# FINANCIAL INSTITUTIONS INC (FISI) FY 2023 MD&A Verbatim Item 7 Management's Discussion and Analysis from FINANCIAL INSTITUTIONS INC's 10-K for fiscal year 2023. SEC filing source: https://www.sec.gov/Archives/edgar/data/862831/000095017024030754/fisi-20231231.htm Accession: 0000950170-24-030754 Filing date: 2024-03-13 Report date: 2023-12-31 Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Confidence: high Company profile: /company/FISI/ All MD&A years: /company/FISI/mda/ Previous year: /company/FISI/mda/fy2022/ (FY 2022) Next year: /company/FISI/mda/fy2024/ (FY 2024) 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, “Risk 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. Effective January 1, 2024, we exited the Pennsylvania automobile market in order to align our focus more fully around our core Upstate New York market. We also have loan production offices in Baltimore, Maryland, and Syracuse, New York, which expands our footprint into the Mid-Atlantic and Central New York regions. In addition, we offer Banking-as-a-Service (“BaaS”) and financial technology (“FinTech”) solutions. 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 subsidiary Courier Capital, LLC (“Courier Capital”) an SEC-registered investment advisory and wealth management firm. 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 2023 Financial Performance Review Net income decreased $6.3 million to $50.3 million for 2023, compared to $56.6 million for 2022. This resulted in a 0.83% return on average assets and an 11.86% return on average equity. Net income available to common shareholders was $48.8 million or $3.15 per diluted share for 2023, compared to $55.1 million or $3.56 per diluted share for 2022. The decrease in net income reflects the impact of the prolonged higher interest rate environment on funding costs in 2023 that generated revenue pressure and adversely impacted current year earnings in comparison to 2022. We declared cash dividends of $1.20 per common share during 2023, an increase of $0.04 per common share, or 3%, compared to the prior year. Net interest income was $165.7 million for 2023, compared to $167.4 million for 2022, a decrease of $1.7 million. Fully-taxable equivalent net interest income was $166.1 million in 2023, a decrease of $1.8 million, compared to 2022. Average interest-earning assets were $408.9 million higher than 2022 due to a $511.8 million increase in average loans and a $31.4 million increase in the average balance of Federal Reserve interest-earning cash, partially offset by a $134.3 million decrease in average investment securities. Net interest margin was 2.94% for 2023, compared to 3.20% for 2022, primarily as a result of higher funding costs amid the rising interest rate environment, partially offset by an increase in the average yield on interest-earning assets. The provision for credit losses was $13.7 million in 2023 compared to a provision of $13.3 million in 2022. Net charge-offs were $8.5 million in 2023, representing 0.20% of average loans, compared to $5.2 million, or 0.14% of average loans in 2022. Non-performing loans increased $16.5 million to $26.7 million compared to a year ago and represented 0.60% of total loans at December 31, 2023, compared to 0.25% of total loans at December 31, 2022. The increase in non-performing loans in the current year was driven by one commercial loan relationship totaling $13.6 million that was placed on nonaccrual status during the fourth quarter of 2023. - 38 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS Noninterest income totaled $48.2 million for the full year 2023, an increase of $2.0 million, or 4.3%, when compared to the prior year. The increase was primarily attributed to an increase in income from company owned life insurance (“COLI”) and partially offset by an increase in net loss on investment securities and a decrease in service charges on deposits. Included in income from company owned life insurance for 2023 was an approximate $8 million increase in income, which was generated by the surrender and redeploy of $53.9 million in cash surrender value of company owned life insurance, coupled with additional premium investment. The revenue from the transaction, which was partially offset by $5.4 million of related incremental income taxes, was based upon the crediting rate of the premium allocation to separate account investments, as supported by the performance of the underlying investment divisions. The cash surrender value of the separate account COLI and corresponding revenue is expected to stabilize in future periods. Net loss on investment securities of $3.6 million for the full year 2023 reflected the loss on the sale of approximately $54 million of lower yielding available-for-sale agency mortgage-backed securities, reinvesting the proceeds of such sale into higher yielding bonds. The decrease in service charges on deposits was primarily due to a reduction in nonsufficient fund fees as a result of January 2023 changes in the Bank’s consumer overdraft program that align with trends in community banking. Noninterest expense for the full year 2023 totaled $137.2 million, a $7.9 million increase compared to $129.4 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, primarily driven by a new customer relationship management system implemented in late 2021. FDIC assessments increased $2.5 million, due in part to the increase in the base deposit insurance assessment rate schedules by two basis points, coupled with balance sheet growth compared to 2022. Salaries and benefits expense increased $2.3 million year-over-year, primarily due to annual merit increases, higher pension expenses and increased medical and dental claim activity, partially offset by lower stock-based compensation, executive bonuses and incentive compensation. Other expenses were $3.0 million higher than 2022 primarily due to interest charges related to collateral held for derivative transactions, higher insurance costs and the impact of inflationary pressures generally. These increases were partially offset by a decrease in restructuring charges in 2023, as restructuring charges related to the 2020 closing of five branches totaled $1.6 million in 2022. Income tax expense for the year was $12.8 million, representing an effective tax rate of 20.3% compared to $14.4 million, representing an effective tax rate of 20.3% in 2022. The decrease in income tax expense was primarily due to the decrease in income before income taxes in 2023 compared to 2022. Income tax expense for 2023 and 2022 included $5.4 million and $2.0 million, respectively, of incremental taxes associated with the COLI surrender and redeployment strategy executed in in the respective 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 COLI and tax credit investments placed in service. Total assets were $6.16 billion at December 31, 2023, up $363.6 million from $5.80 billion at December 31, 2022. Investment securities were $1.04 billion at December 31, 2023, down $107.5 million from December 31, 2022. The decrease from year-end 2022 was primarily the result of the use of portfolio cash flow to fund loan originations. Total loans were $4.46 billion at December 31, 2023, up $411.7 million, or 10%, from December 31, 2022. The increase in loans in 2023 was primarily driven by strong commercial loan growth in the first half of the year. The following discusses significant changes within our loan portfolio: • Commercial business loans totaled $735.7 million, an increase of $71.5 million, or 11%, from December 31, 2022. • Commercial mortgage loans totaled $2.01 billion, an increase of $325.5 million, or 19%, from December 31, 2022. • Residential real estate loans totaled $649.8 million, an increase of $59.9 million, or 10%, from December 31, 2022. • Consumer indirect loans totaled $948.8 million, a decrease of $74.8 million, or 7%, from December 31, 2022. Total deposits were $5.21 billion at December 31, 2023, an increase of $283.5 million from December 31, 2022, which was driven by increases in nonpublic deposits associated with a money market advertising campaign during 2023, as well as reciprocal and Banking-as-a-Service deposit growth. Short-term borrowings were $185.0 million at December 31, 2023, a decrease of $20.0 million from December 31, 2022. Short-term borrowings and brokered deposits have historically been utilized to manage the seasonality of public deposits. - 39 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS Shareholders’ equity was $454.8 million at December 31, 2023, compared to $405.6 million at December 31, 2022. Common book value per share was $28.40 at December 31, 2023, an increase of $3.09, or 12%, from $25.31 at December 31, 2022. Tangible common book value per share (1) was $23.69 at December 31, 2023, an increase of $3.16, or 15%, from $20.53 at December 31, 2022. The increase in shareholders’ equity as compared to December 31, 2022, was primarily attributable to an increase in retained earnings due to our net income for the year and a reduction in longer-term interest rates, which reduced accumulated other comprehensive loss associated with unrealized losses in the available for sale securities portfolio. Management believes the unrealized losses are temporary in nature, as the losses are associated with the increase in interest rates. The securities portfolio continues to generate cash flow and given the high quality of our agency mortgaged-backed securities portfolio, management expects the bonds to ultimately mature at a terminal value equivalent to par. (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. The Company’s leverage ratio was 8.18% at December 31, 2023 compared to 8.33% at December 31, 2022. The Bank’s leverage ratio and total risk-based capital ratio were 9.06% and 11.76%, respectively, at December 31, 2023, compared to 9.17% and 11.60%, respectively, at December 31, 2022. Additional financial highlights of the Company are as follows: [[GREPCENT_TABLE]] [["","","At or for the year ended December 31,"],["","","2023","","","2022","","","2021"],["Performance ratios:"],["Net income, returns on:"],["Average assets","","","0.83","%","","","1.01","%","","","1.46","%"],["Average equity","","","11.86","%","","","12.81","%","","","16.01","%"],["Net income available to common shareholders, returns on:"],["Average common equity","","","12.01","%","","","12.99","%","","","16.29","%"],["Average tangible common equity (1)","","","14.64","%","","","15.72","%","","","19.37","%"],["Average tangible assets (1)","","","0.82","%","","","1.00","%","","","1.45","%"],["Common dividend payout ratio","","","37.85","%","","","32.40","%","","","22.45","%"],["Net interest margin (fully tax-equivalent)","","","2.94","%","","","3.20","%","","","3.14","%"],["Effective tax rate","","","20.3","%","","","20.3","%","","","20.1","%"],["Efficiency ratio (2)","","","62.96","%","","","60.39","%","","","55.76","%"],["Capital ratios:"],["Leverage ratio","","","8.18","%","","","8.33","%","","","8.23","%"],["Common equity Tier 1 capital ratio","","","9.43","%","","","9.42","%","","","10.28","%"],["Tier 1 capital ratio","","","9.76","%","","","9.78","%","","","10.68","%"],["Total risk-based capital ratio","","","12.13","%","","","12.13","%","","","13.12","%"],["Average equity to average assets","","","7.03","%","","","7.88","%","","","9.10","%"],["Common equity to assets","","","7.10","%","","","6.70","%","","","8.84","%"],["Tangible common equity to tangible assets (1)","","","6.00","%","","","5.50","%","","","7.59","%"]] [[/GREPCENT_TABLE]] (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. - 40 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS GAAP to Non-GAAP Reconciliation [[GREPCENT_TABLE]] [["(In thousands, except per share data)","","At or for the year ended December 31,"],["","","2023","","","2022","","","2021"],["Computation of ending tangible common equity:"],["Common shareholders\u2019 equity","","$","437,504","","","$","388,313","","","$","487,850"],["Less: goodwill and other intangible assets, net","","","72,504","","","","73,414","","","","74,400"],["Tangible common equity","","$","365,000","","","$","314,899","","","$","413,450"],["Computation of ending tangible assets:"],["Total assets","","$","6,160,881","","","$","5,797,272","","","$","5,520,779"],["Less: goodwill and other intangible assets, net","","","72,504","","","","73,414","","","","74,400"],["Tangible assets","","$","6,088,377","","","$","5,723,858","","","$","5,446,379"],["Tangible common equity to tangible assets (1)","","","6.00","%","","","5.50","%","","","7.59","%"],["Common shares outstanding","","","15,407","","","","15,340","","","","15,745"],["Tangible common book value per share (2)","","$","23.69","","","$","20.53","","","$","26.26"],["Computation of average tangible common equity:"],["Average common equity","","$","406,394","","","$","424,421","","","$","468,085"],["Average goodwill and other intangible assets, net","","","73,055","","","","73,913","","","","74,411"],["Average tangible common equity","","$","333,339","","","$","350,508","","","$","393,674"],["Computation of average tangible assets:"],["Average assets","","$","6,025,383","","","$","5,606,733","","","$","5,335,808"],["Average goodwill and other intangible assets, net","","","73,055","","","","73,913","","","","74,411"],["Average tangible assets","","$","5,952,328","","","$","5,532,820","","","$","5,261,397"],["Net income available to common shareholders","","$","48,805","","","$","55,114","","","$","76,237"],["Return on average tangible common equity (3)","","","14.64","%","","","15.72","%","","","19.37","%"],["Return on average tangible assets (4)","","","0.82","%","","","1.00","%","","","1.45","%"]] [[/GREPCENT_TABLE]] (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. - 41 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS RESULTS OF OPERATIONS FOR THE YEARS ENDED December 31, 2023 AND December 31, 2022 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, 2023. 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 interest-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 interest-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 interest-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 interest-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 Federal Reserve increased the intended federal funds rate, which is the cost of immediately available overnight funds, throughout 2022 and 2023, in an attempt by the Federal Reserve to curb inflation. The first increase in March 2022 increased the federal funds rate by 25-basis points to 0.25% to 0.50%, followed by a 50-basis points increase in May 2022 to 0.75% to 1.00%. The Federal Reserve increased the federal funds rate by 75-basis points each in June, July, September, and November 2022, and by 50-basis points in December 2022 resulting in a federal funds rate of 4.25% to 4.50% as of year-end 2022. The Federal Reserve further increased the federal funds rate by 25-basis points each in February, March, May, and July 2023 resulting in a federal funds rate of 5.25% to 5.50% as of year-end 2023. 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, was 8.50% at December 31, 2023, compared to 7.50% at December 31, 2022. 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): [[GREPCENT_TABLE]] [["","","2023","","","2022","","","2021"],["Interest income per consolidated statements of income","","$","286,133","","","$","196,107","","","$","167,205"],["Adjustment to fully taxable equivalent basis","","","418","","","","544","","","","626"],["Interest income adjusted to a fully taxable equivalent basis","","","286,551","","","","196,651","","","","167,831"],["Interest expense per consolidated statements of income","","","120,418","","","","28,735","","","","12,475"],["Net interest income on a taxable equivalent basis","","$","166,133","","","$","167,916","","","$","155,356"]] [[/GREPCENT_TABLE]] Analysis of Net Interest Income and Net Interest Margin Net interest income on a taxable equivalent basis for 2023 was $166.1 million, a decrease of $1.8 million compared to $167.9 million for 2022. The decrease in net interest income was due primarily to higher funding costs amid the rising interest rate environment. Our net interest margin for 2023 was 2.94%, 26-basis points lower than 3.20% from the prior year. This decrease was a function of a 70-basis points decrease in the interest rate spread, partially offset by a 44-basis points higher contribution from net free funds. The change in interest rate spread was a net result of a 202-basis points increase in the average cost of interest-bearing liabilities, partially offset by a 132-basis points increase in the average yield on average interest-earning assets. For the year ended December 31, 2023, the average yield on average interest-earning assets of 5.07% was 132-basis points higher than 2022. Loan yields increased 150-basis points during 2023 to 5.98%. The average yield on investment securities increased 11-basis points during 2023 to 1.92%. Overall, the interest-earning asset rate changes increased interest income by $64.3 million during 2023 and a favorable volume variance increased interest income by $25.6 million, which collectively drove an $89.9 million increase in interest income. - 42 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS Average interest-earning assets were $5.65 billion for 2023 compared to $5.24 billion for 2022, an increase of $408.9 million, or 8%, with average loans up $511.8 million from $3.81 billion for 2022 to $4.32 billion for 2023, while average securities were down $134.3 million from $1.38 billion for 2022 to $1.25 billion for 2023. Securities represented 22.1% of average interest-earning assets during 2023 compared to 26.4% in 2022. Loans comprised 76.5% of average interest-earning assets during 2023 compared to 72.7% during 2022. The growth in average loans was primarily due to organic growth in commercial loans bolstered by our expansion into the Mid-Atlantic Region, as well as organic growth residential and other consumer loans, partially offset by a decline in consumer indirect. Loans generally have significantly higher yields compared to other interest-earning assets and, as such, have a more positive effect on the net interest margin. An increase in the volume of average loans resulted in a $27.6 million increase in interest income and higher interest rates increased interest income by $60.2 million. The decrease in the average balance of investment securities was primarily due to repayment and maturities of investment securities, and the use of cash to fund loan originations. For the year ended December 31, 2023, the average cost of average interest-bearing liabilities of 2.75% was 202-basis points higher than 2022. The average cost of average interest-bearing deposits of 2.63% was 202-basis points higher than 2022 primarily due to the continued repricing of deposits at higher rates as a result of the rising interest rate environment that occurred in 2022 and continued into 2023. The average cost of total borrowings increased 65-basis points to 4.23% in 2023, compared to 3.58% in 2022. Average interest-bearing liabilities of $4.39 billion in 2023 were $456.1 million, or 12%, higher than 2022. On average, interest-bearing deposits grew $307.5 million from $3.77 billion for 2022 to $4.08 billion for 2023, while noninterest-bearing demand deposits (a principal component of net free funds) decreased $74.6 million, or 7%, to $1.03 billion. The increase in average deposits was due to growth in non-public deposits, brokered deposits, and reciprocal deposits, partially offset by a decrease in public deposits. Average short-term borrowings increased $100.8 million from $86.1 million in 2022 to $186.9 million in 2023 as short-term borrowings were utilized, in addition to deposits, to fund interest-earning asset growth. 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 interest rate changes and volume changes resulted in an increase in interest expense of $77.8 million and $6.6 million, respectively, as compared to 2022, and total borrowings volume and interest rate changes contributed $7.3 million of higher interest expense during 2023. - 43 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS The following table presents, for the years indicated, information regarding: (i) average balances, which were derived from daily balances; (ii) the amount of interest income from interest-earning assets and the resulting annualized yields (tax-exempt yields have been adjusted to a tax-equivalent basis using the applicable Federal tax rate in each year); (iii) the amount of interest expense on interest-bearing liabilities and the resulting annualized rates; (iv) net interest income; (v) net interest rate spread; (vi) net interest income as a percentage of average interest-earning assets (“net interest margin”); and (vii) the ratio of average interest-earning assets to average interest-bearing liabilities. Investment securities are at amortized cost for both held to maturity and available for sale securities. Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Dollar amounts are shown in thousands. [[GREPCENT_TABLE]] [["","","Years ended December 31,"],["","","2023","","","2022"],["","","Average Balance","","","Interest","","","Average Rate","","","Average Balance","","","Interest","","","Average Rate"],["Interest-earning assets:"],["Federal funds sold and other interest-earning deposits","","$","80,415","","","$","3,927","","","","4.88","%","","$","49,055","","","$","747","","","","1.52","%"],["Investment securities (1):"],["Taxable","","","1,177,615","","","","22,048","","","","1.87","","","","1,283,575","","","","22,498","","","","1.75"],["Tax-exempt (2)","","","72,313","","","","1,993","","","","2.76","","","","100,633","","","","2,587","","","","2.57"],["Total investment securities","","","1,249,928","","","","24,041","","","","1.92","","","","1,384,208","","","","25,085","","","","1.81"],["Loans:"],["Commercial business","","","698,861","","","","50,388","","","","7.21","","","","628,729","","","","30,188","","","","4.80"],["Commercial mortgage","","","1,908,355","","","","124,240","","","","6.51","","","","1,502,904","","","","70,608","","","","4.70"],["Residential real estate loans","","","612,767","","","","22,728","","","","3.71","","","","579,362","","","","19,558","","","","3.38"],["Residential real estate lines","","","76,350","","","","5,608","","","","7.34","","","","77,132","","","","3,283","","","","4.26"],["Consumer indirect","","","997,538","","","","53,435","","","","5.36","","","","1,008,026","","","","45,645","","","","4.53"],["Other consumer","","","28,741","","","","2,184","","","","7.60","","","","14,636","","","","1,538","","","","10.51"],["Total loans (3)","","","4,322,612","","","","258,583","","","","5.98","","","","3,810,789","","","","170,820","","","","4.48"],["Total interest-earning assets","","","5,652,955","","","","286,551","","","","5.07","","","","5,244,052","","","","196,652","","","","3.75"],["Less: Allowance for credit losses","","","(49,198",")","","","","","","","","","(42,689",")"],["Other noninterest-earning assets","","","421,626","","","","","","","","","","405,370"],["Total assets","","$","6,025,383","","","","","","","","","$","5,606,733"],["Interest-bearing liabilities:"],["Deposits:"],["Interest-bearing demand","","$","818,541","","","","7,127","","","","0.87","","","$","909,799","","","","2,180","","","","0.24"],["Savings and money market","","","1,781,776","","","","41,424","","","","2.32","","","","1,852,571","","","","9,778","","","","0.53"],["Time deposits","","","1,477,596","","","","58,810","","","","3.98","","","","1,008,092","","","","11,036","","","","1.09"],["Total interest-bearing deposits","","","4,077,913","","","","107,361","","","","2.63","","","","3,770,462","","","","22,994","","","","0.61"],["Short-term borrowings","","","186,910","","","","6,890","","","","3.69","","","","86,139","","","","1,500","","","","1.74"],["Long-term borrowings","","","121,903","","","","6,167","","","","5.06","","","","74,059","","","","4,242","","","","5.73"],["Total borrowings","","","308,813","","","","13,057","","","","4.23","","","","160,198","","","","5,742","","","","3.58"],["Total interest-bearing liabilities","","","4,386,726","","","","120,418","","","","2.75","","","","3,930,660","","","","28,736","","","","0.73"],["Noninterest-bearing demand deposits","","","1,030,648","","","","","","","","","","1,105,281"],["Other noninterest-bearing liabilities","","","184,323","","","","","","","","","","129,079"],["Shareholders\u2019 equity","","","423,686","","","","","","","","","","441,713"],["Total liabilities and shareholders\u2019 equity","","$","6,025,383","","","","","","","","","$","5,606,733"],["Net interest income (tax-equivalent)","","","","","$","166,133","","","","","","","","","$","167,916"],["Interest rate spread","","","","","","","","","2.32","%","","","","","","","","","3.02","%"],["Net earning assets","","$","1,266,229","","","","","","","","","$","1,313,392"],["Net interest margin (tax-equivalent)","","","","","","","","","2.94","%","","","","","","","","","3.20","%"],["Ratio of average interest-earning assets to average interest-bearing liabilities","","","128.87","%","","","","","","","","","133.41","%"]] [[/GREPCENT_TABLE]] (1) Investment securities are shown at amortized cost. (2) The interest on tax-exempt securities is calculated on a tax-equivalent basis assuming a Federal income tax rate of 21%. (3) Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Net deferred loan fees (costs) included in interest income were as follows (in thousands): [[GREPCENT_TABLE]] [["","","2023","","","2022","","","2021"],["Commercial business","","$","(56",")","","$","2,002","","","$","8,087"],["Commercial mortgage","","","2,324","","","","2,200","","","","1,573"],["Residential real estate loans","","","(1,672",")","","","(1,829",")","","","(2,241",")"],["Residential real estate lines","","","(373",")","","","(327",")","","","(426",")"],["Consumer indirect","","","(1,792",")","","","(2,141",")","","","(1,549",")"],["Other consumer","","","19","","","","18","","","","6"],["Total","","$","(1,550",")","","$","(77",")","","$","5,450"]] [[/GREPCENT_TABLE]] The net interest spread, as well as the net interest margin, will be impacted by future changes in short-term and long-term interest rate levels, as well as the impact from the competitive environment. A discussion of the effects of changing interest rates on net interest income is set forth in Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” included elsewhere in this report. - 44 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS Rate /Volume Analysis The following table presents, on a tax-equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest income or interest expense not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands). No out-of-period adjustments were included in the rate/volume analysis. [[GREPCENT_TABLE]] [["","","Change from 2022 to 2023","","","Change from 2021 to 2022"],["Increase (decrease) in:","","Volume","","","Rate","","","Total","","","Volume","","","Rate","","","Total"],["Interest income:"],["Federal funds sold and interest-earning deposits","","$","715","","","$","2,465","","","$","3,180","","","$","(255",")","","$","786","","","$","531"],["Investment securities:"],["Taxable","","","(1,927",")","","","1,477","","","","(450",")","","","4,798","","","","964","","","","5,762"],["Tax-exempt","","","(770",")","","","176","","","","(594",")","","","(533",")","","","139","","","","(394",")"],["Total investment securities","","","(2,697",")","","","1,653","","","","(1,044",")","","","4,265","","","","1,103","","","","5,368"],["Loans:"],["Commercial business","","","3,674","","","","16,526","","","","20,200","","","","(4,606",")","","","5,327","","","","721"],["Commercial mortgage","","","22,073","","","","31,559","","","","53,632","","","","7,371","","","","11,518","","","","18,889"],["Residential real estate loans","","","1,169","","","","2,001","","","","3,170","","","","(474",")","","","(130",")","","","(604",")"],["Residential real estate lines","","","(33",")","","","2,358","","","","2,325","","","","(181",")","","","680","","","","499"],["Consumer indirect","","","(480",")","","","8,270","","","","7,790","","","","5,083","","","","(1,619",")","","","3,464"],["Other consumer","","","1,164","","","","(518",")","","","646","","","","(70",")","","","23","","","","(47",")"],["Total loans","","","27,567","","","","60,196","","","","87,763","","","","7,123","","","","15,799","","","","22,922"],["Total interest income","","","25,585","","","","64,314","","","","89,899","","","","11,133","","","","17,688","","","","28,821"],["Interest expense:"],["Deposits:"],["Interest-bearing demand","","","(240",")","","","5,187","","","","4,947","","","","124","","","","900","","","","1,024"],["Savings and money market","","","(388",")","","","32,034","","","","31,646","","","","(22",")","","","6,437","","","","6,415"],["Time deposits","","","7,174","","","","40,600","","","","47,774","","","","438","","","","6,999","","","","7,437"],["Total interest-bearing deposits","","","6,546","","","","77,821","","","","84,367","","","","540","","","","14,336","","","","14,876"],["Short-term borrowings","","","2,758","","","","2,632","","","","5,390","","","","1,593","","","","(213",")","","","1,380"],["Long-term borrowings","","","2,469","","","","(544",")","","","1,925","","","","18","","","","(13",")","","","5"],["Total borrowings","","","5,227","","","","2,088","","","","7,315","","","","1,611","","","","(226",")","","","1,385"],["Total interest expense","","","11,773","","","","79,909","","","","91,682","","","","2,151","","","","14,110","","","","16,261"],["Net interest income","","$","13,812","","","$","(15,595",")","","$","(1,783",")","","$","8,982","","","$","3,578","","","$","12,560"]] [[/GREPCENT_TABLE]] Provision for Credit Losses The provision for credit losses was $13.7 million for the year ended December 31, 2023 compared with $13.3 million for 2022. The provision for credit losses – loans was $14.2 million for 2023, compared with $11.0 million for 2022. The increase to the loan loss provision in 2023 was primarily driven by higher overall net charge-offs and specific reserves, partially offset by a decline in the level of unfunded commitments. Also included in the provision for credit losses was a credit loss benefit for unfunded commitments of $531 thousand for 2023, compared to credit loss expense of $2.3 million for 2022. See the “Allowance for Credit Losses” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion. - 45 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS Noninterest Income The following table summarizes our noninterest income for the years ended December 31 (in thousands): [[GREPCENT_TABLE]] [["","","2023","","","2022","","","2021"],["Service charges on deposits","","$","4,625","","","$","5,889","","","$","5,571"],["Insurance income","","","6,708","","","","6,364","","","","5,750"],["Card interchange income","","","8,220","","","","8,205","","","","8,498"],["Investment advisory","","","10,955","","","","11,493","","","","11,672"],["Company owned life insurance","","","12,106","","","","5,542","","","","2,947"],["Investments in limited partnerships","","","1,783","","","","1,293","","","","2,081"],["Loan servicing","","","479","","","","507","","","","415"],["Income from derivative instruments, net","","","1,350","","","","1,919","","","","2,695"],["Net gain on sale of loans held for sale","","","566","","","","1,227","","","","2,950"],["Net (loss) gain on investment securities","","","(3,576",")","","","(15",")","","","71"],["Net (loss) gain on other assets","","","(6",")","","","(16",")","","","441"],["Net loss on tax credit investments","","","(252",")","","","(815",")","","","(431",")"],["Other","","","5,286","","","","4,678","","","","4,246"],["Total noninterest income","","$","48,244","","","$","46,271","","","$","46,906"]] [[/GREPCENT_TABLE]] The following information discusses the significant changes in noninterest income for the year ended December 31, 2023 compared to the year ended December 31, 2022. Service charges on deposits decreased $1.3 million, or 21% to $4.6 million in 2023, compared to $5.9 million in 2022. The decrease was primarily due to a reduction in nonsufficient funds fees as a result of January 2023 changes in the Bank’s consumer overdraft program that align with trends in community banking. Company owned life insurance (“COLI”) income increased $6.6 million to $12.1 million in 2023, compared to $5.5 million in 2022. The increase was primarily attributable to income from the surrender and redeploy of $53.9 million in cash surrender COLI in 2023. The revenue from the transaction, which was partially offset by $5.4 million of related incremental income taxes, was based upon the credit rating of the premium allocation to separate account investments, as supported by the performance of the underlying investment divisions. The cash surrender value of the separate account COLI and the corresponding revenue is expected to stabilize in future periods. Included in income in 2022 was $2.0 million of income from the surrender and redeployment of $25.5 million in cash surrender value of company owned life insurance, which was offset by approximately $2.0 million of incremental income tax expense. Income from derivative instruments, net decreased $569 thousand, or 30%, to $1.4 million in 2023, compared to $1.9 million in 2022. Income from derivative instruments, net is based on the number and value of interest rate swap transactions executed during the year combined with the impact of changes in the fair value of borrower-facing trades. Net gain on sale of loans held for sale was $566 thousand in 2023, compared to $1.2 million in 2022. Included in 2022 was a gain of $586 thousand related to the sale of a $31.2 million portfolio of indirect loans in the second quarter of 2022. A net loss on investment securities of $3.6 million was recognized in 2023 due to the sale of approximately $54 million in lower yielding available-for-sale agency mortgage-backed securities at an after-tax loss of $2.8 million, reinvesting the proceeds of such sale into higher yielding bonds. The after-tax interest income benefit of $1.4 million annually translates to an earn-back to shareholders’ equity of two years. Net loss on tax credit investments of $252 thousand was recognized in 2023, compared to $815 thousand in 2022. The net losses include amortization of tax credit investments, partially offset by New York investment tax credits that are refundable and recorded in noninterest income. Other noninterest income increased $608 thousand, or 13%, to $5.3 million in 2023, compared to $4.7 million in 2022, primarily due to an increase in FHLB dividends which correlates with the increase in FHLB stock owned in 2023 compared to 2022. - 46 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS Noninterest Expense The following table summarizes our noninterest expense for the years ended December 31 (in thousands): [[GREPCENT_TABLE]] [["","","2023","","","2022","","","2021"],["Salaries and employee benefits","","$","71,889","","","$","69,633","","","$","60,893"],["Occupancy and equipment","","","14,798","","","","15,103","","","","14,371"],["Professional services","","","5,259","","","","5,592","","","","6,535"],["Computer and data processing","","","20,110","","","","17,638","","","","14,112"],["Supplies and postage","","","1,873","","","","1,943","","","","1,769"],["FDIC assessments","","","4,902","","","","2,440","","","","2,624"],["Advertising and promotions","","","1,926","","","","2,013","","","","1,704"],["Amortization of intangibles","","","910","","","","986","","","","1,060"],["Restructuring charges","","","114","","","","1,619","","","","111"],["Other","","","15,444","","","","12,395","","","","9,571"],["Total noninterest expense","","$","137,225","","","$","129,362","","","$","112,750"]] [[/GREPCENT_TABLE]] The following information discusses the significant changes in noninterest expense for the year ended December 31, 2023 compared to the year ended December 31, 2022. Salaries and employee benefits expense increased $2.3 million, or 3%, to $71.9 million in 2023, compared to $69.6 million in 2022. The increase was primarily due to annual merit increases, higher pension expense and increases in medical and dental claim activity, partially offset by lower stock-based compensation, executive bonuses and incentive compensation. Computer and data processing expense increased $2.5 million, or 14%, to $20.1 million in 2023, compared to $17.6 million in 2022. The increase was primarily a result of our strategic investments in data efficiency and marketing technology primarily driven by a new customer relationship management system implemented in late 2021. FDIC assessments expense increased $2.5 million to $4.9 million in 2023, compared to $2.4 million in 2022, due in part to the increase in the base deposit insurance assessment rate schedules by two basis points, coupled with balance sheet growth compared to 2022. Restructuring charges related to the 2020 closing of five branches totaled $114 thousand in 2023 and $1.6 million in 2022, representing selling costs and charges related to the write-down of real estate assets to fair market value based upon current market conditions. Other expense of $15.4 million in 2023 increased $3.0 million, or 25%, compared to $12.4 million in 2022, primarily due to interest charges related to collateral held for derivative transactions, higher insurance costs and the impact of general inflationary pressures. The efficiency ratio for the year ended December 31, 2023 was 62.96% compared with 60.39% for 2022. The higher efficiency ratio was primarily the result of the increase in noninterest expense in 2023 as described above. 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 $12.8 million for 2023, compared to $14.4 million for 2022. The decrease in income tax expense was primarily due to the decrease in income before income taxes in 2023 as compared to 2022. In 2023 and 2022, we incurred additional taxes of approximately $5.4 million and $2.0 million, respectively, associated with the capital gains of the previously mentioned COLI surrenders coupled with a 10% modified endowment contract penalty that is typical of general account surrenders. In 2023 and 2022, we recognized tax credit investments resulting in a $3.0 million and $2.6 million, respectively, reduction in income tax expense, in each year, and a $252 thousand and $815 thousand net loss recorded in noninterest income, respectively. Our effective tax rate was 20.3% for both 2023 and 2022. 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 2023 and 2022 reflects the New York State tax benefit generated by our real estate investment trust. - 47 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2022 AND DECEMBER 31, 2021 A discussion regarding our financial condition and results of operations at and for the year ended December 31, 2022 and year-to-year comparisons between 2022 and 2021, 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, 2022 and are incorporated by reference herein. ANALYSIS OF FINANCIAL CONDITION OVERVIEW At December 31, 2023, we had total assets of $6.16 billion, an increase of 6% from $5.80 billion as of December 31, 2022, largely attributable to organic loan growth, partially offset by a decrease in our investment securities portfolio. Net loans were $4.41 billion as of December 31, 2023, up $406.0 million, or 10%, compared to $4.01 billion as of December 31, 2022. The increase in net loans was primarily due to organic growth bolstered by our expansion into the Mid-Atlantic Region, as well as organic growth in residential real estate loans and other consumer loans, partially offset by a decrease in consumer indirect loans. Non-performing assets totaled $26.8 million as of December 31, 2023, up $16.6 million compared to December 31, 2022. The increase in non-performing assets was primarily driven by one commercial loan relationship totaling $13.6 million that was placed on nonaccrual status during the fourth quarter of 2023. Total deposits amounted to $5.21 billion as of December 31, 2023, up $283.5 million, or 6%, compared to December 31, 2022. As of December 31, 2023, borrowings totaled $309.5 million, compared to $279.2 million as of December 31, 2022. Common book value per common share was $28.40 and $25.31 as of December 31, 2023 and 2022, respectively. As of December 31, 2023, our total shareholders’ equity was $454.8 million compared to $405.6 million as of December 31, 2022. The increase in shareholders’ equity as compared to December 31, 2022, was primarily attributable to an increase in retained earnings due to our net income for the year and a reduction in longer-term interest rates, which reduced accumulated other comprehensive loss associated with unrealized losses in the available for sale securities portfolio. INVESTING ACTIVITIES The following table summarizes the composition of our available for sale and held to maturity securities portfolios (in thousands). [[GREPCENT_TABLE]] [["","","Investment Securities Portfolio Composition At December 31,"],["","","2023","","","2022"],["","","Amortized Cost","","","Fair Value","","","Amortized Cost","","","Fair Value"],["Securities available for sale:"],["U.S. Government agency and government-sponsored enterprise securities","","$","24,535","","","$","21,811","","","$","24,535","","","$","21,115"],["Mortgage-backed securities:"],["Agency mortgage-backed securities","","","1,013,455","","","","865,594","","","","1,102,522","","","","932,919"],["Non-Agency mortgage-backed securities","","","-","","","","325","","","","-","","","","337"],["Total available for sale securities","","","1,037,990","","","","887,730","","","","1,127,057","","","","954,371"],["Securities held to maturity:"],["U.S. Government agency and government-sponsored enterprise securities","","","16,513","","","","15,983","","","","16,363","","","","15,515"],["State and political subdivisions","","","68,854","","","","63,782","","","","97,583","","","","90,435"],["Mortgage-backed securities","","","62,793","","","","57,265","","","","75,034","","","","68,238"],["Total held to maturity securities","","","148,160","","","","137,030","","","","188,980","","","","174,188"],["Allowance for credit losses \u2013 securities","","","(4",")","","","","","","(5",")"],["Total held to maturity securities, net","","","148,156","","","","","","","188,975"],["Total investment securities","","$","1,186,146","","","$","1,024,760","","","$","1,316,032","","","$","1,128,559"]] [[/GREPCENT_TABLE]] 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. - 48 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS Our available for sale (“AFS”) investment securities portfolio decreased $66.6 million from $954.4 million at December 31, 2022 to $887.7 million at December 31, 2023. The decrease from year-end 2022 was primarily the result of the use of portfolio cash flow to fund loan originations. Our AFS portfolio had a net unrealized loss totaling $150.3 million at December 31, 2023 compared to a net unrealized loss of $172.7 million at December 31, 2022. The fair value of most of the investment securities in the AFS portfolio fluctuates as market interest rates change. A net loss on investment securities of $3.6 million was recognized in 2023 due to the sale of approximately $54 million in lower yielding available-for-sale agency mortgage-backed securities at an after-tax loss of $2.8 million, reinvesting the proceeds of such sale into higher yielding bonds. The after-tax interest income benefit of $1.4 million annually translates to an earn-back to shareholder’s equity of two years. 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, 2023 and 2022 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. 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, 2023, 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. As the portfolio is managed from a liquidity, earnings, and risk standpoint, sales from the AFS portfolio may be warranted based upon prevailing market factors. 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, 2023, there were two AFS securities with unrealized losses of $2.7 million in the U.S. Government agencies and GSE portfolio, both of which were in a continuous unrealized loss position for more than 12 months. The decline in fair value is attributable to changes in interest rates, not to credit quality. We do not have the intent to sell these securities and it is 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, 2023, 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, 2023, there were 199 securities in the AFS Agency MBS portfolio that were in an unrealized loss position with unrealized losses totaling $148.8 million. Of these, 196 were in an unrealized loss position for 12 months or longer and had an aggregate fair value of $813.7 million and unrealized losses of $148.8 million. 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 in prior 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, 2023 on such Agency MBS to be credit related. As of December 31, 2023, 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. - 49 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS 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 $325 thousand as of December 31, 2023. 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, 2023, our ownership of FHLB and FRB stock totaled $11.0 million and $6.4 million, respectively, and is included in other assets and recorded at cost, which approximates fair value. LENDING ACTIVITIES Total loans were $4.46 billion at December 31, 2023, an increase of $411.7 million, or 10%, from December 31, 2022. Commercial loans represented 61% of total loans at the end of 2023 and consumer loans represented 39% of total loans at December 31, 2023. The composition of our loan portfolio, excluding loans held for sale and including net unearned income and net deferred fees and costs, is summarized as follows (in thousands): [[GREPCENT_TABLE]] [["","","Loan Portfolio Composition"],["","","At December 31,"],["","","2023","","","2022"],["","","Amount","","","Percent","","","Amount","","","Percent"],["Commercial business","","$","735,700","","","","16.5","%","","$","664,249","","","","16.4","%"],["Commercial mortgage","","","2,005,319","","","","44.9","","","","1,679,840","","","","41.5"],["Total commercial","","","2,741,019","","","","61.4","","","","2,344,089","","","","57.9"],["Residential real estate loans","","","649,822","","","","14.6","","","","589,960","","","","14.5"],["Residential real estate lines","","","77,367","","","","1.7","","","","77,670","","","","1.9"],["Consumer indirect","","","948,831","","","","21.3","","","","1,023,620","","","","25.3"],["Other consumer","","","45,100","","","","1.0","","","","15,110","","","","0.4"],["Total consumer","","","1,721,120","","","","38.6","","","","1,706,360","","","","42.1"],["Total loans","","","4,462,139","","","","100.0","%","","","4,050,449","","","","100.0","%"],["Less: Allowance for credit losses","","","51,082","","","","","","","45,413"],["Total loans, net","","$","4,411,057","","","","","","$","4,005,036"]] [[/GREPCENT_TABLE]] Total commercial loans of $2.74 billion, or 61% of total loans at December 31, 2023, were comprised of commercial business loans of $735.7 million, or 16% of total loans, up $71.5 million, or 11%, from December 31, 2022, and commercial mortgage loans of $2.01 billion, or 45% of total loans, up $325.5 million, or 19%, from December 31, 2022. We typically originate commercial business loans of up to $25.0 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. We also offer commercial mortgage loans to finance the purchase of real property, which generally consists of real estate with completed structures. The majority of our commercial mortgage loans are secured by office buildings, manufacturing facilities, distribution/warehouse facilities, and retail centers, which are generally located in our local market area. Commercial loans include both owner-occupied and non-owner occupied commercial real estate loans. Approximately 16% and 19% of our total commercial loan portfolio at December 31, 2023 and December 31, 2022, respectively, was owner occupied real estate. As of December 31, 2023, commercial real estate (“CRE”) loans make up approximately 65% of total commercial loans, and 40% of total loans, commercial and industrial loans approximated 30% of total commercial loans, and 19% of total loans, and business banking unit loans were approximately 4% of total commercial loans and 3% of total loans. Our CRE committed credit exposure at December 31, 2023 related to approximately 42% multi-family, 17% office, 8% retail, 7% hospitality, 7% home builder, and 7% industrial property. Approximately 71% of our office exposure at December 31, 2023, or 12% of our total CRE exposure, related to Class B or medial office space. More than 90% of our CRE loans have full or limited personal or corporate recourse. - 50 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS The credit risk related to commercial loans is largely influenced by general economic conditions, 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, 2023, the principal balance of such loans (included in commercial loans) was $20.5 million, and the guaranteed portion amounted to $12.1 million. 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 $1.72 billion at December 31, 2023, up $14.8 million compared to 2022, and represented 39% of the 2023 year-end loan portfolio versus 42% at year-end 2022. 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 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 750 and 769 during the years ended December 31, 2023 and 2022, respectively. Residential real estate loans totaled $649.8 million at the end of 2023, down $59.9 million, or 10%, from the end of the prior year and comprised 15% of total loans outstanding at both December 31, 2023 and December 31, 2022. The residential real estate line portfolio amounted to $77.4 million at December 31, 2023 down $303 thousand, compared to 2022 and represented 2% of total loans at both December 31, 2023 and December 31, 2022. The residential real estate loans and lines portfolios had a weighted average LTV at origination of approximately 70% at December 31, 2023 and 2022. Approximately 92% of the loans and lines were first lien positions at December 31, 2023 and 2022. Consumer indirect loans amounted to $948.8 million at December 31, 2023 down $74.8 million, or 7%, compared to 2022 and represented 21% of the 2023 year-end loan portfolio versus 25% at year-end 2022. 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, 2023, we originated $292.1 million in indirect loans with a mix of approximately 27% new vehicles and 73% used vehicles. This compares with $489.0 million in indirect loans with a mix of approximately 29% new vehicles and 71% used vehicles for 2022. The average FICO score for indirect loan production was approximately 713 and 714 during the years ended December 31, 2023 and 2022, respectively. Effective January 1, 2024, we exited the Pennsylvania automobile market in order to align our focus more fully around our core Upstate New York market, which includes a strong network of approximately 375 new automobile dealers. Other consumer loans totaled $45.1 million at December 31, 2023, up $30.0 million, compared to 2022, and represented 1% of the 2023 and less than 1% of the 2022 year-end loan portfolio. Other consumer loans consist of BaaS loans, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The loan growth in our other consumer loans primarily relates to our increases in BaaS loans. - 51 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS 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, 2023, no significant concentrations, as defined above, existed in our portfolio in excess of 10% of total loans. 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 $1.4 million and $550 thousand as of December 31, 2023 and 2022, 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 $269.4 million and $275.3 million as of December 31, 2023 and 2022, respectively. Allowance for Credit Losses The following table summarizes the activity in the allowance for credit losses - loans (in thousands) for the periods indicated. [[GREPCENT_TABLE]] [["","","Credit Loss - Loans Analysis"],["","","Year Ended December 31,"],["","","2023","","","2022","","","2021"],["Allowance for credit losses - loans, beginning of period","","$","45,413","","","$","39,676","","","$","52,420"],["Net charge-offs (recoveries):"],["Commercial business","","","(109",")","","","(64",")","","","(212",")"],["Commercial mortgage","","","35","","","","(853",")","","","3,814"],["Residential real estate loans","","","89","","","","279","","","","56"],["Residential real estate lines","","","41","","","","(1",")","","","141"],["Consumer indirect","","","7,595","","","","4,538","","","","1,256"],["Other consumer","","","893","","","","1,339","","","","705"],["Total net charge-offs","","","8,544","","","","5,238","","","","5,760"],["Provision (benefit) for credit losses \u2013 loans","","","14,213","","","","10,975","","","","(6,984",")"],["Allowance for credit losses \u2013 loans, end of year","","$","51,082","","","$","45,413","","","$","39,676"],["Net loan charge-offs (recoveries) to average loans:"],["Commercial business","","","-0.02","%","","","-0.01","%","","","-0.03","%"],["Commercial mortgage","","","0.00","%","","","-0.06","%","","","0.29","%"],["Residential real estate loans","","","0.01","%","","","0.05","%","","","0.01","%"],["Residential real estate lines","","","0.05","%","","","0.00","%","","","0.17","%"],["Consumer indirect","","","0.76","%","","","0.45","%","","","0.14","%"],["Other consumer","","","3.11","%","","","9.15","%","","","4.61","%"],["Total loans","","","0.20","%","","","0.14","%","","","0.16","%"],["Allowance for credit losses \u2013 loans to total loans","","","1.14","%","","","1.12","%","","","1.08","%"],["Allowance for credit losses \u2013 loans to nonaccrual loans","","","192","%","","","445","%","","","349","%"],["Allowance for credit losses \u2013 loans to non-performing loans","","","192","%","","","445","%","","","326","%"]] [[/GREPCENT_TABLE]] Net charge-offs of $8.5 million in 2023 represented 0.20% of average loans compared to $5.2 million, or 0.14%, in 2022. The lower level of net charge-offs for 2022 included a $2.0 million recovery in connection with the pay-off of a commercial loan that was downgraded to non-performing status with a partial charge-off in the fourth quarter of 2021. The allowance for credit losses–loans increased to $51.1 million at December 31, 2023, compared with $45.4 million at December 31, 2022, due to an increase in net charge-offs and specific reserves. Non-performing loans increased $16.5 million to $26.7 million at December 31, 2023 from prior year end, primarily due to one large commercial loan relationship totaling $13.6 million that was placed on nonaccrual status during the fourth quarter of 2023. The ratio of the allowance for credit losses–loans to total loans was 1.14% and 1.12% at December 31, 2023 and 2022, respectively. The ratio of allowance for credit losses–loans to non-performing loans was 192% at December 31, 2023, compared with 445% at December 31, 2022, reflective of the large commercial loan relationship noted above. - 52 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS The following table sets forth the allocation of the allowance for credit losses–loans by loan category as of the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which actual losses may occur. The total allowance is available to absorb losses from any segment of the loan portfolio (in thousands). [[GREPCENT_TABLE]] [["","","Allowance for Credit Losses - Loans by Loan Category"],["","","At December 31,"],["","","2023","","","2022"],["","","","","","Percentage","","","","","","Percentage"],["","","Credit","","","of loans by","","","Credit","","","of loans by"],["","","Loss","","","category to","","","Loss","","","category to"],["","","Allowance","","","total loans","","","Allowance","","","total loans"],["Commercial business","","$","13,102","","","","16.5","%","","$","12,585","","","","16.4","%"],["Commercial mortgage","","","15,858","","","","44.9","","","","14,412","","","","41.5"],["Residential real estate loans","","","5,286","","","","14.6","","","","3,301","","","","14.5"],["Residential real estate lines","","","764","","","","1.7","","","","608","","","","1.9"],["Consumer indirect","","","14,099","","","","21.3","","","","14,238","","","","25.3"],["Other consumer","","","1,973","","","","1.0","","","","269","","","","0.4"],["Total","","$","51,082","","","","100.0","%","","$","45,413","","","","100.0","%"]] [[/GREPCENT_TABLE]] Loans not analyzed for a specific reserve are segmented into “pools” of loans based upon similar risk characteristics. This is referred to as the “pooled loan” component of the allowance for credit losses estimate. 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, 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, 2023. 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. - 53 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS Non-performing Assets and Potential Problem Loans The following table summarizes our non-performing assets (in thousands) as of the dates indicated: [[GREPCENT_TABLE]] [["","","Non-performing Assets"],["","","At December 31,"],["","","2023","","","2022"],["Nonaccrual loans:"],["Commercial business","","$","5,664","","","$","340"],["Commercial mortgage","","","10,563","","","","2,564"],["Residential real estate loans","","","6,364","","","","4,071"],["Residential real estate lines","","","221","","","","142"],["Consumer indirect","","","3,814","","","","3,079"],["Other consumer","","","13","","","","1"],["Total nonaccrual loans","","","26,639","","","","10,197"],["Accruing loans 90 days or more delinquent","","","21","","","","1"],["Total non-performing loans","","","26,660","","","","10,198"],["Foreclosed assets","","","142","","","","19"],["Total non-performing assets","","$","26,802","","","$","10,217"],["Nonaccrual loans to total loans","","","0.60","%","","","0.25","%"],["Non-performing loans to total loans","","","0.60","%","","","0.25","%"],["Non-performing assets to total assets","","","0.44","%","","","0.18","%"]] [[/GREPCENT_TABLE]] Non-performing assets include non-performing loans and foreclosed assets. Non-performing assets at December 31, 2023 were $26.8 million, an increase of $16.6 million from $10.2 million at December 31, 2022. The primary component of non-performing assets is non-performing loans, which were $26.7 million or 0.60% of total loans at December 31, 2023, compared with $10.2 million or 0.25% of total loans at December 31, 2022. The increase in nonperforming loans related primarily to one commercial loan relationship totaling $13.6 million that was placed on nonaccrual status during the fourth quarter of 2023. Approximately $2.3 million, or 8%, of the $26.6 million of nonaccrual loans, a component of non-performing loans, as of December 31, 2023 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. 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 $142 thousand and $19 thousand of properties representing foreclosed asset holdings at December 31, 2023 and 2022, respectively. 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 $29.9 million and $25.5 million in loans that continued to accrue interest which were classified as substandard as of December 31, 2023 and 2022, respectively. FUNDING ACTIVITIES Deposits The following table summarizes the composition of our deposits (in thousands) as of the dates indicated. [[GREPCENT_TABLE]] [["","","At December 31,"],["","","2023","","","2022"],["","","Amount","","","Percent","","","Amount","","","Percent"],["Noninterest-bearing demand","","$","1,010,614","","","","19.4","%","","$","1,139,214","","","","23.1","%"],["Interest-bearing demand","","","713,158","","","","13.7","","","","863,822","","","","17.5"],["Savings and money market","","","2,084,444","","","","40.0","","","","1,643,516","","","","33.4"],["Time deposits","","","1,404,696","","","","26.9","","","","1,282,872","","","","26.0"],["Total deposits","","$","5,212,912","","","","100.0","%","","$","4,929,424","","","","100.0","%"]] [[/GREPCENT_TABLE]] - 54 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS As of December 31, 2023 and 2022, the aggregate amount of uninsured deposits (deposits in amounts greater than $250 thousand, which is the maximum amount for federal deposit insurance) was $1.82 billion, or 35% of total deposits, and $1.29 billion, or 26% of total deposits, respectively. The portion of our time deposits by account that were in excess of the FDIC insurance limit was $302.6 million and $258.7 million at December 31, 2023 and 2022, respectively. The maturities of our uninsured time deposits at December 31, 2023 were as follows: $107.7 million in three months or less; $84.3 million between three months and six months; $51.0 million between six months and one year; and $59.6 million over one year. Approximately $956.3 million and $1.05 billion of reciprocal and public deposits, characterized as preferred deposits for FDIC call report purposes, were collateralized by government-backed securities as of December 31, 2023 and 2022, respectively. 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, 2023, total deposits were $5.21 billion, representing an increase of $283.5 million, or 6%, which was primarily the result of growth in non-public deposits. Time deposits were approximately 27% and 26% of total deposits at December 31, 2023 and 2022, respectively. Non-public deposits, the largest component of our funding sources, totaled $3.12 billion and $2.77 billion at December 31, 2023 and 2022, respectively, and represented 60% and 56% of total deposits as of the end of each year, 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 $1.02 billion and $1.12 billion at December 31, 2023 and December 31, 2022, respectively, and represented 20% and 23% of total deposits as of the end of each year, 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 $817.6 million at December 31, 2023, compared to $696.1 million at December 31, 2022, and represented 16% and 14% of total deposits as of the end of each year, respectively. Brokered deposits totaled $256.8 million, or 5% of total deposits, and $347.2 million, or 7% of total deposits, at December 31, 2023 and 2022, respectively. Borrowings The Company classifies borrowings as short-term or long-term in accordance with the original terms of the agreement. Outstanding borrowings are summarized as follows as of December 31 (in thousands): [[GREPCENT_TABLE]] [["","","2023","","","2022"],["Short-term borrowings:"],["FHLB","","$","107,000","","","$","205,000"],["FRB","","","78,000","","","","-"],["Total short-term borrowings","","","185,000","","","","205,000"],["Long-term borrowings:"],["FHLB","","","50,000","","","","-"],["Subordinated notes, net","","","74,532","","","","74,222"],["Total long-term borrowings","","","124,532","","","","74,222"],["Total borrowings","","$","309,532","","","$","279,222"]] [[/GREPCENT_TABLE]] Short-term Borrowings Short-term borrowings at December 31, 2023 and 2022 were $185.0 million and $205.0 million, respectively, which consisted of $107.0 million in short-term FHLB borrowings and $78.0 million of funds borrowed under the Federal Reserve Bank (“FRB”) Bank Term funding program. In May 2023, we borrowed $15.0 million under the FRB Bank Term Funding Program at an interest rate of 4.8%, which matures on May 8, 2024. In December 2023, we borrowed $50.0 million under the program at 4.89%, which matures on December 13, 2024 and $13.0 million at 4.88%, which matures on December 20, 2024. 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 borrowings and brokered deposits have historically been utilized to manage the seasonality of public deposits. - 55 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS As of December 31, 2023, $50.0 million of the short-term borrowings balance is designated as a cash-flow hedge, which became effective in April 2022, at a fixed rate of 0.787%, $30.0 million is designated as a cash-flow hedge, which became effective in January 2023, at a fixed rate of 3.669%, and $25.0 million is designated as a cash-flow hedge, which became effective in May 2023, at a fixed rate of 3.4615%. The FHLB borrowings are collateralized by securities from the Company’s investment portfolio and certain qualifying loans. At December 31, 2023 and 2022, the Company’s borrowings had a weighted average rate of 5.29% and 4.60%, 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 $291.1 million of immediate credit capacity with the FHLB as of December 31, 2023. We had approximately $808.5 million in secured borrowing capacity at the FRB discount window, none of which was outstanding at December 31, 2023. The FHLB and FRB credit capacity are collateralized by securities from our investment portfolio and certain qualifying loans. We had approximately $165.0 million of credit available under unsecured federal funds purchased lines with various banks as of December 31, 2023, with no amounts outstanding at December 31, 2023. Additionally, we had approximately $175.4 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, 2023, no amounts have been drawn on the line of credit. Long-term Borrowings As of December 31, 2023 we had a long-term advance payable to FHLB of $50.0 million. The advance matures on January 20, 2026 and bears interest at a fixed rate of 4.05%. FHLB advances are collateralized by securities from our investment portfolio and certain qualifying loans. 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. Proceeds, net of debt issuance costs of $740 thousand, were $34.3 million. The 2020 Notes qualify as Tier 2 capital for regulatory purposes. 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 CME Term SOFR plus 0.26161% plus a spread of 3.944%. 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 $454.8 million at December 31, 2023, an increase of $49.2 million from $405.6 million at December 31, 2022. Net income for the year increased shareholders’ equity by $50.3 million, partially offset by common and preferred stock dividends declared of $19.9 million. Accumulated other comprehensive loss included in shareholders’ equity decreased $17.5 million during the year due primarily to lower net unrealized losses on securities available for sale. Treasury stock included in shareholders’ equity decreased $2.1 million primarily due to the issuance of shares for the vesting of restricted stock awards. For detailed information on shareholders’ equity, see Note 15, Shareholders’ Equity, of the notes to consolidated financial statements. FII and the Bank are subject to various regulatory capital requirements. At December 31, 2023, both FII and the Bank exceeded all regulatory requirements. For detailed information on regulatory capital requirements, see Note 14, 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. - 56 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS 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 such as the FHLB and the FRB. 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 $124.4 million as of December 31, 2023, a decrease of approximately $6.0 million from $130.5 million as of December 31, 2022. During 2023, net cash provided by operating activities totaled $10.9 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 $310.1 million, which included outflows of $420.2 million for net loan originations, $53.7 million from purchases of COLI, net of death benefits received, and $3.0 million purchases of premises and equipment, partially offset by $122.9 million net cash provided from investment securities and $43.9 million proceeds from the surrender of COLI policies. We repositioned a portion of our AFS investment securities portfolio, selling $54 million of lower yielding agency mortgage-backed securities at an after-tax net loss of $2.8 million, reinvesting the proceeds of such sale into higher yielding bonds. Net cash provided by financing activities of $293.2 million was primarily attributed to a $283.5 million net increase in deposits and a $50.0 million net increase in long-term borrowings, partially offset by a $20.0 million net decrease in short-term borrowings and $19.7 million in dividend payments. Planned Uses of Capital Resources The Company has various long-term contractual obligations as of December 31, 2023, which include: • Time deposits for $1.40 billion; • Supplemental executive retirement plans for $374 thousand; • Subordinated notes for $75.0 million • FHLB long-term advances for $50.0 million; and • Operating leases for $50.7 million. For additional information on the Company’s long-term contractual obligations above, see Note 10, Deposits, Note 20, Employee Benefit Plans, Note 11, Borrowings, and Note 8, Leases, in the accompanying consolidated financial statements. 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 $1.20 billion and standby letters of credit for $13.5 million as of December 31, 2023. 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, tax credit investments and FinTech and ESG-related investment funds. As of December 31, 2023, the off-balance sheet commitments related to these investments totaled $27.6 million. We have also recorded a $14.0 million liability primarily related to committed contributions for tax credit investments in property placed in service on or before December 31, 2023. With the exception of obligations in connection with our irrevocable loan commitments, limited partnership investments and tax credit investments as of December 31, 2023, 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 13, Commitments and Contingencies, in the notes to the accompanying consolidated financial statements. - 57 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS 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, 2023 (dollars in thousands). 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. [[GREPCENT_TABLE]] [["","","Due in less than one year","","","Due from one to five years","","","Due after five years through ten years","","","Due after ten years","","","Total"],["","","Cost","","","Yield","","","Cost","","","Yield","","","Cost","","","Yield","","","Cost","","","Yield","","","Cost","","","Yield"],["Available for sale debt securities:"],["U.S. Government agencies and government-sponsored enterprises","","$","-","","","","0.00","%","","$","15,000","","","","1.69","%","","$","9,535","","","","1.90","%","","$","-","","","","0.00","%","","$","24,535","","","","1.77","%"],["Mortgage-backed securities","","","37","","","","2.96","","","","26,028","","","","1.53","","","","124,443","","","","2.04","","","","862,947","","","","1.99","","","","1,013,455","","","","1.99"],["","","","37","","","","2.96","","","","41,028","","","1..59","","","","133,978","","","","2.03","","","","862,947","","","","1.99","","","","1,037,990","","","","1.98"],["Held to maturity debt securities:"],["U.S. Government agencies and government-sponsored enterprises","","","-","","","","0.00","%","","","10,000","","","","0.00","%","","","6,513","","","","3.51","%","","","-","","","","0.00","%","","","16,513","","","","3.20","%"],["State and political subdivisions","","","26,357","","","","2.21","","","","15,946","","","","1.99","","","","5,004","","","","1.62","","","","21,547","","","","2.45","","","","68,854","","","","2.19"],["Mortgage-backed securities","","","-","","","","\u2014","","","","4,839","","","","2.50","","","","18,511","","","","2.27","","","","39,443","","","","2.88","","","","62,793","","","","2.67"],["","","","26,357","","","","2.21","","","","30,785","","","","2.11","","","","30,028","","","","2.43","","","","60,990","","","","2.72","","","","148,160","","","","2.51"],["Total investment securities","","$","26,394","","","","2.21","%","","$","71,813","","","","1.94","%","","$","164,006","","","","2.11","%","","$","923,937","","","","2.04","%","","$","1,186,150","","","","2.05","%"]] [[/GREPCENT_TABLE]] Contractual Loan Maturity Schedule The following table summarizes the contractual maturities of our loan portfolio at December 31, 2023. Loans, net of deferred loan origination costs, include principal amortization and non-accruing loans. Demand loans having no stated schedule of repayment or maturity and overdrafts are reported as due in one year or less (in thousands). [[GREPCENT_TABLE]] [["","","Due in less than one year","","","Due from one to five years","","","Due from five to fifteen years","","","Due after fifteen years","","","Total"],["Commercial business","","$","154,830","","","$","312,960","","","$","19,787","","","$","248,123","","","$","735,700"],["Commercial mortgage","","","463,725","","","","1,031,157","","","","506,098","","","","4,339","","","","2,005,319"],["Residential real estate loans","","","85,538","","","","230,189","","","","291,095","","","","43,000","","","","649,822"],["Residential real estate lines","","","1,484","","","","6,635","","","","27,312","","","","41,936","","","","77,367"],["Consumer indirect (1)","","","324,290","","","","624,541","","","","-","","","","-","","","","948,831"],["Other consumer","","","8,704","","","","19,376","","","","16,747","","","","273","","","","45,100"],["Total loans","","$","1,038,571","","","$","2,224,858","","","$","861,039","","","$","337,671","","","$","4,462,139"],["Loans maturing after one year:"],["With a predetermined interest rate"],["Commercial business","","","","","$","97,313","","","$","9,864","","","$","273","","","$","107,450"],["Commercial mortgage","","","","","","448,948","","","","257,450","","","","832","","","","707,230"],["Residential real estate loans","","","","","","169,021","","","","247,843","","","","38,378","","","","455,242"],["Residential real estate lines","","","","","","-","","","","-","","","","-","","","","-"],["Consumer indirect (1)","","","","","","624,541","","","","-","","","","-","","","","624,541"],["Other consumer","","","","","","19,376","","","","16,747","","","","273","","","","36,396"],["With a floating or adjustable rate"],["Commercial business","","","","","","215,647","","","","9,923","","","","247,850","","","","473,420"],["Commercial mortgage","","","","","","582,209","","","","248,648","","","","3,507","","","","834,364"],["Residential real estate loans","","","","","","61,168","","","","43,252","","","","4,622","","","","109,042"],["Residential real estate lines","","","","","","6,635","","","","27,312","","","","41,936","","","","75,883"],["Consumer indirect (1)","","","","","","-","","","","-","","","","-","","","","-"],["Other consumer","","","","","","-","","","","-","","","","-","","","","-"],["Total loans maturing after one year","","","","","$","2,224,858","","","$","861,039","","","$","337,671","","","$","3,423,568"]] [[/GREPCENT_TABLE]] (1) Amounts include prepayment assumptions based on actual historical experience. - 58 - Table of Contents MANAGEMENT’S DISCUSSION AND ANALYSIS Capital Resources The FRB has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies on a consolidated basis. The final rules implementing the Basel Committee on Banking Supervision’s (“BCBS”) capital guidelines for U.S. banks were fully phased-in on January 1, 2019. As of December 31, 2023, the Company’s capital levels remained characterized as “well-capitalized” under the BCBS rules. See Note 14, Regulatory Matters of the notes to consolidated financial statements and the “Basel III Capital Rules” section below for further discussion. The following table reflects the Company’s ratios and their components as of December 31 (in thousands): [[GREPCENT_TABLE]] [["","","2023","","","2022"],["Common shareholders\u2019 equity","","$","441,773","","","$","394,716"],["Less: Goodwill and other intangible assets","","","69,594","","","","70,643"],["Net unrealized loss on investment securities (1)","","","(111,761",")","","","(128,440",")"],["Hedging derivative instruments","","","3,911","","","","4,735"],["Net periodic pension and postretirement benefits plan adjustments","","","(11,946",")","","","(13,588",")"],["Other","","","(145",")","","","(194",")"],["Common Equity Tier 1 (\u201cCET1\u201d) capital","","","492,120","","","","461,560"],["Plus: Preferred stock","","","17,292","","","","17,292"],["Tier 1 Capital","","","509,412","","","","478,852"],["Plus: Qualifying allowance for credit losses","","","48,916","","","","40,895"],["Subordinated Notes","","","74,532","","","","74,222"],["Total regulatory capital","","$","632,860","","","$","593,969"],["Adjusted average total assets (for leverage capital purposes)","","$","6,224,339","","","$","5,748,203"],["Total risk-weighted assets","","$","5,218,724","","","$","4,896,451"],["Regulatory Capital Ratios"],["Tier 1 Leverage (Tier 1 capital to adjusted average assets)","","","8.18","%","","","8.33","%"],["CET1 Capital (CET1 capital to total risk-weighted assets)","","","9.43","","","","9.42"],["Tier 1 Capital (Tier 1 capital to total risk-weighted assets)","","","9.76","","","","9.78"],["Total Risk-Based Capital (Total regulatory capital to total risk-weighted assets)","","","12.13","","","","12.13"]] [[/GREPCENT_TABLE]] (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 Current Expected Credit Losses methodology (“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 were 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, was also phased 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 (2.5%) 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, 2023, the Company’s capital levels remained characterized as “well-capitalized” under the Basel III rules, including the additional capital conservation buffer. - 59 - Table of Contents 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 policy with respect to the allowance for credit losses requires particularly subjective or complex judgments important to our financial position and results of operations, and, as such, is considered to be a critical accounting estimate as discussed below. 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, and consists of an allowance for credit losses for pooled loans and a specific reserve for individually evaluated loans. Management estimates the allowance for credit losses for pooled loans utilizing a Discounted Cash Flow (“DCF”) method. The DCF method implements a probability of default with loss given default and exposure at default estimation. The probability of default and loss given default are applied to future cash flows that are adjusted to present value and these discounted expected losses become the allowance for credit losses. In the analysis at the portfolio level, we found that the best model for predicting defaults considers the national unemployment rate. With the large number of observations afforded by using peer data, the default curve is less sensitive to unusual loss events and has a much smoother shape. The national unemployment rate is an extremely strong predictor of defaults and explains almost all variation in the default rate. Excluded from the pooled analysis are loans to be individually evaluated due to the assets not maintaining similar risk characteristics to those included in pooled loans. These loans are generally considered to be collateral dependent and, therefore, an analysis of the collateral position versus the pooled loan discounted cash flow approach better reflects the potential loss. Individually evaluated accounts include: loans over 90 days past due, loans placed on non-accrual status and classified assets with exposure greater than $2.0 million. 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 national and local economic trends and conditions (excluding national unemployment), levels and trends in delinquencies, non-accrual loans and classified assets, trends in volume, terms and concentrations of loans, changes in lending policies and procedures, quality of credit review function and administration and changes in the regulatory environment, management, markets and product offerings. 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. Management will periodically assess what adjustments are necessary to qualitatively adjust the allowance for credit losses based on their assessment of current expected credit losses. Various regulatory agencies also review the allowance for credit losses as an integral part of their examination process. 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. As future events cannot be determined with precision, actual results could differ significantly from our estimates. 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. 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. - 60 - Table of Contents