FINANCIAL INSTITUTIONS INC (FISI) FY 2021 MD&A

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

The following is a discussion and analysis of our financial position and results of operations and should be read in conjunction with the information set forth under Part I, Item 1A, “Risks Factors,” and our consolidated financial statements and notes thereto appearing under Part II, Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K.

INTRODUCTION

Financial Institutions, Inc. (the “Parent” and together with all its subsidiaries, “we,” “our,” or “us”), is a financial holding company headquartered in New York State. We offer a broad array of deposit, lending, and other financial services to individuals, municipalities and businesses in Western and Central New York through our wholly-owned New York-chartered banking subsidiary, Five Star Bank (the “Bank”). Our indirect lending network includes relationships with franchised automobile dealers in Western and Central New York, the Capital District of New York and Northern and Central Pennsylvania. We offer insurance services through our wholly-owned subsidiary, SDN Insurance Agency, LLC (“SDN”), a full-service insurance agency. We offer customized investment advice, wealth management, investment consulting and retirement plan services through our wholly-owned subsidiaries Courier Capital, LLC (“Courier Capital”) and HNP Capital, LLC (“HNP Capital”), SEC-registered investment advisory and wealth management firms. In addition, we offer Banking as a Service and Fintech solutions through our wholly-owned subsidiary Corn Hill Innovation Labs, LLC (“CHIL”).

Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from insurance, investment advisory and financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.

EXECUTIVE OVERVIEW

2021 Financial Performance Review

Net income increased $39.4 million to $77.7 million for 2021, compared to $38.3 million for 2020. This resulted in a 1.46% return on average assets and a 16.01% return on average equity. Net income available to common shareholders was $76.2 million or $4.78 per diluted share for 2021, compared to $36.9 million or $2.30 per diluted share for 2020. We declared cash dividends of $1.08 per common share during 2021, an increase of $0.04 per common share or 4% compared to the prior year.

Reflected in the increase in net income was an $8.3 million benefit for credit losses in the current year as compared to a provision of $27.2 million in 2020. Improvement in the national unemployment forecast, positive trends in qualitative factors, a reduction in specific reserves and lower net charge-offs resulted in the release of overall credit loss reserves and a corresponding benefit for credit losses in each quarter of 2021. Results for 2020 were negatively impacted by a higher than historical provision for credit losses, driven by the adoption of the current expected credit loss (“CECL”) standard and uncertainty around the long-term impact of the COVID-19 pandemic on the economic environment.

Fully-taxable equivalent net interest income was $155.4 million in 2021, an increase of $15.5 million, or 11%, compared to 2020. The increase was the result of a $603.5 million, or 14% increase in average interest-earning assets, partially offset by an eight-basis point decrease in the net interest margin, to 3.14%.

The provision for credit losses - loans was a benefit of $7.0 million in 2021 compared to a provision of $26.2 million in 2020. Net charge-offs decreased $8.1 million from the prior year to $5.8 million in 2021. Net charge-offs were an annualized 0.16% of average loans in the current year compared to 0.40% in 2020. Non-performing loans increased $2.7 million to $12.2 million compared to a year ago and represented 0.33% of total loans at December 31, 2021.

Noninterest income totaled $46.9 million for the full year 2021, an increase of $3.7 million, or 9%, when compared to the prior year. The increase is primarily attributed to increases in investment advisory income, investments in limited partnerships and insurance income, partially offset by decreases in income from derivatives instruments, and net gain on investment securities. The increase in investment advisory income of $2.1 million was primarily due to an increase in assets under management driven by a combination of market gains, new customer accounts and contributions to existing accounts. Income from investments in limited partnerships increased $2.0 million compared to the prior year based on performance of the underlying investments. The increase in insurance income of $1.3 million was driven by the two 2021 bolt-on acquisitions (North Woods Capital Benefits LLC in August and Landmark Group in February) and growth in the legacy SDN business, including the impact of increasing insurance premiums. Income from derivative instruments, net was $2.8 million lower than the prior year, primarily due to the execution of fewer swap transactions in 2021.

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Noninterest expense for the full year 2021 totaled $112.8 million, a $3.5 million increase compared to $109.3 million in the prior year. Computer and data processing expense increased $2.5 million year-over-year, as a result of strategic investments in technology, including digital banking initiatives and a customer relationship management solution that was deployed across all lines of business late in 2021. Salaries and benefits expense increased $1.6 million year-over-year, primarily due to higher performance-based incentive compensation and commissions, investments in personnel and the impact of 2021 acquisitions.

Income tax expense for the year was $19.5 million, representing an effective tax rate of 20.1% compared to an effective tax rate of 16.2% in 2020. The year-over-year increase in effective tax rate is primarily the result of higher pre-tax earnings in comparison to the prior year. Effective tax rates are impacted by items of income and expense not subject to federal or state taxation. The Company’s effective tax rates differ from statutory rates primarily because of interest income from tax-exempt securities, earnings on company owned life insurance and tax credit investments placed in service.

Total assets were $5.52 billion at December 31, 2021, up $608.5 million from $4.91 billion at December 31, 2020.

Investment securities were $1.38 billion at December 31, 2021, up $484.1 million from December 31, 2020. The increase from year-end 2020 was primarily due to the reinvestment of cash flow from the portfolio, coupled with the deployment of excess liquidity from higher deposit levels into cash flowing agency backed securities.

Total loans were $3.68 billion at December 31, 2021, up $84.3 million, or 2%, from December 31, 2020.

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Commercial mortgage loans totaled $1.41 billion, an increase of $158.9 million, or 13%, from December 31, 2020.

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Commercial business loans totaled $638.3 million, a decrease of $155.9 million, or 20%, from December 31, 2020. The decrease was primarily attributable to PPP loans. At December 31, 2021 the aggregate PPP loan balance was $55.3 million, net of deferred fees compared to $248.0 million, net of deferred fees at December 31, 2020.

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Residential real estate loans totaled $577.3 million, a decrease of $22.5 million, or 4%, from December 31, 2020.

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Consumer indirect loans totaled $958.0 million, an increase of $117.6 million, or 14%, from December 31, 2020.

Total deposits were $4.83 billion at December 31, 2021, an increase of $548.7 million from December 31, 2020, which was the result of growth in all deposit categories. Short-term borrowings were $30.0 million at December 31, 2021, an increase of $24.7 million from December 31, 2020. Short-term borrowings and brokered deposits have historically been utilized to manage the seasonality of public deposits.

Shareholders’ equity was $505.1 million at December 31, 2021, compared to $468.4 million at December 31, 2020. Common book value per share was $30.98 at December 31, 2021, an increase of $2.86, or 10%, from $28.12 at December 31, 2020. Tangible common book value per share(1) was $26.26 at December 31, 2021, an increase of $2.74, or 12%, from $23.52 at December 31, 2020. The increase in shareholders’ equity as compared to December 31, 2020, is primarily attributable to net income less dividends paid, net of the change in accumulated other comprehensive loss.

The Company’s leverage ratio was 8.23% at December 31, 2021 compared to 8.25% at December 31, 2020. The Bank’s leverage ratio and total risk-based capital ratio were 8.98% and 12.38%, respectively, at December 31, 2021, compared to 8.97% and 12.58%, respectively at December 31, 2020.

(1)
This is a non-GAAP measure that we believe is useful in understanding our financial performance and condition. Refer to the "GAAP to Non-GAAP Reconciliation" section of this Item 7 for further information.

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Additional financial highlights of the Company are as follows:

(1)
This is a non-GAAP measure that we believe is useful in understanding our financial performance and condition. Refer to the "GAAP to Non-GAAP Reconciliation" section of this Item 7 for further information.

(2)
The efficiency ratio provides a ratio of operating expenses to operating income. Efficiency ratio is calculated by dividing noninterest expense by net revenue, which is defined as the sum of tax-equivalent net interest income and noninterest income before net gains on investment securities. The efficiency ratio is not a financial measurement required by GAAP. However, the efficiency ratio is used by management in its assessment of financial performance specifically as it relates to noninterest expense control. Management also believes such information is useful to investors in evaluating Company performance.

Operational, Accounting and Reporting Impacts Related to the COVID-19 Pandemic

The COVID-19 pandemic has negatively impacted the global economy, including our operating footprint of Western and Central New York. In response to this crisis, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was passed by Congress and signed into law on March 27, 2020. The CARES Act provided an estimated $2.2 trillion to fight the COVID-19 pandemic and stimulate the economy by supporting individuals and businesses through loans, grants, tax changes, and other types of relief. Some of the provisions applicable to the Company include, but are not limited to:

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Accounting for Loan Modifications - The CARES Act provides that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a troubled debt restructuring (“TDR”) and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes.

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Paycheck Protection Program - The CARES Act established the Paycheck Protection Program (“PPP”), an expansion of the Small Business Administration’s (“SBA”) 7(a) loan program and the Economic Injury Disaster Loan Program (“EIDL”), administered directly by the SBA. On December 27, 2020, the Consolidated Appropriations Act, 2021 provided approximately $284 billion for PPP loans in an additional round of funding under the program and extended the PPP through March 31, 2021. This additional round of PPP loan funding was authorized for first-time borrowers and for second draws by certain borrowers who have previously received PPP loans. On March 30, 2021, the PPP Extension Act of 2021 was signed into law, which extended the program to May 31, 2021.

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Mortgage Forbearance - Under the CARES Act, a borrower with a federally backed mortgage loan that was experiencing financial hardship due to COVID-19 was able to request a forbearance until December 31, 2021.

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Also, in response to the COVID-19 pandemic, the Board of Governors of the Federal Reserve System (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”), the National Credit Union Administration (“NCUA”), the Office of the Comptroller of the Currency (“OCC”), and the Consumer Financial Protection Bureau (“CFPB”), in consultation with the state financial regulators (collectively, the “agencies”) issued a joint interagency statement (issued March 22, 2020; revised statement issued April 7, 2020). Some of the provisions applicable to the Company include, but are not limited to:

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Accounting for Loan Modifications - Loan modifications that do not meet the conditions of the CARES Act may still qualify as a modification that does not need to be accounted for as a TDR. The agencies confirmed with FASB staff that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or insignificant delays in payment.

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Past Due Reporting - With regard to loans not otherwise reportable as past due, financial institutions are not expected to designate loans with deferrals granted due to COVID-19 as past due because of the deferral. A loan’s payment date is governed by the due date stipulated in the legal agreement. If a financial institution agrees to a payment deferral, these loans would not be considered past due during the period of the deferral.

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Nonaccrual Status and Charge-offs - During short-term COVID-19 modifications, these loans generally should not be reported as nonaccrual or as classified.

Effective March 23, 2020 through July 9, 2020, for consumer customers, the Bank waived early CD penalty fees for withdrawals up to $20,000 (limited to one penalty-free withdrawal per CD account); eliminated all insufficient funds (overdrafts) and returned item fees; eliminated all Pay by Phone fees; waived all late fees; offered the opportunity for monthly mortgage, home equity loan or home equity line payment relief; offered the opportunity to defer unsecured consumer loans or lines of credit and secured consumer loans and lines of credit payments; and offered unsecured personal loans up to $5,000, up to 60 months at 2.95% APR subject to credit approval (additional terms and conditions may apply). In addition, ATM access fees were reinitiated on September 19, 2020.

As of December 31, 2021, we have helped more than 2,900 customers obtain more than $370 million in loans through the PPP. We have helped customers complete the forgiveness process for approximately $320 million of these PPP loans through December 31, 2021.

The Company had $532.4 million of loans with modifications related to COVID-19 during 2020, with $46.2 million and $113.0 million still on deferral as of December 31, 2021 and 2020, respectively. As of December 31, 2021, we have provided payment deferrals for approximately 6,600 borrowers, the majority being consumer indirect loan customers. Less than 1% of our loan customers have active payment deferrals as of December 31, 2021 as the majority of customers whose loans were subject to COVID-19 related deferrals have returned to making regular payments.

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GAAP to Non-GAAP Reconciliation

(1)
Tangible common equity divided by tangible assets.

(2)
Tangible common equity divided by common shares outstanding.

(3)
Net income available to common shareholders divided by average tangible common equity.

(4)
Net income available to common shareholders divided by average tangible assets.

This table contains disclosure that includes calculations for tangible common equity, tangible assets, tangible common equity to tangible assets, tangible common book value per share, average tangible common equity, average tangible assets, return on average tangible common equity and return on average tangible assets, which are determined by methods other than in accordance with GAAP. We believe that these non-GAAP measures are useful to our investors as measures of the strength of our capital and ability to generate earnings on tangible common equity invested by our shareholders. These non-GAAP measures provide supplemental information that may help investors to analyze our capital position without regard to the effects of intangible assets. Non-GAAP financial measures have inherent limitations and are not uniformly utilized by issuers. Therefore, these non-GAAP financial measures should not be considered in isolation, or as a substitute for comparable measures prepared in accordance with GAAP.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

RESULTS OF OPERATIONS FOR THE YEARS ENDED

December 31, 2021 AND December 31, 2020

Net Interest Income and Net Interest Margin

Net interest income is our primary source of revenue, comprising 77% of revenue during the year ended December 31, 2021. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.

We use interest rate spread and net interest margin to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (“net free funds”), principally noninterest-bearing demand deposits and shareholders’ equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.

The Federal Reserve influences the general market rates of interest, which impacts the deposit and loan rates offered by many financial institutions. The intended federal funds rate, which is the cost of immediately available overnight funds, remained at a range of 0.00% to 0.25% at year-end 2021. The Federal Reserve had previously decreased the intended federal funds rate by 150 basis points due to two rate cuts in March of 2020. On March 3, 2020 it decreased 50 basis points and on March 16, 2020 another 100 basis points, resulting in a range of 0.00% to 0.25% at year-end 2020. The Federal Reserve had previously decreased the intended federal funds rate by 25 basis points in each of August, September and October 2019, resulting in a range of 1.50% to 1.75% at year-end 2019. Our loan portfolio is significantly affected by changes in the prime interest rate and changes in the prime interest rate generally follow changes in the federal funds rate. The prime interest rate, which is the rate offered on loans to borrowers with strong credit, remained at 3.25% at year-end 2021. The prime interest rate had previously decreased to 3.25% in March 2020, reflecting the rate cuts of 50 and 100 basis points after the previous three 25 basis point decreases to 4.75% in 2019.

The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis for the years ended December 31 (in thousands):

Analysis of Net Interest Income and Net Interest Margin

Net interest income on a taxable equivalent basis for 2021 was $155.4 million, an increase of $15.5 million compared to $139.9 million for 2020. The increase in net interest income was due primarily to increases in average loans of $212.7 million, or 6%, and average investment securities of $334.1 million, or 42% compared to 2020 and a decrease in the cost of average interest-bearing liabilities. In addition, the increase in net interest income from 2020 included an increase in deferred fee amortization on PPP loans of $5.1 million, due to accelerated amortization of fees on PPP loans paid-off, primarily through the forgiveness process.

Our net interest margin for 2021 was 3.14%, eight-basis points lower than 3.22% from the prior year. This decrease was a function of a nine-basis point lower contribution from net free funds and a one-basis point increase in the interest rate spread. The change in interest rate spread was a net result of a 34-basis point decrease in the yield on average interest-earning assets and a 35-basis point decrease in the cost of interest-bearing liabilities.

For the year ended December 31, 2021, the yield on average interest-earning assets of 3.39% was 34-basis points lower than 2020. Loan yields decreased 13-basis points during 2021 to 4.05%. The yield on investment securities decreased 56-basis points during 2021 to 1.75%. Overall, the interest-earning asset rate changes decreased interest income by $9.4 million during 2021 while a favorable volume variance increased interest income by $15.0 million, which collectively drove a $5.7 million increase in interest income.

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Average interest-earning assets were $4.95 billion for 2021 compared to $4.35 billion for 2020, an increase of $603.5 million, or 14%, with average loans up $212.7 million from $3.44 billion to $3.65 billion and average securities up $334.1 million from $794.9 million to $1.13 billion. The growth in average loans reflected increases in the commercial loans, residential real estate loans and consumer indirect loans categories. Commercial loans, in particular, were up $162.2 million from $1.90 billion to $2.06 billion, or 9%, from 2020. Average balances of PPP loans net of deferred fees, which are included in commercial loans, were $175.4 million and $176.0 million for 2021 and 2020, respectively. Residential real estate loans were up $5.8 million, or 1%, and residential real estate lines were down $15.1 million, or 16%. Consumer indirect loans increased $60.6 million, or 7%, and other consumer loans decreased by $702 thousand, or 4%. Loans comprised 73.8% of average interest-earning assets during 2021 compared to 79.1% during 2020. Loans generally have significantly higher yields compared to securities and federal funds sold and interest-bearing deposits and, as such, can have a more positive effect on the net interest margin. The yield on average loans was 4.05% for 2021, a decrease of 13 basis points compared to 4.18% for 2020. An increase in the volume of average loans resulted in a $9.0 million increase in interest income, partially offset by a $4.6 million decrease due to the unfavorable rate variance. Securities comprised 22.8% of average interest-earning assets in 2021 compared to 18.3% in 2020. The taxable equivalent yield on average securities was 1.75% in 2021 compared to 2.31% in 2020. An increase in the volume of average securities resulted in a $5.9 million increase in interest income, partially offset by a $4.5 million decrease due to the unfavorable rate variance. Our asset mix negatively impacted net interest margin because loans constituted a smaller percentage and investment securities constituted a larger percentage of our interest-earning assets in 2021.

For the year ended December 31, 2021, the cost of average interest-bearing liabilities of 0.34% was 35 basis points lower than 2020 and the cost of average interest-bearing deposits of 0.23% was 34 basis points lower than 2020. Average short-term borrowings decreased $86.0 million from $86.5 million to $538 thousand in 2021. The decrease in average short-term borrowings was a result of our use of brokered deposits as a cost effective alternative to Federal Home Loan Bank ("FHLB") borrowings. The cost of long-term borrowings decreased 34 basis points to 5.75%. Overall, interest-bearing liability rate and volume decreases resulted in $9.8 million of lower interest expense during 2021.

Average interest-bearing liabilities of $3.67 billion in 2021 were $422.7 million, or 13%, higher than 2020. On average, interest-bearing deposits grew $482.3 million and noninterest-bearing demand deposits (a principal component of net free funds) were up $199.8 million. The increase in average deposits was due to growth in all deposit categories including non-public deposits, public deposits, reciprocal deposits and brokered deposits, which were utilized as a cost-effective alternative to FHLB borrowings during 2021. For further discussion of our reciprocal and brokered deposits, refer to the “Funding Activities – Deposits” section of this Management’s Discussion and Analysis. Overall, interest-bearing deposit rate and volume changes resulted in $9.7 million of lower interest expense during 2021. Average short-term and long-term borrowings were $74.3 million in 2021, $59.6 million lower than in 2020. Overall, short- and long-term borrowing rate and volume changes resulted in $135 thousand of lower interest expense during 2021.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The following tables present, for the periods indicated, information regarding: (i) the average balances; (ii) the amount of interest income from interest-earning assets and the resulting annualized yields (tax-exempt yields have been adjusted to a tax-equivalent basis using the applicable Federal tax rate in each year); (iii) the amount of interest expense on interest-bearing liabilities and the resulting annualized rates; (iv) net interest income; (v) net interest rate spread; (vi) net interest income as a percentage of average interest-earning assets (“net interest margin”); and (vii) the ratio of average interest-earning assets to average interest-bearing liabilities. Investment securities are at amortized cost for both held to maturity and available for sale securities. Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Dollar amounts are shown in thousands.

The net interest spread, as well as the net interest margin, will be impacted by future changes in short-term and long-term interest rate levels, as well as the impact from the competitive environment. A discussion of the effects of changing interest rates on net interest income is set forth in Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” included elsewhere in this report.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Rate /Volume Analysis

The following table presents, on a tax-equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest income or interest expense not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands):

Provision for Credit Losses

The provision for credit losses was a benefit of $8.3 million for the year ended December 31, 2021 compared with a provision of $27.2 million for 2020. There was a benefit for credit losses in each quarter of 2021 as a result of continued improvement in the national unemployment forecast, the designated loss driver for our current expected credit loss (“CECL”) model, positive trends in qualitative factors, a reduction in specific reserves and lower net charge-offs resulting in releases of credit loss reserves. The elevated level of provision for credit losses for 2020 was driven by the adoption of the CECL standard and the impact of COVID-19 pandemic on the economic environment. The designated loss driver for our CECL model is the national unemployment forecast, which spiked in early 2020 at the onset of the pandemic and improved in 2021. The provision for credit losses - loans varies based primarily on forecasted unemployment rates, loan growth, net charge-offs, collateral values associated with collateral dependent loans and qualitative factors.

See the “Allowance for Credit Losses” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion.

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Noninterest Income

The following table summarizes our noninterest income for the years ended December 31 (in thousands):

Service charges on deposits increased $761 thousand, or 16%, to $5.6 million in 2021, compared to $4.8 million in 2020. The increase in 2021 was primarily due to our COVID-19 relief initiatives implemented from March 23, 2020 to July 9, 2020.

Insurance income increased $1.3 million, or 31%, to $5.8 million in 2021, compared to $4.4 million in 2020. The increase was primarily due to two 2021 bolt-on acquisitions and growth in the legacy SDN business, including the impact of increasing insurance premiums.

Card interchange income increased $1.2 million, or 17%, to $8.5 million in 2021, compared to $7.3 million in 2020. The increase was primarily due to an increase in customer transactions.

Investment advisory income increased $2.1 million, or 22%, to $11.7 million in 2021, compared to $9.5 million in 2020. The increase was primarily due to an increase in assets under management driven by a combination of market gains, new customer accounts and contributions to existing accounts.

Company owned life insurance income increased $1.0 million, or 55%, to $2.9 million in 2021, compared to $1.9 million in 2020. We made additional investments in company-owned life insurance of $20.0 million in the third quarter of 2021 and $30.0 million in the fourth quarter of 2020.

Income from investments in limited partnerships increased $2.0 million to $2.1 million in 2021, compared to $104 thousand in 2020. We have investments in limited partnerships, primarily small business investment companies, and account for these investments under the equity method. The income from these investments fluctuates based on the maturity and performance of the underlying investments.

Income from derivative instruments, net decreased $2.8 million to $2.7 million in 2021, compared to $5.5 million in 2020. Fee income per transaction in 2021 was higher than in 2020, however, aggregate swap fee income decreased $2.2 million as a result of fewer swap transactions. Mortgage derivative income was $589 thousand lower than 2020, primarily as a result of fewer mortgage loans in the pipeline.

Net gain on sale of loans held for sale decreased $908 thousand to $3.0 million in 2021, compared to $3.9 million in 2020. The decrease was primarily driven by lower transaction volumes and margins in 2021. Transaction volume and margin were at historically high levels in the second half of 2020, driven by mortgage refinancing activity.

Net gain on investment securities decreased $1.5 million to $71 thousand in 2021, compared to $1.6 million in 2020. The amount and timing of our sale of investment securities is dependent on several factors, including our prudent efforts to realize gains while managing duration, premium and credit risk.

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Noninterest Expense

The following table summarizes our noninterest expense for the years ended December 31 (in thousands):

Salaries and employee benefits expense increased $1.6 million, or 3%, to $60.9 million in 2021, compared to $59.3 million in 2020. The increase was primarily attributable to higher performance-based incentive compensation and commissions, investments in personnel and the impact of 2021 acquisitions.

Occupancy and equipment expense increased $716 thousand, or 5%, to $14.4 million in 2021 compared to $13.7 million in 2020. The increase was primarily due to the purchase of personal computers and security equipment for multiple locations and expenses related to two bank branches opened in June 2021.

Computer and data processing expense increased $2.5 million, or 21%, to $14.1 million in 2021, compared to $11.6 million in 2020. The increase was primarily due to investments in technology, including digital banking initiatives and a customer relationship management solution that was deployed across all lines of business late in 2021.

Advertising and promotions expense decreased $905 thousand, or 35%, to $1.7 million in 2021, compared to $2.6 million in 2020. The decrease was primarily related to a temporary reduction in external advertising expense. The Company decreased its total advertising spend in both 2021 and 2020 as a result of the COVID-19 pandemic and is continuing to evaluate its long-term marketing strategy.

Restructuring charges were $1.5 million in 2020, representing non-recurring real estate related charges related to the 2020 closure of six branches and a staffing reduction. Additional related restructuring charges of $111 thousand were incurred in 2021 as a result of property valuation adjustments.

The efficiency ratio for the year ended December 31, 2021 was 55.76% compared with 60.22% for 2020. The lower efficiency ratio is a result of higher net interest income associated with an increase in average interest-earning assets for the year, deferred fee amortization on PPP loans, an increase in noninterest income and a decrease in interest expense compared to the prior year. The efficiency ratio is calculated by dividing total noninterest expense by net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains on investment securities. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease indicates a more efficient allocation of resources. The efficiency ratio, a banking industry financial measure, is not required by GAAP. However, the efficiency ratio is used by management in its assessment of financial performance specifically as it relates to noninterest expense control. Management also believes such information is useful to investors in evaluating Company performance.

Income Taxes

We recorded income tax expense of $19.5 million for 2021, compared to $7.4 million for 2020. In 2021 and 2020, we recognized tax credit investments resulting in a $2.6 million and $1.5 million reduction in income tax expense, respectively, and a $431 thousand and $275 thousand net loss recorded in noninterest income, respectively.

Our effective tax rate was 20.1% for 2021 compared to 16.2% for 2020. Effective tax rates are typically impacted by items of income and expense that are not subject to federal or state taxation. Our effective tax rates reflect the impact of these items, which include, but are not limited to, interest income from tax-exempt securities, earnings on company owned life insurance and the impact of tax credit investments. In addition, our effective tax rate for 2021 and 2020 reflects the New York State tax benefit generated by our real estate investment trust.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

RESULTS OF OPERATIONS FOR THE YEARS ENDED

DECEMBER 31, 2020 AND DECEMBER 31, 2019

A discussion regarding our financial condition and results of operations for the year ended December 31, 2019 and year-to-year comparisons between 2020 and 2019, which are not included in this Form 10-K, can be found under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020 and are incorporated by reference herein.

ANALYSIS OF FINANCIAL CONDITION

OVERVIEW

At December 31, 2021, we had total assets of $5.52 billion, an increase of 12% from $4.91 billion as of December 31, 2020, largely attributable to organic loan growth and an increase in our investment securities portfolio. Net loans were $3.64 billion as of December 31, 2021, up $97.0 million, or 3%, when compared to $3.54 billion as of December 31, 2020. The increase in net loans was primarily attributable to organic growth in our consumer indirect loans. Non-performing assets totaled $12.2 million as of December 31, 2021, down $317 thousand from a year ago. Total deposits amounted to $4.83 billion as of December 31, 2021, up $548.7 million, or 13%, compared to December 31, 2020. As of December 31, 2021, borrowed funds totaled $103.9 million, compared to $78.9 million as of December 31, 2020. Common book value per common share was $30.98 and $28.12 as of December 31, 2021 and 2020, respectively. As of December 31, 2021, our total shareholders’ equity was $505.1 million compared to $468.4 million a year earlier.

INVESTING ACTIVITIES

The following table summarizes the composition of our available for sale and held to maturity securities portfolios (in thousands).

Our investment policy is contained within our overall Asset-Liability Management and Investment Policy. This policy dictates that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, need for collateral and desired risk parameters. In pursuing these objectives, we consider the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability, pledgeable nature and risk diversification. Our Chief Financial Officer and Treasurer, guided by ALCO, is responsible for investment portfolio decisions within the established policies.

Our available for sale (“AFS”) investment securities portfolio increased $550.5 million from $628.1 million at December 31, 2020 to $1.18 billion at December 31, 2021. The increase from year-end 2020 was primarily due to the reinvestment of cash flow from the portfolio, coupled with the deployment of excess liquidity from higher deposit levels into cash flowing agency backed securities. Our AFS portfolio had a net unrealized loss totaling $6.3 million at December 31, 2021 compared to a net unrealized gain of $20.4 million at December 31, 2020. The fair value of most of the investment securities in the AFS portfolio fluctuates as market interest rates change.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Impairment Assessment

For AFS securities in an unrealized loss position, we first assess whether (i) we intend to sell, or (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. If either case is affirmative, any previously recognized allowances are charged-off and the security's amortized cost is written down to fair value through income. If neither case is affirmative, the security is evaluated to determine whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency and any adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income. Adjustments to the allowance are reported in our income statement as a component of credit loss expense. AFS securities are charged-off against the allowance or, in the absence of any allowance, written down through income when deemed uncollectible by management or when either of the aforementioned criteria regarding intent or requirement to sell is met. For the year ended December 31, 2021 and 2020 no allowance for credit losses has been recognized on AFS securities in an unrealized loss position as management does not believe any of the securities are impaired due to reasons of credit quality.

As of December 31, 2021, we do not have the intent to sell any of our securities in a loss position and we believe that it is not likely that we will be required to sell any such securities before the anticipated recovery of amortized cost. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the bonds approach their maturity date, repricing date or if market yields for such investments decline. We do not believe any of the securities in a loss position are impaired due to reasons of credit quality. Accordingly, as of December 31, 2021, we concluded that unrealized losses on our AFS securities are not impaired due to reasons of credit quality and no allowance for credit losses has been recognized on AFS securities. The following discussion provides further details of our assessment of the AFS securities portfolio by investment category.

U.S. Government Agencies and Government Sponsored Enterprises (“GSE”). As of December 31, 2021, there was one security in an unrealized loss position for less than 12 months in the U.S. Government agencies and GSE portfolio with an unrealized loss totaling $97 thousand. The decline in fair value is attributable to changes in interest rates, not to credit quality. We did not have the intent to sell this security and it was likely that we will not be required to sell the security before the anticipated recovery.

Agency Mortgage-backed Securities. With the exception of the non-Agency mortgage-backed securities (“non-Agency MBS”) discussed below, all of the mortgage-backed securities held by us as of December 31, 2021, were issued by U.S. Government sponsored entities and agencies (“Agency MBS”), primarily FNMA and FHLMC. The contractual cash flows of our Agency MBS are guaranteed by FNMA, FHLMC or GNMA. The GNMA mortgage-backed securities are backed by the full faith and credit of the U.S. Government.

As of December 31, 2021, there were 116 securities in the AFS Agency MBS portfolio that were in an unrealized loss position with unrealized losses totaling $14.7 million. Of these, 28 were in an unrealized loss position for 12 months or longer and had an aggregate fair value of $172.2 million and unrealized losses of $4.7 million dollars. The unrealized loss of these securities is driven by the timing of the purchases of fixed-rate securities during the extended low interest rate environments experienced over the past two years, which has been compounded with subsequent increases in benchmark interest rates. However, these fixed-rate securities were purchased with the expectation that they will continue to prepay principal and the proceeds will be invested at current market rates.

Given the high credit quality inherent in Agency MBS, we do not consider any of the unrealized losses as of December 31, 2021 on such Agency MBS to be credit related. As of December 31, 2021, we did not intend to sell any Agency MBS that were in an unrealized loss position, all of which were performing in accordance with their terms.

Non-Agency Mortgage-backed Securities. Our non-Agency MBS portfolio consists of positions in one privately issued whole loan collateralized mortgage obligations with a fair value and net unrealized gain of $410 thousand as of December 31, 2021. As of that date, the one non-Agency MBS was rated below investment grade. This security was not in an unrealized loss position.

Other Investments. As a member of the FHLB, the Bank is required to hold FHLB stock. The amount of required FHLB stock is based on the Bank’s asset size and the amount of borrowings from the FHLB. We have assessed the ultimate recoverability of our FHLB stock and believe that no impairment currently exists. As a member of the FRB system, we are required to maintain a specified investment in FRB stock based on a ratio relative to our capital. At December 31, 2021, our ownership of FHLB and FRB stock totaled $4.4 million and $6.4 million, respectively, and is included in other assets and recorded at cost, which approximates fair value.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

LENDING ACTIVITIES

Total loans were $3.68 billion at December 31, 2021, an increase of $84.3 million, or 2%, from December 31, 2020. Commercial loans represented 55.7% of total loans at the end of 2021. Consumer loans represented 44.3% of total loans at December 31, 2021. The composition of our loan portfolio, excluding loans held for sale and including net unearned income and net deferred fees and costs, is summarized as follows (in thousands):

Commercial business loans decreased $155.9 million from December 31, 2020 to $638.3 million at December 31, 2021. The decrease was driven by the forgiveness or repayment of PPP loans. PPP loans net of deferred fees are included in commercial business loans and were $55.3 million at December 31, 2021 and $248.0 million at December 31, 2020. Accordingly, commercial business loans excluding the impact of PPP loans increased 7% from December 31, 2020. Commercial mortgage loans increased $158.9 million, or 13%, from December 31, 2020 to $1.41 billion at December 31, 2021. The credit risk related to commercial loans is largely influenced by general economic conditions, including the impact of the COVID-19 pandemic on small to mid-sized business in our market area, inflation, and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.

Factors that are important to managing overall credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early identification of potential problems, an appropriate allowance for credit losses, and sound nonaccrual and charge off policies.

An active credit risk management process is used for commercial loans to further ensure that sound and consistent credit decisions are made. Credit risk is controlled by detailed underwriting procedures, comprehensive loan administration, and periodic review of borrowers’ outstanding loans and commitments. Borrower relationships are formally reviewed and graded on an ongoing basis for early identification of potential problems. Further analyses by customer, industry, and geographic location are performed to monitor trends, financial performance, and concentrations.

We participate in various lending programs in which guarantees are supplied by U.S. government agencies, such as the SBA, U.S. Department of Agriculture, Rural Economic and Community Development and Farm Service Agency, among others. As of December 31, 2021, the principal balance of such loans (included in commercial loans) was $87.6 million and the guaranteed portion amounted to $72.7 million. Excluding PPP Loans, the principal balance of such loans (included in commercial loans) was $30.1 million and the guaranteed portion amounted to $15.2 million. Most of these loans were guaranteed by the SBA.

Commercial business loans were $638.3 million at the end of 2021, down $155.9 million, or 20%, since the end of 2020, and comprised 17.3% of total loans outstanding at December 31, 2021, compared to 22.1% at December 31, 2020. The decrease in commercial business loans was primarily driven by the forgiveness or repayment of PPP loans. As of December 31, 2021, we had $55.3 million of PPP loans, net of deferred loan fees and costs compared to $248.0 million at December 31, 2020. We typically originate business loans of up to $15.0 million for small to mid-sized businesses in our market area for working capital, equipment financing, inventory financing, accounts receivable financing, or other general business purposes. Loans of this type are in a diverse range of industries. As of December 31, 2021, commercial business SBA loans including PPP loans accounted for a total of $75.1 million, or 12% of our commercial business loan portfolio.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Commercial mortgage loans totaled $1.41 billion at December 31, 2021, up $158.9 million, or 13%, from December 31, 2020, and comprised 38.4% of total loans, compared to 34.9% at December 31, 2020. Commercial mortgage loans include both owner occupied and non-owner occupied commercial real estate loans. Approximately 23% and 24% of our commercial mortgage portfolio at December 31, 2021 and 2020, respectively, was owner occupied commercial real estate. The majority of our commercial real estate loans are secured by office buildings, manufacturing facilities, distribution/warehouse facilities, and retail centers, which are generally located in our local market area. As of December 31, 2021, commercial mortgage SBA loans accounted for a total of $5.4 million or less than one percent of our commercial mortgage loan portfolio.

We determine our current lending standards for commercial real estate and real estate construction lending by property type and specifically address many criteria, including: maximum loan amounts, maximum loan-to-value (“LTV”), requirements for pre-leasing or pre-sales, minimum debt-service coverage ratios, minimum borrower equity, and maximum loan to cost. Currently, the maximum standard for LTV is 85%, with lower limits established for certain higher risk types, such as raw land which has a 65% LTV maximum.

Consumer loans totaled $1.63 billion at December 31, 2021, up $81.3 million compared to 2020, and represented 44.3% of the 2021 year-end loan portfolio versus 43.0% at year-end 2020. Loans in this classification include residential real estate loans, residential real estate lines, indirect consumer and other consumer installment loans. Credit risk for these types of loans is generally influenced by general economic conditions, including inflation, the impact of the COVID-19 pandemic on the employment income of these borrowers, the characteristics of individual borrowers, and the nature of the loan collateral. Risks of loss are generally on smaller average balances per loan spread over many borrowers. Once charged off, there is usually less opportunity for recovery on these smaller retail loans. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers, monitoring payment histories, and taking appropriate collateral and guaranty positions.

Residential real estate portfolios include conventional first lien mortgages and home equity loans and lines of credit. For conventional first lien mortgages, we generally limit the maximum loan to 85% of collateral value without credit enhancement (e.g. personal mortgage insurance). A portion of our fixed-rate conventional mortgage loans are sold in the secondary market with servicing rights retained. Our conventional mortgage products continue to be underwritten using FHLMC secondary marketing guidelines. Our underwriting guidelines for home equity products include a combination of borrower FICO (credit score), the LTV of the property securing the loan and evidence of the borrower having sufficient income to repay the loan. Currently, for home equity products, the maximum acceptable LTV is 90%. The average FICO score for new home equity production was 768 and 764 during the years ended December 31, 2021 and 2020, respectively.

Residential real estate loans totaled $577.3 million at the end of 2021, down $22.5 million, or 4%, from the end of the prior year and comprised 15.7% and 16.7% of total loans outstanding at December 31, 2021 and December 31, 2020, respectively. The residential real estate line portfolio amounted to $78.5 million at December 31, 2021 down $11.3 million, or 13%, compared to 2020 and represented 2.2% of the 2021 year-end loan portfolio versus 2.5% at year-end 2020. The residential real estate loans and lines portfolios had a weighted average LTV at origination of approximately 70% and 69% at December 31, 2021 and 2020, respectively. Approximately 93% and 92% of the loans and lines were first lien positions at December 31, 2021 and 2020, respectively.

Consumer indirect loans amounted to $958.0 million at December 31, 2021 up $117.6 million, or 14%, compared to 2020 and represented 26.0% of the 2021 year-end loan portfolio versus 23.4% at year-end 2020. The loans are primarily for the purchase of automobiles (both new and used) and light duty trucks primarily by individuals, but also by corporations and other organizations. The loans are originated through dealerships and assigned to us with terms that typically range from 36 to 84 months. During the year ended December 31, 2021, we originated $504.3 million in indirect loans with a mix of approximately 25% new vehicles and 75% used vehicles. This compares with $318.9 million in indirect loans with a mix of approximately 33% new vehicles and 67% used vehicles for the same period in 2020. We do business with over 450 franchised auto dealers located in Western, Central, and the Capital District of New York, and Northern and Central Pennsylvania. The average FICO score for indirect loan production was 706 and 712 during the years ended December 31, 2021 and 2020, respectively. Other consumer loans totaled $14.5 million at December 31, 2021, down 2.6 million, or 15%, compared to 2020, and represented less than one percent of the 2021 and 2020 year-end loan portfolio. Other consumer loans consist of personal loans (collateralized and uncollateralized) and deposit account collateralized loans.

Our loan portfolio is widely diversified by types of borrowers, industry groups, and market areas within our operating footprint. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to numerous borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. At December 31, 2021, no significant concentrations, as defined above, existed in our portfolio in excess of 10% of total loans.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Loans Held for Sale and Loan Servicing Rights. Loans held for sale (not included in the loan portfolio composition table) were entirely comprised of residential real estate loans and totaled $6.2 million and $4.3 million as of December 31, 2021 and 2020, respectively.

We sell certain qualifying newly originated or refinanced residential real estate loans on the secondary market. Residential real estate loans serviced for others, which are not included in the consolidated statements of financial condition, amounted to $272.7 million and $241.7 million as of December 31, 2021 and 2020, respectively.

Allowance for Credit Losses

The following table summarizes the activity in the allowance for credit losses - loans (in thousands).

Net charge-offs of $5.8 million in 2021 represented 0.16% of average loans compared to $13.8 million, or 0.40%, in 2020. The decrease in commercial business net charge-offs in 2021 was primarily due to an $8.2 million partial charge-off of an $11.9 million commercial loan downgraded in the first quarter of 2020 and for which a foreclosure occurred in the third quarter of 2020. The borrower’s business was related to the hospitality industry and the downgrade and charge-off were precipitated by the impact of the COVID-19 pandemic. The increase in commercial mortgage net charge-offs in 2021 was primarily due to a $3.8 million partial charge off of an $7.8 million commercial loan downgraded in the fourth quarter of 2021. The allowance for credit losses - loans was $39.7 million at December 31, 2021, compared with $52.4 million at December 31, 2020. The ratio of the allowance for credit losses - loans to total loans was 1.08% and 1.46% at December 31, 2021 and 2020, respectively. The ratio of allowance for credit losses - loans to non-performing loans was 326% at December 31, 2021, compared with 551% at December 31, 2020.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The following table sets forth the allocation of the allowance for credit losses - loans by loan category as of the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which actual losses may occur. The total allowance is available to absorb losses from any segment of the loan portfolio (in thousands).

The Company adopted ASC 326 effective January 1, 2020, which resulted in an increase to the allowance for credit losses - loans of $9.6 million and established a reserve for unfunded commitments of $2.1 million, for a total pre-tax cumulative effect adjustment of $11.7 million.

The allowance for credit losses for pooled loans estimate is based upon periodic review of the collectability of the loans quantitatively correlating historical loan experience with reasonable and supportable forecasts using forward looking information. Adjustments to the quantitative evaluation may be made for differences in current or expected qualitative risk characteristics such as changes in: underwriting standards, delinquency level, regulatory environment, economic condition, Company management and the status of portfolio administration including the Company’s credit risk review function. The Company establishes a specific reserve for individually evaluated loans which do not share similar risk characteristics with the loans included in the forecasted allowance for credit losses. These individually evaluated loans are removed from the pooling approach discussed above for the forecasted allowance for credit losses, and include nonaccrual loans, TDRs, and other loans deemed appropriate by management. The process we use to determine the overall allowance for credit losses is based on this analysis. Based on this analysis, we believe the allowance for credit losses is adequate as of December 31, 2021.

Assessing the adequacy of the allowance for credit losses involves substantial uncertainties and is based upon management’s evaluation of the amounts required to meet estimated charge-offs in the loan portfolio after weighing a variety of factors, including the risk profile of our loan products and customers.

Factors beyond our control, however, such as general national and local economic conditions, can adversely impact the adequacy of the allowance for credit losses. As a result, no assurance can be given that adverse economic conditions or other circumstances will not result in increased losses in the portfolio or that the allowance for credit losses will be sufficient to meet actual loan losses. See Part I, Item 1A “Risk Factors” for the risks impacting this estimate. Management presents a quarterly review of the adequacy of the allowance for credit losses to the Audit Committee of our Board of Directors based on the methodology that is described in further detail in Part I, Item I “Business” under the section titled “Lending Activities.” See also “Critical Accounting Estimates” for additional information on the allowance for credit losses.

The adequacy of the allowance for credit losses is subject to ongoing management review. While management evaluates currently available information in establishing the allowance for credit losses - loans, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for credit losses - loans. Such agencies may require us to increase the allowance based on their judgments about information available to them at the time of their examination.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Non-performing Assets and Potential Problem Loans

The following table summarizes our non-performing assets (in thousands):

Non-performing assets include non-performing loans and foreclosed assets. Non-performing assets at December 31, 2021 were $12.2 million, a decrease of $317 thousand from $12.5 million at December 31, 2020. The primary component of non-performing assets is non-performing loans, which were $12.2 million or 0.33% of total loans at December 31, 2021, compared with $9.5 million or 0.26% of total loans at December 31, 2020. The increase in nonperforming loans was primarily due to the downgrade of a $7.8 million commercial mortgage loan, with $3.8 million partially charged-off, in the fourth quarter of 2021.

Approximately $7.8 million, or 69%, of the $11.4 million of nonaccrual loans, a component of non-performing loans, as of December 31, 2021 were current with respect to payment of principal and interest but were classified as non-accruing because repayment in full of principal and/or interest was uncertain. We had no TDRs included in nonaccrual loans at December 31, 2021 and $200 thousand at December 31, 2020. Additionally, we had no TDRs that were accruing interest as of December 31, 2021 and December 31, 2020.

Foreclosed assets consist of real property formerly pledged as collateral for loans, which we have acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. We had no properties representing foreclosed asset holdings at December 31, 2021 and two properties totaling $3.0 million at December 31, 2020. The decrease in foreclosed assets during 2021 was primarily the result of the sale of an asset on which foreclosure occurred in the third quarter of 2020. The borrower's business was related to the hospitality industry and the downgrade and partial charge-off in the first quarter of 2020 were precipitated by the impact of the COVID-19 pandemic.

Potential problem loans are loans that are currently performing, but information known about possible credit problems of the borrowers causes us to have concern as to the ability of such borrowers to comply with the present loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future. These loans remain in a performing status due to a variety of factors, including payment history, the value of collateral supporting the credits, and/or personal or government guarantees. We consider loans classified as substandard, which continue to accrue interest, to be potential problem loans. We identified $22.7 million and $17.9 million in loans that continued to accrue interest which were classified as substandard as of December 31, 2021 and 2020, respectively.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

FUNDING ACTIVITIES

Deposits

The following table summarizes the composition of our deposits (dollars in thousands).

As of December 31, 2021 and 2020, the aggregate amount of uninsured deposits (deposits in amounts greater than $250,000, which is the maximum amount for federal deposit insurance) was $1.29 billion and $1.08 billion, respectively. The portion of our time deposits by account that were in excess of the FDIC insurance limit was $182.3 million and $155.3 million at December 31, 2021 and 2020, respectively. The maturities of our uninsured time deposits at December 31, 2021 were as follows: $45.2 million in three months or less; $74.7 million between three months and six months; $62.1 million between six months and one year; and $287 thousand over one year.

We offer a variety of deposit products designed to attract and retain customers, with the primary focus on building and expanding long-term relationships. At December 31, 2021, total deposits were $4.83 billion, representing an increase of $548.7 million, or 13%, for the year. The increase from December 31, 2020, was primarily due to growth in non-public, public and reciprocal deposits. Time deposits were approximately 19% and 21% of total deposits at December 31, 2021 and 2020, respectively.

Nonpublic deposits, the largest component of our funding sources, totaled $2.70 billion and $2.55 billion at December 31, 2021 and 2020, respectively, and represented 56% and 60% of total deposits as of the end of each period, respectively. We have managed this segment of funding through a strategy of competitive pricing that minimizes the number of customer relationships that have only a single service high cost deposit account.

As an additional source of funding, we offer a variety of public (municipal) deposit products to the towns, villages, counties and school districts within our market. Public deposits generally range from 20% to 30% of our total deposits. There is a high degree of seasonality in this component of funding, because the level of deposits varies with the seasonal cash flows for these public customers. We maintain the necessary levels of short-term liquid assets to accommodate the seasonality associated with public deposits. Total public deposits were $1.10 billion and $834.9 million at December 31, 2021 and December 31, 2020, respectively, and represented 23% and 20% of total deposits as of the end of each period, respectively.

We participate in reciprocal deposit programs, which enable depositors to receive FDIC insurance coverage for deposits otherwise exceeding the maximum insurable amount. Through these programs, deposits in excess of the maximum insurable amount are placed with multiple participating financial institutions. Reciprocal deposits totaled $771.4 million at December 31, 2021, compared to $612.3 million at December 31, 2020, and represented 16% and 14% of total deposits as of the end of each period, respectively.

Brokered deposits totaled $254.7 million and $279.6 million at December 31, 2021 and 2020, respectively, and represented 5% and 7% of total deposits as of the end of each period, respectively.

Borrowings

The Company classifies borrowings as short-term or long-term in accordance with the original terms of the agreement. Outstanding borrowings are summarized as follows as of December 31 (in thousands):

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Short-term Borrowings

Short-term FHLB borrowings have original maturities of less than one year and include overnight borrowings which we typically utilize to address short term funding needs as they arise. Short-term FHLB borrowings at December 31, 2021 consisted of $30.0 million in short-term borrowings. Short-term FHLB borrowings at December 31, 2020 consisted of $5.3 million in short-term borrowings. The FHLB borrowings are collateralized by securities from the Company’s investment portfolio and certain qualifying loans. At December 31, 2021 and 2020, the Company’s borrowings had a weighted average rate of 0.34% and 1.70%, respectively.

We have credit capacity with the FHLB and can borrow through facilities that include amortizing and term advances or repurchase agreements. We had approximately $201.7 million of immediate credit capacity with the FHLB as of December 31, 2021. We had approximately $613.4 million in secured borrowing capacity at the FRB discount window, none of which was outstanding at December 31, 2021. The FHLB and FRB credit capacity are collateralized by securities from our investment portfolio and certain qualifying loans. We had approximately $130.0 million of credit available under unsecured federal funds purchased lines with various banks as of December 31, 2021, with no amounts outstanding at December 31, 2021. Additionally, we had approximately $534.6 million of unencumbered liquid securities available for pledging.

The Parent has a revolving line of credit with a commercial bank allowing borrowings up to $20.0 million in total as an additional source of working capital. At December 31, 2021, no amounts have been drawn on the line of credit.

Long-term Borrowings

On October 7, 2020, we completed a private placement of $35.0 million in aggregate principal amount of fixed-to-floating rate subordinated notes due 2030 to qualified institutional buyers and accredited institutional investors that were subsequently exchanged for subordinated notes with substantially the same terms (the “2020 Notes”) registered under the Securities Act of 1933, as amended. The 2020 Notes have a maturity date of October 15, 2030 and bear interest, payable semi-annually, at the rate of 4.375% per annum, until October 15, 2025. Commencing on that date, the interest rate will reset quarterly to an interest rate per annum equal to the then current three-month SOFR plus 4.265%, payable quarterly until maturity. The 2020 Notes are redeemable by us, in whole or in part, on any interest payment date on or after October 15, 2025, and we may redeem the Notes in whole at any time upon certain other specified events. We used the net proceeds for general corporate purposes, organic growth and to support regulatory capital ratios at Five Star Bank.

On April 15, 2015, we issued $40.0 million of subordinated notes (the “2015 Notes”) in a registered public offering. The 2015 Notes bear interest at a fixed rate of 6.0% per year, payable semi-annually, for the first 10 years. From April 15, 2025 to the April 15, 2030 maturity date, the interest rate will reset quarterly to an annual interest rate equal to the then current three-month London Interbank Offered Rate (“LIBOR”) plus 3.944%, payable quarterly. After the discontinuance of LIBOR, the interest rate will be determined by an alternate method as reasonably selected by the Company. The 2015 Notes are redeemable by us at any quarterly interest payment date beginning on April 15, 2025 to maturity at par, plus accrued and unpaid interest. Proceeds, net of debt issuance costs of $1.1 million, were $38.9 million. The 2020 and 2015 Notes qualify as Tier 2 capital for regulatory purposes.

Shareholders’ Equity

Total shareholders’ equity was $505.1 million at December 31, 2021, an increase of $36.8 million from $468.4 million at December 31, 2020. Net income for the year increased shareholders’ equity by $77.7 million, partially offset by common and preferred stock dividends declared of $18.5 million. Accumulated other comprehensive loss included in shareholders’ equity increased $15.3 million during the year due primarily to higher net unrealized losses on securities available for sale. Treasury stock included in shareholders' equity increased $8.0 million primarily due to the purchase of shares of common stock in 2021 under our 2020 Repurchase Program. For detailed information on shareholders’ equity, see Note 16, Shareholders’ Equity, of the notes to consolidated financial statements. FII and the Bank are subject to various regulatory capital requirements. At December 31, 2021, both FII and the Bank exceeded all regulatory requirements. For detailed information on regulatory capital requirements, see Note 15, Regulatory Matters, of the notes to consolidated financial statements.

LIQUIDITY AND CAPITAL MANAGEMENT

The objective of maintaining adequate liquidity is to assure that we meet our financial obligations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of matured borrowings, the ability to fund new and existing loan commitments and the ability to take advantage of new business opportunities. We achieve liquidity by maintaining a strong base of both core customer funds and maturing short-term assets; we also rely on our ability to sell or pledge securities and lines-of-credit and our overall ability to access to the financial and capital markets.

Liquidity for the Bank is managed through the monitoring of anticipated changes in loans, the investment portfolio, core deposits and wholesale funds. The strength of the Bank’s liquidity position is a result of its base of core customer deposits. These core deposits are supplemented by wholesale funding sources that include credit lines with the other banking institutions, the FHLB and the FRB.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The primary sources of liquidity for FII are dividends from the Bank and access to financial and capital markets. Dividends from the Bank are limited by various regulatory requirements related to capital adequacy and earnings trends. The Bank relies on cash flows from operations, core deposits, borrowings and short-term liquid assets.

Cash and cash equivalents were $79.1 million as of December 31, 2021, a decrease of approximately $14.8 million from $93.9 million as of December 31, 2020. During 2021, net cash provided by operating activities totaled $59.4 million and the principal source of operating activity cash flow was net income adjusted for noncash income and expense items. Net cash used in investing activities totaled $619.8 million, which included outflows of $502.4 million from net investment securities transactions and outflows of $90.1 million for net loan originations. Net cash provided by financing activities of $545.7 million was attributed to a $548.7 million increase in deposits and a $24.7 million increase in short-term borrowings, partially offset by $9.2 million in purchases of common stock for treasury and $18.5 million in dividend payments.

Planned Uses of Capital Resources

The Company has various long-term contractual obligations as of December 31, 2021, which include:

•
Time deposits for $922.0 million;

•
Supplemental executive retirement plans for $1.0 million;

•
Subordinated notes for $75.0 million; and

•
Operating leases for $37.7 million.

For additional information on the Company's long-term contractual obligations above, see Note 11, Deposits, Note 21, Employee Benefit Plans, Note 12, Borrowings, and Note 9, Leases, in the accompanying consolidated financial statements.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

We have financial instruments with off-balance sheet risk established in the normal course of business to meet the financing needs of customers. These financial instruments include commitments to extend credit for $936.3 million and standby letters of credit for $24.9 million as of December 31, 2021. We do not expect all of the commitments to extend credit and standby letters of credit to be funded. Thus, the total commitment amounts do not necessarily represent our future cash requirements.

We have committed to investments in limited partnerships primarily related to small business investment companies and tax credit investments. As of December 31, 2021, the off-balance sheet commitments related to the limited partnership small business investment companies and tax credit investments totaled $6.4 million and $9.7 million, respectively. We have also recorded a $20.2 million liability primarily related to committed contributions for tax credit investments in property placed in service on or before December 31, 2021. The timing of future contributions to be made to these tax credit investments cannot be specifically or reasonably determined.

With the exception of obligations in connection with our irrevocable loan commitments, limited partnership investments and tax credit investments as of December 31, 2021, we had no other off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. For additional information on off-balance sheet arrangements, see Note 1, Summary of Significant Accounting Policies and Note 14, Commitments and Contingencies, in the notes to the accompanying consolidated financial statements.

Security Yields and Maturities Schedule

The following table sets forth certain information regarding the amortized cost (“Cost”), cost-weighted average yields (“Yield”), which is defined as the book yield weighted against the ending book value, and contractual maturities of our debt securities portfolio as of December 31, 2021. Mortgage-backed securities are included in maturity categories based on their stated maturity date. Actual maturities may differ from the contractual maturities presented because borrowers may have the right to call or prepay certain investments. No tax-equivalent adjustments were made to the weighted average yields. The tax-exempt portfolio book balance has decreased by $43.3 million since December 31, 2020 due to maturities in 2021 (dollars in thousands).

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Contractual Loan Maturity Schedule

The following table summarizes the contractual maturities of our loan portfolio at December 31, 2021. Loans, net of deferred loan origination costs, include principal amortization and non-accruing loans. Demand loans having no stated schedule of repayment or maturity and overdrafts are reported as due in one year or less (in thousands).

(1) Amounts include prepayment assumptions based on actual historical experience.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Capital Resources

The FRB has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies on a consolidated basis. The final rules implementing the Basel Committee on Banking Supervision’s (“BCBS”) capital guidelines for U.S. banks were fully phased-in on January 1, 2019. As of December 31, 2021, the Company’s capital levels remained characterized as “well-capitalized” under the BCBS rules. See Note 15, Regulatory Matters of the notes to consolidated financial statements and the “Basel III Capital Rules” section below for further discussion. The following table reflects the Company’s ratios and their components as of December 31 (in thousands):

(1)
Includes unrealized gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category.

We have elected to apply the 2020 CECL transition provision related to the impact of the CECL accounting standard on regulatory capital, as provided by the US banking agencies’ March 2020 interim final rule. Under the 2020 CECL transition provision, the regulatory capital impact of the Day 1 adjustment to the allowance for credit losses (after-tax) upon the January 1, 2020 CECL adoption date has been deferred and will phase in to regulatory capital at 25% per year commencing January 1, 2022. For the ongoing impact of CECL, we are allowed to defer the regulatory capital impact of the allowance for credit losses in an amount equal to 25% of the change in the allowance for credit losses (pre-tax) recognized through earnings for each period between January 1, 2020, and December 31, 2021. The cumulative adjustment to the allowance for credit losses between January 1, 2020, and December 31, 2021, will also phase in to regulatory capital at 25% per year commencing January 1, 2022.

Basel III Capital Rules

Under the Basel III Rules, the current minimum capital ratios, including an additional capital conservation buffer applicable to the Company and the Bank, are:

•
7.0% CET1 to risk-weighted assets;

•
8.5% Tier 1 capital (that is, CET1 plus Additional Tier 1 capital) to risk-weighted assets; and

•
10.5% Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets.

As of December 31, 2021, the Company’s capital levels remained characterized as “well-capitalized” under the Basel III rules.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

CRITICAL ACCOUNTING ESTIMATES

Our consolidated financial statements are prepared in accordance with GAAP and are consistent with predominant practices in the financial services industry. Application of critical accounting policies, which are those policies that management believes are the most important to our financial position and results, requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes and are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions and judgments, which, in turn, may affect amounts reported in the financial statements.

We have numerous accounting policies, of which the most significant are presented in Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and, in this discussion, provide information on how significant assets, liabilities, revenues and expenses are reported in the consolidated financial statements and how those reported amounts are determined. Based on the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for credit losses, valuation of goodwill and deferred tax assets, and accounting for defined benefit plans require particularly subjective or complex judgments important to our financial position and results of operations, and, as such, are considered to be critical accounting policies as discussed below. These estimates and assumptions are based on management’s best estimates and judgment and are evaluated on an ongoing basis using historical experience and other factors, including the current economic environment. We adjust these estimates and assumptions when facts and circumstances dictate. Illiquid credit markets and volatile equity have combined with declines in consumer spending to increase the uncertainty inherent in these estimates and assumptions. As future events cannot be determined with precision, actual results could differ significantly from our estimates.

Adequacy of the Allowance for Credit Losses

The allowance for credit losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of subjective measurements including, but not limited to, management’s assessment of the internal risk classifications of loans, estimating future losses utilizing current forecasts, forward-looking estimates of qualitative factors including existing economic conditions, portfolio administration, delinquency, the regulatory environment and the Company’s lending policies. Because current economic conditions and borrower strength can change, and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the appropriateness of the allowance for credit losses, could change significantly. As an integral part of their examination process, various regulatory agencies also review the allowance for credit losses. Such agencies may require additions to the allowance for credit losses or may require that certain loan balances be charged off or downgraded into criticized loan categories when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. We believe the level of the allowance for credit losses is appropriate as recorded in the consolidated financial statements.

For additional discussion related to our accounting policies for the allowance for credit losses, see the sections titled “Allowance for Credit Losses” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements.

Valuation of Goodwill

Goodwill represents the excess of the purchase price over the fair value of net assets acquired in accordance with the purchase method of accounting for business combinations. Goodwill has an indefinite useful life and is not amortized but is tested for impairment. GAAP requires goodwill to be tested for impairment at our reporting unit level on an annual basis and more frequently if events or circumstances indicate that there may be impairment. We test goodwill for impairment as of October 1st of each year.

Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value. In testing goodwill for impairment, GAAP permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If, after assessing the totality of events and circumstances, we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying value, no further testing is performed. However, if we conclude otherwise, we would then be required to perform a goodwill impairment test by comparing the fair value of the reporting unit with its carrying value. If the carrying value of the reporting unit exceeds its fair value, a goodwill impairment charge is recognized for the difference, but not to exceed the amount of goodwill allocated to the reporting unit.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Valuation of Deferred Tax Assets and Liabilities

The determination of deferred tax expense or benefit is based on changes in the carrying amounts of assets and liabilities that generate temporary differences. The carrying value of our net deferred tax assets or liabilities assumes that we will be able to generate sufficient future taxable income based on estimates and assumptions (after consideration of historical taxable income as well as tax planning strategies). If these estimates and related assumptions change, we may be required to record valuation allowances against our deferred tax assets and liabilities resulting in additional income tax expense or benefit in the consolidated statements of income. We evaluate deferred tax assets and liabilities on a quarterly basis and assess the need for a valuation allowance, if any. A valuation allowance is established when management believes that it is more likely than not that some portion of its deferred tax assets and liabilities will not be realized. Changes in valuation allowance from period to period are included in our tax provision in the period of change. For additional discussion related to our accounting policy for income taxes see Note 19, Income Taxes, of the notes to consolidated financial statements.

Defined Benefit Pension Plan

We have a defined benefit pension plan covering substantially all employees. For employees hired prior to December 31, 2006, who met participation requirements on or before January 1, 2008 (“Tier 1 Participant”), the benefits are generally based on years of service and the employee’s highest average compensation during five consecutive years of employment. For eligible employees who were hired on and after January 1, 2007 (“Tier 2 Participant”), the benefits are generally based on a cash balance benefit formula. Assumptions are made concerning future events that will determine the amount and timing of required benefit payments, funding requirements and defined benefit pension expense. The major assumptions are the weighted average discount rate used in determining the current benefit obligation, the weighted average expected long-term rate of return on plan assets, the rate of compensation increase and the estimated mortality rate. The weighted average discount rate was based upon the projected benefit cash flows and the market yields of high grade corporate bonds that are available to pay such cash flows as of the measurement date, December 31. The weighted average expected long-term rate of return is estimated based on current trends experienced by the assets in the plan as well as projected future rates of return on those assets and reasonable actuarial assumptions for long term inflation, and the real and nominal rate of investment return for a specific mix of asset classes. The current target asset allocation model for the plans is detailed in Note 21 to the consolidated financial statements. The expected returns on these various asset categories are blended to derive one long-term return assumption. The assets are invested in certain collective investment and mutual funds, common stocks, U.S. Treasury and other U.S. government agency securities, and corporate and municipal bonds and notes. The rate of compensation increase is based on reviewing the compensation increase practices of other plan sponsors in similar industries and geographic areas as well as the expectation of future increases. Mortality rate assumptions are based on mortality tables published by third-parties such as the Society of Actuaries (“SOA”), considering other available information including historical data as well as studies and publications from reputable sources. We review the pension plan assumptions on an annual basis with our actuarial consultants to determine if the assumptions are reasonable and adjust the assumptions to reflect changes in future expectations.

The assumptions used to calculate 2021 expense for the defined benefit pension plan were a weighted average discount rate of 2.32%, a weighted average long-term rate of return on plan assets of 5.25% and a rate of compensation increase of 3.00%. Defined benefit pension expense in 2022 is expected to decrease to $1.8 million from the $1.9 million recorded in 2021.

Due to the long-term nature of pension plan assumptions, actual results may differ significantly from the actuarial-based estimates. Differences resulting in actuarial gains or losses are required to be recorded in shareholders’ equity as part of accumulated other comprehensive income (loss) and amortized to defined benefit pension expense in future years. For 2021, the actual return on plan assets in the qualified defined benefit pension plan was $6.4 million, compared to an expected return on plan assets of $5.2 million. Total pretax losses recognized in accumulated other comprehensive income (loss) at December 31, 2021 were $12.6 million for the defined benefit pension plan. Actuarial pretax net gains recognized in other comprehensive income (loss) for the year ended December 31, 2021 were $3.1 million for the defined benefit pension plan.

Defined benefit pension expense is recorded in “Salaries and employee benefits” expense on the consolidated statements of income.

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 1, Summary of Significant Accounting Policies - Recent Accounting Pronouncements, in the notes to consolidated financial statements for a discussion of recent accounting pronouncements.

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