonperforming assets as a percentage of assets ranged from a low of 0.80% in 2019 to a high of 1.37% in 2018.

Over the period 2018-2022, each period includes a few large commercial relationships that have required significant monitoring and workout efforts. As a result, a limited number of relationships may significantly impact the total amount of allowance required on impaired loans, and may significantly impact the provision for loan losses and the amount of total charge-offs reported in any one period.

Management believes it has been conservative in its decisions concerning identification of impaired loans, estimates of loss, and nonaccrual status; however, the actual losses realized from these relationships could vary materially from the allowances calculated as of December 31, 2022.

Tables IX through XII present historical data related to loans and the allowance for loan losses.

As described in Note 2 to the consolidated financial statements, effective January 1, 2023, the Corporation is adopting the required change in accounting for credit losses on loans receivable from an incurred loss methodology to an expected credit loss methodology commonly referred to as CECL. The allowance for credit losses will be based on the Corporation’s historical loss experience, borrower characteristics, forecasts of future economic conditions and other relevant factors. The Corporation will also apply qualitative factors to account for information that may not be reflected in quantitatively derived results or other relevant factors to ensure the allowance reflects management’s best estimate of current expected credit losses.

The Corporation is adopting CECL on January 1, 2023 using the modified retrospective approach.  Based on implementation efforts to date, management estimates CECL adoption will result in a reduction in retained earnings estimated at $1,000,000 to $3,000,000, net of

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tax. Management estimates CECL adoption will result in an increase in the allowance for credit losses of $2,000,000 to $4,000,000 over the balance in the allowance for loan losses of $16,615,000 at December 31, 2022.

The Corporation is in the process of finalizing its expected credit loss estimates and the operational and control structure supporting the process.

TABLE IX - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES

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TABLE X - COMPONENTS OF THE ALLOWANCE FOR LOAN LOSSES

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