FIRST COMMUNITY BANKSHARES INC /VA/ (FCBC) FY 2023 MD&A

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand our financial condition, changes in financial condition, and results of operations. MD&A contains forward-looking statements and should be read in conjunction with our consolidated financial statements, accompanying notes, and other financial information included in this report.

Executive Overview

First Community Bankshares, Inc. is a financial holding company, headquartered in Bluefield, Virginia, that provides banking products and services through its wholly owned subsidiary First Community Bank (the “Bank”), a 150 year-old Virginia-chartered banking institution. Unless the context suggests otherwise, the terms “First Community,” “Company,” “we,” “our,” and “us” refer to First Community Bankshares, Inc. and its subsidiaries as a consolidated entity.  As of December 31, 2023, the Bank operated 53 branches in Virginia, West Virginia, North Carolina and Tennessee. Our primary source of earnings is net interest income, the difference between interest earned on assets and interest paid on liabilities, which is supplemented by fees for services, commissions on sales, and various deposit service charges. We fund our lending and investing activities primarily through the retail deposit operations of our branch banking network supplemented by retail and wholesale repurchase agreements and Federal Home Loan Bank (“FHLB”) borrowings. We invest our funds primarily in loans to retail and commercial customers and various investment securities.

The Bank offers trust management, estate administration, and investment advisory services through its Trust Division and wholly owned subsidiary First Community Wealth Management (“FCWM”). The Trust Division manages inter vivos trusts and trusts under will, develops and administers employee benefit and individual retirement plans, and manages and settles estates. Fiduciary fees for these services are charged on a schedule related to the size, nature, and complexity of the account. Revenues consist primarily of commissions on assets under management and investment advisory fees. As of December 31, 2023, the Trust Division and FCWM managed and administered $1.49 billion in combined assets under various fee-based arrangements as fiduciary or agent.

On April 21, 2023, the Company completed the acquisition of Surrey Bancorp.  Total assets of $466.25 million were acquired in the transaction.  In addition the Company issued 2.99 million common shares in the transaction.  The purchase transaction created $14.38 million in goodwill and $12.7 million in other intangible assets. The Company completed the sale of its Emporia, Virginia branch to Benchmark Community Bank on September 16, 2022, which resulted in a gain of $1.66 million. The Company had no acquisition and divestiture activity during 2021.    For additional information, see Note 2, “Acquisitions and Divestitures,” to the Consolidated Financial Statements in Item 8 of this report.

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Critical Accounting Policies

Our consolidated financial statements are prepared in conformity with generally accepted accounting principles (“GAAP”) in the U.S. and prevailing practices in the banking industry. Our accounting policies, as presented in Note 1, “Basis of Presentation and Significant Accounting Policies,” to the Consolidated Financial Statements in Item 8 of this report are fundamental in understanding MD&A and the disclosures presented in Item 8, “Financial Statements and Supplementary Data,” of this report. Management may be required to make significant estimates and assumptions that have a material impact on our financial condition or operating performance. Due to the level of subjectivity and the susceptibility of such matters to change, actual results could differ significantly from management’s assumptions and estimates. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates used, we have identified the allowance for loan losses and goodwill as the accounting areas that require the most subjective or complex judgments or are the most susceptible to change.

Allowance for Credit Losses or "ACL"

The ACL reflects management’s estimate of losses that will result from the inability of our borrowers to make required loan payments. Management uses a systematic methodology to determine its ACL for loans held for investment and certain off-balance-sheet credit exposures. Management considers the effects of past events, current conditions, and reasonable and supportable forecasts on the collectability of the loan portfolio. The Company’s estimate of its ACL involves a high degree of judgment; therefore, management’s process for determining expected credit losses may result in a range of expected credit losses. It is possible that others, given the same information, may at any point in time reach a different reasonable conclusion. The Company’s ACL recorded in the balance sheet reflects management’s best estimate of expected credit losses. The Company recognizes in net income the amount needed to adjust the ACL for management’s current estimate of expected credit losses. See Note 1 – "Basis of Presentation - Significant Accounting Policies" in this Annual Report on Form 10-K for further detailed descriptions of our estimation process and methodology related to the ACL. See also Note 6 — "Allowance for Credit Losses" in this Annual Report on Form 10-K, “Allowance for Credit Losses” in this MD&A.

The Company uses a number of economic variables to estimate the allowance for credit losses, with the most significant driver being a forecast of the national unemployment rate. In the
December 31, 2023, estimate, the Company assumed an unemployment forecast range of
4.0% to 4.3%, compared to the range of
3.9% to 4.8% utilized in the
December 31, 2022, estimate.  Based on a sensitivity analysis as of
December 31, 2023, an increase of 1% in the unemployment forecast would result in an increase in the allowance for credit losses of approximately 9.00%.

Business Combinations

The Company accounts for business combinations using the acquisition method of accounting as outlined in using Topic 805 of the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”). Under this method, all identifiable assets acquired, including purchased loans, and liabilities assumed are recorded at fair value. Any excess of the purchase price over the fair value of net assets acquired is recorded as goodwill. In instances where the price of the acquired business is less than the net assets acquired, a gain on the purchase is recorded. Fair values are assigned based on quoted prices for similar assets, if readily available, or appraisals by qualified independent parties for relevant asset and liability categories. Certain financial assets and liabilities are valued using discount models that apply current discount rates to streams of cash flow. Valuation methods require assumptions, which can result in alternate valuations, varying levels of goodwill or bargain purchase gains, or amortization expense or accretion income. Management must make estimates for the useful or economic lives of certain acquired assets and liabilities that are used to establish the amortization or accretion of some intangible assets and liabilities, such as core deposits. Fair values are subject to refinement for up to one year after the closing date of the acquisition as additional information about the closing date fair values becomes available. Acquisition and divestiture activities are included in the Company’s consolidated results of operations from the closing date of the transaction. Acquisition and divestiture related costs are recognized in noninterest expense as incurred.

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Goodwill

Goodwill is tested for impairment annually, on October 31st, or more frequently if events or circumstances indicate there may be impairment.  We have one reporting unit, Community Banking.  If we elect to perform a qualitative assessment, we evaluate factors such as macroeconomic conditions, industry and market considerations, overall financial performance, changes in stock price, and progress towards stated objectives in determining if it is more likely than not that the fair value of our reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of our reporting unit is less than its carrying amount, a quantitative test is performed; otherwise, no further testing is required. The quantitative test consists of comparing the fair value of our reporting unit to its carrying amount, including goodwill. If the fair value of our reporting unit is greater than its book value, no goodwill impairment exists. If the carrying amount of our reporting unit is greater than its calculated fair value, a goodwill impairment charge is recognized for the difference. We performed a quantitative assessment for the annual test on October 31, 2023, which resulted in no goodwill impairment. For additional information, see Note 8, “Goodwill and Other Intangible Assets,” to the Consolidated Financial Statements in Item 8 of this report.

Non-GAAP Financial Measures

In addition to financial statements prepared in accordance with GAAP, we use certain non-GAAP financial measures that provide useful information for financial and operational decision making, evaluating trends, and comparing financial results to other financial institutions. The non-GAAP financial measures presented in this report include certain financial measures presented on a fully taxable equivalent (“FTE”) basis. While we believe certain non-GAAP financial measures enhance the understanding of our business and performance, they are supplemental and not a substitute for, or more important than, financial measures prepared in accordance with GAAP and may not be comparable to those reported by other financial institutions. The reconciliations of non-GAAP to GAAP measures are presented below.

We believe FTE basis is the preferred industry measurement of net interest income and provides better comparability between taxable and tax exempt amounts. We use this non-GAAP financial measure to monitor net interest income performance and to manage the composition of our balance sheet. FTE basis adjusts for the tax benefits of income from certain tax exempt loans and investments using the federal statutory income tax rate of 21%. The following table reconciles net interest income and margin, as presented in our consolidated statements of income, to net interest income on a FTE basis for the periods indicated:

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Performance Overview

Highlights of our results of operations in 2023, and financial condition as of December 31, 2023, include the following:

Results of Operations

Net Income

The following table presents the changes in net income and related information for the periods indicated:

2023 Compared to 2022.  Pre-tax income increased $1.82 million compared to 2022.  The increase was primarily attributable to an increase in net interest income of $15.02 million.  Net interest income totaled $127.68 million compared to $112.66 million in 2022.  The increase in net interest income was offset by an increase in the provision for credit losses of $1.41 million and an increase in noninterest expense of $12.06 million.  The increase in provision for credit losses was primarily due to $1.61 million recorded for the day two provision for the acquisition of the Surrey loan portfolio.  The increase in noninterest expense included a $3.00 million accrual for estimated litigation expenses, an increase in salaries and benefits costs of $2.70 million, and an increase of $1.80 million in merger expenses.  Both the merger expense and the increase in salaries and benefits were primarily due to the acquisition of Surrey Bancorp.

2022 Compared to 2021.   Pre-tax income decreased $6.37 million, or 9.58%, primarily due  to an increase of $15.04 million in provision for credit losses offset by an increase in net interest income of $10.19 million.  The increase in provision for credit losses of $15.04 million was attributable to a return to normalized provisions that include forecasts for higher unemployment rates and weaker macroeconomic trends as compared with prior year recoveries of pandemic-related provisioning.  The increase in net interest income of $10.19 million was primarily due to increases in both interest on securities and interest and fees on loans.  The increases were primarily driven by significant growth in both portfolios.  Interest on deposits in banks increased as well and was primarily driven by rate increases in the FOMC's target federal funds rate throughout 2022.

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Net Interest Income

Net interest income, our largest contributor to earnings, is analyzed on a fully taxable equivalent (“FTE”) basis, a non-GAAP financial measure. For additional information, see “Non-GAAP Financial Measures” above. The following table presents the consolidated average balance sheets and net interest analysis on a FTE basis for the dates indicated:

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The following table presents the impact to net interest income on a FTE basis due to changes in volume (average volume times the prior year’s average rate), rate (average rate times the prior year’s average volume), and rate/volume (average volume times the change in average rate), for the periods indicated:

2023 Compared to 2022. Net interest income comprised 77.32% of total net interest and noninterest income in 2023 compared to 75.19% in 2022.  Net interest income increased $15.02 million, or 13.33%, and increased $15.02 million, or 13.28%, on a FTE basis. The FTE net interest margin increased 52 basis points and the FTE net interest spread increased36 basis points.  The increase was primarily driven by increases in both average balances and rates for loans and securities available for sale.  The average balance for loans increased $239.86 million, while the yield increased 44 basis points resulting in a tax effected increase in interest on loans of $22.19 million compared to 2022.  The average balance for securities available for sale increased $42.17 million and the yield increased 31 basis points resulting in a tax effected increase to interest on securities available for sale of $1.94 million compared to 2022.

Average earning assets decreased $2.16 million, or 0.07%, primarily due to a decrease in interest-bearing deposits with banks of $284.18 million, or 85.91%.  This decrease was offset by an increase in average loans and average securities available for sale as noted above.  The yield on earning assets increased 79 basis points, or 19.85%, primarily due to significant increase in benchmark rates as compared to the same period of 2022.  The average loan to deposit ratio increased to 93.04% from 83.58% in 2022.  Non-cash accretion increased  $125 thousand, or 4.77% to $2.74 million.  The impact of non-cash purchase accounting accretion income on the FTE net interest margin was 9 basis points for both 2023 and 2022.

Average interest-bearing liabilities, which consist of interest-bearing deposits and borrowings, decreased $81.94 million, or 4.34%, primarily due to a decrease in deposits.  Time deposits decreased $54.20 million, or 16.82%, and savings deposits decreased $32.77 million, or 3.72%. Interest-bearing demand deposits increased $3.03 million or 0.44%.  The yield on interest-bearings liabilities increased 43 basis points and is primarily due to increases in benchmark rates throughout 2022 and 2023.

2022 Compared to 2021. Net interest income comprised 75.19% of total net interest and noninterest income in 2022 compared to 74.92% in 2021.  Net interest income increased $10.19 million, or 9.94%, and increased $10.20 million, or 9.91%, on a FTE basis. The FTE net interest margin increased 25 basis points and the FTE net interest spread increased 27 basis points.  The increase in net interest margin was primarily driven by an increase in yield on earning assets of 21 basis points, specifically, interest on deposits in banks. The increased yield on interest on deposits in banks was primarily driven by rate increases in the FOMC's target federal funds rate throughout 2022.

Average earning assets increased $81.32 million, or 2.90%, primarily due to an increase in average securities available for sale of $175.17 million, or 216.13%, and average loans of $145.40 million, or 6.75%.  The increases were offset by a decrease in average interest-bearing deposits in banks of $239.26 million, or 41.97%. The yield on earning assets increased 21 basis points primarily due to an increase in yield on interest on deposits in banks of 101 basis points to 1.14% compared to 0.13% in 2021.   The increase in yield was primarily driven by rate increases in the FOMC's target federal funds rate throughout 2022.  The average loan to deposit ratio increased to 83.58% from 80.71% in 2022.  Non-cash accretion income related to PCD loans decreased $2.04 million, or 43.77%, to $2.62 million due to reduced balances in the PCD portfolios. The impact of non-cash purchase accounting accretion income on the FTE net interest margin was 9 basis points compared to 17 basis points in 2021.

Average interest-bearing liabilities, which consist of interest-bearing deposits and borrowings, increased $35.78 million, or 1.93%, primarily due to an increase in average interest-bearing deposits. The yield on interest-bearing liabilities decreased 6 basis points.  Average interest-bearing deposits increased $34.74 million, or 1.88%, with increases of $63.33 million, or 7.75%, in average savings deposits, $36.50 million, or 5.64%, in average interest-bearing demand deposits, offset by a decrease of $65.09 million, or 16.81%, in average time deposits.

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Provision for Credit Losses

2023 Compared to 2022.  The provision charged to operations increased $1.41 million compared to the prior year.  The provision expense of $7.99 million was comprised of $8.44 million related to provision expense for loans and a recovery of provision of $450 thousand for unfunded loan commitments.  Provision for credit losses for loans of $8.44 million was recorded compared to the provision of $6.57 million recorded in 2022.  The increase in provision is commensurate with changes in economic forecasts and growth in the loan portfolio associated with the acquisition of Surrey Bancorp on April 21, 2023.  $1.61 million of the provision is attributable to day two provision for the Surrey portfolio.  As noted above a recovery of provision for loan commitments was recorded in 2023 of $450 thousand and was recorded in provision for credit losses.   A provision expense of $518 thousand was recorded for unfunded loan commitments in 2022 and was recorded in other operating expense.

2022 Compared to 2021.  The provision charged to operations increased $15.04 million, or 177.58%.  The increase was attributable to growth of the loan portfolio throughout 2022 and an economic forecast that projects higher unemployment rates and weaker macroeconomic trends.  The prior year included recoveries of pandemic-related provisioning.

Noninterest Income

The following table presents the components of, and changes in, noninterest income for the periods indicated:

2023 Compared to 2022. Noninterest income comprised 22.68% of total net interest and noninterest income in 2023 compared to 24.81% in 2022.  Noninterest income increased $270 thousand, or 0.73%.  The increase was primarily the result of an increase in other service charges and fees of $1.34 million, or 10.88%.  The increase in other services charges was primarily driven by an increase in interchange income. Wealth management income increased $324 thousand, or 8.40%.  These increases to noninterest income were offset by the 2022 gain recorded for the divestiture of the Emporia, Virginia branch of $1.66 million.

2022 Compared to 2021. Noninterest income comprised 24.81% of total net interest and noninterest income in 2022 compared to 25.08% in 2021. Noninterest income increased $2.88 million, or 8.40%, primarily due to the $1.66 million gain recognized from the sale of the Company's Emporia, Virginia, branch to Benchmark Community Bank in the third quarter of 2022.   Also contributing to the increase was $1.23 million in net FDIC indemnification asset amortization recognized in 2021, as the asset became fully amortized in 2021.  Service charges on deposits increased $767 thousand, or 5.70%, and is attributable to increased customer activity compared to the activity levels experienced during the pandemic lock-downs.  Other operating income decreased $658 thousand, or 11.33%, and is primarily attributable to the 2021 recovered amount of $1.00 million of an acquired loan from a failed bank acquisition that had been written down prior to acquisition.

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Noninterest Expense

The following table presents the components of, and changes in, noninterest expense for the periods indicated:

2023 Compared to 2022.  Non interest expense increased $12.06 million, or 14.51%, compared to 2022.  The Company recorded $3.00 million in estimated litigation expenses in the fourth quarter of 2023.  Other increases occurred in salaries and employee benefits of $2.70 million, or 5.73%, other operating expense of $1.56 million, or 14.89%, service fees of $1.30 million or 17.12%, and advertising and public relations of  $891 thousand, or 36.99%.  In addition, the Company recorded merger expenses of $2.39 million in 2023 related to the Surrey Bancorp acquisition.  The related cost for the addition of Surrey branches and staff was a primary driver in the increase to noninterest expense.

2022 Compared to 2021. Noninterest expense increased $4.40 million, or 5.59%.  The increase was primarily due to an increase in salaries and employee benefits of $2.94 million, or 6.65%, and service fees of $1.28 million, or 20.27%.  The increase in salaries and benefits is due to wage increases implemented in the first quarter of 2022 as part of the Company's strategic initiative to enhance Human Capital Management, which included an increased minimum wage.  Service fees increased due to an increase in core processing expense.  In addition, the Company recorded merger and divestiture expenses related to the announced Surrey Bancorp acquisition and the divestiture of the Company's Emporia Virginia branch of $596 thousand and $153 thousand, respectively.  These increases to expense were offset primarily by a decrease in other operating expense of $1.26 million, or 10.75%.  The decrease is primarily attributable to the 2021 write-down of bank property of $781 thousand.

Income Tax Expense

The Company’s effective tax rate, income tax as a percent of pre-tax income, may vary significantly from the statutory rate due to permanent differences and available tax credits. Permanent differences are income and expense items excluded by law in the calculation of taxable income. The Company’s most significant permanent differences generally include interest income on municipal securities and increases in the cash surrender value of life insurance policies.

2023 Compared to 2022. Income tax expense increased $459 thousand, or 3.40% and was primarily due to the increase in pre-tax income.  The effective tax rate increased slightly to 22.51% in 2023 compared to 22.43% in 2022.

2022 Compared to 2021. Income tax expense decreased $1.87 million or 12.14%, and is primarily attributable to the decrease in pre-tax net income.  The effective tax rate decreased to 22.43% in 2022 compared to 23.09% in 2021.

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Financial Condition

Total assets as of December 31, 2023, increased $132.97 million, or 4.24%, to $3.27 billion from $3.14 billion as of December 31, 2022. Total liabilities increased $51.66 million, or 1.90%, and stockholders' equity increased $81.31 million, or 19.27%.  The primary driver for the change in the balance sheet components was the acquisition of Surrey Bancorp on April 21, 2023.  Total assets of $466.25 million were acquired in the transaction.  In addition, the Company issued 2.99 million common shares in the purchase resulting in an increase in capital of $71.35 million.  The purchase transaction created $14.38 million in goodwill and $12.7 million in other intangible assets.

Investment Securities

Our investment securities are used to generate interest income through the deployment of excess funds, to fund loan demand or deposit liquidation, to pledge as collateral where required, and to make selective investments for Community Reinvestment Act purposes. The composition of our investment portfolio changes from time to time as we consider our liquidity needs, interest rate expectations, asset/liability management strategies, and capital requirements. Available-for-sale debt securities as of December 31, 2023, decreased $19.39 million, or 6.46%, compared to December 31, 2022. The decrease was  due to $83.59 million in maturities, prepayments, and calls, as well as sales of $38.98 million in securities available for sale.  Included in the sale of securities was the entire portfolio of Surrey with an acquired fair value of $20.93 million comprised primarily of U.S. Treasury securities.  A loss of $28 thousand was recognized in the sale of the portfolio.  The decreases were offset by purchases of $74.10 million and $20.93 million in investments acquired in the Surrey acquisition.  The market value of debt securities available for sale as a percentage of amortized cost was 95.23% as of December 31, 2023, compared to 93.82% as of December 31, 2022. There were no held-to-maturity debt securities as of December 31, 2023, or 2022.

The following table provides information about our investment portfolio as of the dates indicated:

There were no holdings of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of our total consolidated shareholders’ equity as of December 31, 2023 or 2022.

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Management evaluates securities for impairment where there has been a decline in fair value below the amortized cost basis of a security to determine whether there is a credit loss associated with the decline in fair value on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Credit losses are calculated individually, rather than collectively, using a discounted cash flow method, whereby Management compares the present value of expected cash flows with the amortized cost basis of the security.  The credit loss component would be recognized through the provision for credit losses and the creation of an allowance for credit losses. Consideration is given to (1) the financial condition and near-term prospects of the issuer including looking at default and delinquency rates, (2) the outlook for receiving the contractual cash flows of the investments, (3) the length of time and the extent to which the fair value has been less than cost, (4) our intent and ability to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value or for a debt security whether it is more-likely-than-not that we will be required to sell the debt security prior to recovering its fair value, (5) the anticipated outlook for changes in the general level of interest rates, (6) credit ratings, (7) third party guarantees, and (8) collateral values. In analyzing an issuer’s financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, the results of reviews of the issuer’s financial condition, and the issuer’s anticipated ability to pay the contractual cash flows of the investments. All of the U.S. Treasury and Agency-Backed Securities have the full faith and credit backing of the United State Government or one of its agencies. Municipal securities and all other securities that do not have a zero expected credit loss are evaluated quarterly to determine whether there is a credit loss associated with a decline in fair value. Based on the application of the new standard, and that all debt securities available for sale in an unrealized loss position as of December 31, 2023, continue to perform as scheduled, we do not believe that a provision for credit losses is necessary in 2023. We recognized no impairment charges in earnings associated with debt securities in 2022. For additional information, see Note 1, “Basis of Presentation and Significant Accounting Policies,” and Note 3, “Debt Securities,” to the Consolidated Financial Statements in Item 8, of this report.

Loans Held for Investment

Loans held for investment, our largest component of interest income, are grouped into commercial, consumer real estate, and consumer and other loan segments. Each segment is divided into various loan classes based on collateral or purpose. The general characteristics of each loan segment are as follows:

Total loans held for investment, net of unearned income, as of December 31, 2023, increased $172.10 million, or 7.17%, compared to December 31, 2022. primarily due to the Surrey acquisition with loans acquired totaling $239.08 million.  The largest components of Surrey's portfolio included approximately $98.89 million in non-farm, non-residential loans, $61.47 million commercial and industrial loans, and $23.03 million in non-owner occupied single family loans.  We had no foreign loans or loan concentrations to any single borrower or industry, which are not otherwise disclosed as a category of loans that represented 10% or more of outstanding loans, as of December 31, 2023 or 2022. For additional information, see Note 4, “Loans,” to the Consolidated Financial Statements in Item 8 of this report.

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The following table presents the maturities and rate sensitivities of the loan portfolio as of December 31, 2023:

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Risk Elements

We seek to mitigate credit risk by following specific underwriting practices and by ongoing monitoring of our loan portfolio. Our underwriting practices include the analysis of borrowers’ prior credit histories, financial statements, tax returns, and cash flow projections; valuation of collateral based on independent appraisers’ reports; and verification of liquid assets. We believe our underwriting criteria are appropriate for the various loan types we offer; however, losses may occur that exceed the reserves established in our allowance for loan losses. The Company has a loan review function independent of credit administration that performs a risk-based review of a sample of loans and loan relationships in the Company's commercial portfolio, and conducts analytical review of credit quality on the Company's non-commercial portfolios.

Nonperforming assets consist of nonaccrual loans, accrual loans contractually past due 90 days or more, modified loans past due 90 days or more, and other real estate owned ("OREO"). Prior to the adoption of ASU 2022-02, unseasoned troubled debt restructurings ("TDRs") were included in nonperforming assets.  Ongoing activity in the classification and categories of nonperforming loans include collections on delinquencies, foreclosures, loan restructurings, and movements into or out of the nonperforming classification due to changing economic conditions, borrower financial capacity, or resolution efforts.  For additional information, see Note 5, “Credit Quality,” to the Consolidated Financial Statements in Item 8 of this report.

The following table presents the components of nonperforming assets and related information as of the periods indicated:

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Nonperforming assets as of December 31, 2023, increased $2.25 million, or 12.95%, from December 31, 2022, with the largest increase due to an increase due to an increase in nonaccrual loans of $4.15 million.  The increase was offset by a decrease of $1.35 million in nonaccrual TDRs that was reported in December 31, 2022.  The adoption of ASU 2022-02, Financial Instruments-Credit Losses (Topic 326), Troubled Debt Restructurings and Vintage Disclosures, on January 1, 2023, eliminated the accounting guidance for troubled debt restructurings by creditors as provided in ASC 310-40, Receivables - Troubled Debt Restructuring by Creditors.  Therefore, the guidance applied prior to January 1, 2023, is no longer applicable.  OREO decreased $511 thousand, or 72.69% and accruing loans past due 90 days or more decreased $38 thousand from 2022.  As of December 31, 2023, nonaccrual loans were largely attributed to single family owner occupied (48.38%), non-farm, non-residential real estate (12.63%), and consumer loans (9.85%).  Certain loans included in the nonaccrual category have been written down to estimated realizable value or assigned specific reserves in the allowance for credit losses based on management's estimate of loss at ultimate resolution.

Delinquent loans, comprised of loans 30 days or more past due and nonaccrual loans, totaled $33.93 million as of December 31, 2023, a increase of $4.25 million, or 14.32%, compared to $29.68 million as of December 31, 2022. Delinquent loans as a percent of total loans totaled 1.32% as of December 31, 2023, which includes past due loans 0.57% and nonaccrual loans 0.75%, compared to 1.24%  as of December 31, 2022.

When restructuring loans for borrowers experiencing financial difficulty, we generally make concessions in interest rates, loan terms, or amortization terms.  As noted above, ASU 2022-02, eliminated and replaced the accounting guidance for borrowers experiencing financial difficulties previously applied under ASC 310-40, Receivables - Troubled Debt Restructurings by Creditors.  ASU 2022-02, Financial Instruments-Credit Losses (Topic 326), Troubled Debt Restructurings and Vintage Disclosures, discloses loans for borrowers experiencing financial difficulty as modified loans.  Total loans modified as of December 31, 2023, were $2.05 million.

OREO, which is carried at the lesser of estimated net realizable value or cost, consisted of 6 properties with an average holding period of 10 months as of December 31, 2023. The net loss on the sale of OREO was  $84 thousand in 2023, $453 thousand in 2022, and $231 thousand in 2021. The following table presents the changes in OREO during the periods indicated:

Allowance for Credit Losses (ACL)

The ACL reflects management’s estimate of losses that will result from the inability of our borrowers to make required loan payments. Management uses a systematic methodology to determine its ACL for loans held for investment and certain off-balance-sheet credit exposures. The ACL is a valuation account that is deducted from the amortized cost basis to present the net amount expected to be collected on the loan portfolio. Management considers the effects of past events, current conditions, and reasonable and supportable forecasts on the collectability of the loan portfolio. The Company’s estimate of its ACL involves a high degree of judgment; therefore, management’s process for determining expected credit losses may result in a range of expected credit losses. It is possible that others, given the same information, may at any point in time reach a different reasonable conclusion. The Company’s ACL recorded in the balance sheet reflects management’s best estimate of expected credit losses. The Company recognizes in net income the amount needed to adjust the ACL for management’s current estimate of expected credit losses. The Company’s measurement of credit losses policy adheres to GAAP as well as interagency guidance. The Company's ACL is calculated using collectively evaluated and individually evaluated loans.

For collectively evaluated loans, the Company in general uses two modeling approaches to estimate expected credit losses. The Company projects the contractual run-off of its portfolio at the segment level and incorporates a prepayment assumption in order to estimate exposure at default. Financial assets that have been individually evaluated can be returned to a pool for purposes of estimating the expected credit loss insofar as their credit profile improves and that the repayment terms were not considered to be unique to the asset.

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In addition to its own loss experience, management also includes peer bank historical loss experience in its assessment of expected credit losses to determine the ACL. The Company utilized call report data to measure historical credit loss experience with similar risk characteristics within the segments. For the majority of segment models for collectively evaluated loans, the Company incorporated at least one macroeconomic driver either using a statistical regression modeling methodology or simple loss rate modeling methodology.

Included in its systematic methodology to determine its ACL for loans held for investment and certain off-balance-sheet credit exposures, management considers the need to qualitatively adjust expected credit losses for information not already captured in the loss estimation process. These qualitative adjustments either increase or decrease the quantitative model estimation (i.e. formulaic model results). Each period, the Company considers qualitative factors that are relevant within the qualitative framework.  For further discussion of our Allowance for Credit Losses - See Note 1 - "Basis of Presentation - Significant Accounting Policies".

With the adoption of ASU 2016-13 effective January 1, 2021, the Company changed its method for calculating it allowance for loan losses from an incurred loss method to a life of loan method. See Note 1 – "Basis of Presentation and Significant Accounting Policies" for further details. As of December 31, 2023,  the balance of the ACL for loans was $36.19 million, or 1.41% of total loans. The ACL at December 31, 2023, increased $5.63 million from the balance of $30.56 million recorded December 31, 2022. This increase included a provision of $7.99 million and net charge-offs for the twelve months of $4.81 million. The increase in provision for the twelve months ended December 31, 2023, included a day two provision of $1.61 million for Surrey loans.  In addition, $2.01 million was added to the reserve for Surrey's purchased credit deteriorated loans.

At December 31, 2023, the Company also had an allowance for unfunded commitments of $746 thousand which was recorded in Other Liabilities on the Balance Sheet.  During 2023, there was a recovery of provision for credit losses on unfunded commitments of $450 thousand which was recorded in provision expense on the Statement of Income. During 2022, the provision for credit losses on unfunded commitments was $518 thousand and was recorded in other expense on the Statement of Income.

Management considered the allowance adequate as of December 31, 2023; however, no assurance can be made that additions to the allowance will not be required in future periods. For additional information, see “Allowance for Credit Losses or ("ACL")” in the “Critical Accounting Policies” section above and Note 6, “Allowance for Loan Losses,” to the Consolidated Financial Statements in Item 8 of this report.

The following table presents net charge-offs, by loan class, and the ratio to average loans during the periods indicated:

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The following table presents the allowance for loan losses, by loan class, as of the dates indicated:

Deposits

Total deposits as of December 31, 2023, increased $43.51 million, or 1.62%, compared to December 31, 2022.  The increase was primarily attributable to the acquisition of Surrey Bancorp.  The Company acquired $403.64 million in deposits in the transaction: acquiring $158.39 million in demand accounts, $99.32 million in interest-bearing demand, $102.70 million in savings, and $43.23 million in time deposit accounts.  Excluding the Surrey acquisition, deposits decreased $360.13 million with decreases occurring in savings of $103.35 million, demand deposits of $98.64 million, interest-bearing demand of $84.95 million, and time deposits of $73,18 million.  Deposit attrition related to Surrey post-merger totaled $70.77 million, with attrition of $36.97 million in interest-bearing demand, $13.65 million in time deposits, $13.18 million in demand, and $6.96 million in savings. We had no deposit concentrations to any single customer or industry that represented 10% or more of outstanding deposits as of December 31, 2023 or 2022.

The following schedule presents the contractual maturities of time deposits of $250 thousand or more as of December 31, 2023:

Borrowings

Total borrowings as of December 31, 2023, decreased $755 thousand, or 40.29%, compared to December 31, 2022. Total borrowings for 2023 were comprised entirely of short-term borrowings, which consist of retail repurchase agreements.  The weighted average rate of 0.06% as of December 31, 2023, decreased one basis point from the weighted average rate of 0.07% as of  December 31, 2022.

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Liquidity and Capital Resources

Liquidity

Liquidity is a measure of our ability to meet current and future cash flow needs as they become due. The liquidity of a financial institution reflects its ability to meet loan requests, to accommodate possible outflows in deposits and to take advantage of interest rate market opportunities. The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure that draws together all sources and uses of liquidity. The objective of our liquidity management is to manage cash flow and liquidity reserves so that they are adequate to fund our operations and to meet obligations and other commitments on a timely basis and at a reasonable cost. We seek to achieve this objective and ensure that funding needs are met by maintaining an appropriate level of liquid funds through asset/liability management, which includes managing the mix and time to maturity of financial assets and financial liabilities on our balance sheet.

Poor or inadequate liquidity risk management may result in a funding deficit that could have a material impact on our operations. We maintain a liquidity risk management policy and contingency funding policy (“Liquidity Plan”) to detect potential liquidity issues and protect our depositors, creditors, and shareholders. The Liquidity Plan includes various internal and external indicators that are reviewed on a recurring basis by our Asset/Liability Management Committee (“ALCO”) of the Board of Directors. ALCO reviews liquidity risk exposure and policies related to liquidity management; ensures that systems and internal controls are consistent with liquidity policies; and provides accurate reports about liquidity needs, sources, and compliance. The Liquidity Plan involves ongoing monitoring and estimation of potentially credit sensitive liabilities and the sources and amounts of balance sheet and external liquidity available to replace outflows during a funding crisis. The liquidity model incorporates various funding crisis scenarios and a specific action plan is formulated, and activated, when a financial shock that affects our normal funding activities is identified. Generally, the plan will reflect a strategy of replacing liability outflows with alternative liabilities, rather than balance sheet asset liquidity, to the extent that significant premiums can be avoided. If alternative liabilities are not available, outflows will be met through liquidation of balance sheet assets, including unpledged securities. As of December 31, 2023, management is not aware of any events that are reasonably likely to have a material adverse effect on our liquidity, capital resources or operations. In addition, management is not aware of any regulatory recommendations regarding liquidity that would have a material adverse effect on the Company.

In the ordinary course of business we have entered into contractual obligations and have made other commitments to make future payments. Refer to the accompanying notes to the Consolidated Financial Statements in Item 8 of this report for the expected timing of such payments as of December 31, 2023. These include payments related to (i) operating leases (Note - 7 Premises, Equipment, and Leases ), (ii) time deposits with stated maturity dates (Note 9 - Deposits), and (iii) commitments to extend credit and standby letters of credit (Note - 19 Litigation, Commitments, and Contingencies).

As a financial holding company, the Company’s primary source of liquidity is dividends received from the Bank, which are subject to certain regulatory limitations. Other sources of liquidity include cash, investment securities, and borrowings. As of December 31, 2023, the Company’s cash reserves and short-term investment securities totaled $14.68 million and $22.47 million, respectively.  The Company’s cash reserves and investments provide adequate working capital to meet obligations and projected dividends to shareholders for the next twelve months.

In addition to cash on hand and deposits with other financial institutions, we rely on customer deposits, cash flows from loans and investment securities, and lines of credit from the FHLB and the FRB Discount Window to meet potential liquidity demands. These sources of liquidity are immediately available to satisfy deposit withdrawals, customer credit needs, and our operations. Secondary sources of liquidity include approved lines of credit with correspondent banks and unpledged available-for-sale securities. As of December 31, 2023, our unencumbered cash totaled $116.42 million, unused borrowing capacity from the FHLB totaled $342.81 million, available credit from the FRB Discount Window totaled $123.81 million, available lines from correspondent banks totaled $100.00 million, and unpledged available-for-sale securities totaled $135.88 million.

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Capital Resources

We are committed to effectively managing our capital to protect our depositors, creditors, and shareholders. Failure to meet certain capital requirements may result in actions by regulatory agencies that could have a material impact on our operations. Total stockholders’ equity as of December 31, 2023, increased $81.31 million, or 19.27%, to $503.29 million from $421.99 million as of December 31, 2022.  The change in stockholders' equity was largely due to the acquisition of Surrey Bancorp.  The Company issued 2.99 million shares of common stock in the transaction resulting in an increase to capital of $71.35 million.  In addition, the Company earned $48.02 million, which was offset by repurchasing 768,079 shares of our common stock totaling $23.04 million and dividends on our common stock of $21.09 million. Our book value per common share increased $1.19 to $27.20 as of December 31, 2023, from $26.01 as of December 31, 2022.

Capital Adequacy Requirements

Risk-based capital guidelines, issued by state and federal banking agencies, include balance sheet assets and off-balance sheet arrangements weighted by the risks inherent in the specific asset type. Our current risk-based capital requirements are based on the international capital standards known as Basel III.  Our current minimum required capital ratios are as follows:

The following table presents our capital ratios as of the dates indicated:

As of December 31, 2023, we continued to meet all capital adequacy requirements and were classified as well-capitalized under the regulatory framework for prompt corrective action. Management believes there have been no conditions or events since those notifications that would change the Bank’s classification. Additionally, our capital ratios were in excess of the minimum standards under the Basel III capital rules on a fully phased-in basis, as of December 31, 2023. For additional information, see “Capital Requirements” in Part I, Item 1 and Note 20, “Regulatory Requirements and Restrictions,” to the Consolidated Financial Statements in Item 8 of this report.

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Market Risk and Interest Rate Sensitivity

Market risk represents the risk of loss due to adverse changes in current and future cash flows, fair values, earnings, or capital due to movements in interest rates and other factors. Our profitability is largely dependent upon net interest income, which is subject to variation due to changes in the interest rate environment and unbalanced repricing opportunities. We are subject to interest rate risk when interest-earning assets and interest-bearing liabilities reprice at differing times, when underlying rates change at different levels or in varying degrees, when there is an unequal change in the spread between two or more rates for different maturities, and when embedded options, if any, are exercised. ALCO reviews our mix of assets and liabilities with the goal of limiting exposure to interest rate risk, ensuring adequate liquidity, and coordinating sources and uses of funds while maintaining an acceptable level of net interest income given the current interest rate environment. ALCO is also responsible for overseeing the formulation and implementation of policies and strategies to improve balance sheet positioning and mitigate the effect of interest rate changes.

In order to manage our exposure to interest rate risk, we periodically review internal and third-party simulation models that project net interest income at risk, which measures the impact of different interest rate scenarios on net interest income, and the economic value of equity at risk, which measures potential long-term risk in the balance sheet by valuing our assets and liabilities at fair value under different interest rate scenarios. Simulation results show the existence and severity of interest rate risk in each scenario based on our current balance sheet position, assumptions about changes in the volume and mix of interest-earning assets and interest-bearing liabilities, and estimated yields earned on assets and rates paid on liabilities. The simulation model provides the best tool available to us and the industry for managing interest rate risk; however, the model cannot precisely predict the impact of fluctuations in interest rates on net interest income due to the use of significant estimates and assumptions. Actual results will differ from simulated results due to the timing, magnitude, and frequency of interest rate changes; changes in market conditions and customer behavior; and changes in our strategies that management might undertake in response to a sudden and sustained rate shock.

At December 31, 2023, the Federal Open Market Committee set the benchmark federal funds rate at a range of 5.25% - 5.50% basis points. The following table presents the sensitivity of net interest income from immediate and sustained rate shocks in various interest rate scenarios over a twelve-month period for the periods indicated.  In the downward rate shock presented, benchmark interest rates were assumed at levels with floors near 0%.  The following table presents the sensitivity of net interest income from immediate and sustained rate shocks in various interest rate scenarios over a twelve-month period for the periods indicated.

We have established policy limits for tolerance of interest rate risk in various interest rate scenarios and exposure limits to changes in the economic value of equity. As of December 31, 2023, we feel our exposure to interest rate risk was adequately mitigated for the scenarios presented.