Virginia National Bankshares Corp (VABK) FY 2021 MD&A

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

The following discussion provides information about the major components of the results of operations and financial condition, liquidity, and capital resources of Virginia National Bankshares Corporation. This discussion and analysis should be read in conjunction with the consolidated financial statements and Notes to Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data.

Merger with Fauquier

On April 1, 2021, the Company merged with Fauquier, pursuant to the Agreement and Plan of Reorganization dated October 1, 2020, including a related Plan of Merger. Pursuant to the Merger Agreement, Fauquier shareholders received 0.675 shares of Company stock for each share of Fauquier common stock, with cash paid in lieu of fractional shares, resulting in the Company issuing 2,571,213 shares of common stock. In connection with the transaction, TFB, Fauquier's wholly-owned bank subsidiary, was merged with and into the Bank.

Impact of COVID-19

The COVID-19 pandemic has caused, and will likely continue to cause, economic and social disruption, significantly affecting many industries, including many of our clients. Significant uncertainty exists regarding the magnitude of the impact and duration of this pandemic. Following are brief descriptions of areas within the Company that have been negatively impacted.

Allowance for loan losses - The Company’s consolidated financial statements include estimates and assumptions made by management which affect the reported amounts of assets and liabilities, including the level of the ALLL that is established. The ALLL calculation and resulting provision for loan losses are impacted by changes in economic conditions. During the first and second quarters of 2020, the Company downgraded the economic qualitative factors within its ALLL model in light of the effects of the COVID-19 pandemic on the economy. No additional downgrades of such factors were taken during the third and fourth quarters of 2020,or the first quarter of 2021. During the second quarter of 2021, the Company upgraded the economic qualitative factors, resulting in a release of a portion of the reserves for loan losses related to the pandemic, as credit deterioration since the onset of COVID-19 had not been experienced to the extent anticipated. No additional changes were made to the economic qualitative factors during the third or fourth quarters of 2021. If economic conditions improve or worsen, the Company could experience changes in the required ALLL. It is possible that asset quality metrics could decline in the future if the effects of the COVID-19 pandemic are sustained.

Potential credit exposures - While most industries have been adversely impacted by the COVID-19 pandemic, the Company has exposures on its balance sheet as of December 31, 2021 in the following categories of loans that are considered to have higher risk of significant impact:

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Travel accommodations (hotels/motels/B&B) - $29.0 million, or 2.8% of loans,

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Restaurants - $19.8 million, or 1.9% of loans,

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Retail trade - $13.3 million, or 1.3% of loans,

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Arts, entertainment and recreation - $13.0 million, or 1.3% of loans, and

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Wholesale trade - $9.5 million, or 0.9% of loans.

Note that the loan balances and percentages above do not include PPP loans made to entities within such categories.

Loan deferrals - In accordance with guidance from regulators and the CARES Act, the Bank worked with borrowers who have been adversely affected by COVID-19 to defer principal only, or principal and interest payments for a 90- to 180-day period. While interest will continue to accrue to income, in accordance with GAAP, if the Company ultimately incurs a credit loss on these deferred payments, interest income would need to be reversed and therefore, interest income in future periods could be negatively affected. Loan deferrals as of December 31, 2021 amount to $1.2 million and consist of only two loans. Both loans are 100% government-guaranteed for which the deferrals were approved by the United States Department of Agriculture. In accordance with interagency guidance issued in March 2020 and the CARES Act, these short-term deferrals are not considered TDRs.

PPP Loans - Primarily within the second quarter of 2020 and the first quarter of 2021, the Company devoted significant resources to accept PPP applications, a program designed to provide a direct incentive for small businesses to keep employees on their payroll. In total, the Company, including the Bank and TFB, funded

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$207.5 million in PPP loans, with average origination fees of 3.9%, assisting many nonprofits and local businesses through this program. As of December 31, 2021, 89.9% of the total dollars of PPP loans had been forgiven by the SBA, with $20.7 million outstanding. Loans funded through the PPP are fully guaranteed by the U.S. government. The Company believes that it performed the required due diligence pursuant to the established SBA criteria; nonetheless, if a determination is made that certain loans did not meet the criteria established for the program, the Company may be required to establish additional ALLL through provision for loan loss expense, which will negatively impact net income.

Credit quality standards - Throughout the onset of this pandemic, the Company has maintained its high standards of credit quality on organic loan funding to limit credit risk exposure.

Capital and Liquidity

As of December 31, 2021, capital ratios of the Company were in excess of regulatory requirements. While currently included in the category of “well capitalized” by bank regulators, a prolonged economic recession could adversely impact reported and regulatory capital ratios.

The Company maintains access to multiple sources of liquidity. Management has also enhanced its capital, liquidity, loan and deposit stress tests, as well as capital and liquidity contingency plans to validate how the Company can react effectively to the economic downturn caused by this pandemic and other potential impacts on the economy.

Goodwill

As of December 31, 2021, the goodwill on the Company's balance sheet was not deemed to be impaired. However, management may determine that goodwill is required to be evaluated for impairment in the future due to the presence of a triggering event, which may have a negative impact on the Company’s results of operations.

Operations, Processes, Controls and Business Continuity Plan

The Company reacted quickly to the COVID-19 pandemic and began internal social distancing in mid-March 2020, as well as distancing from the public by keeping drive-thru services available, and encouraging customers to conduct transactions at ATMs, through online banking and the mobile app. The Company also increased consumer and business mobile deposit limits to encourage customers to make deposits remotely from the safety of their home or business. The Company implemented a schedule whereby most staff members worked remotely, allowing the remaining essential staff to create more distance between each other within the offices. The Company temporarily increased the number of staff in the client service center to assist more customers by telephone and encourage them to utilize online and mobile banking. The client service center was also temporarily moved to a larger location to allow for appropriate social distancing. In addition, the Company enhanced disinfecting procedures to include hospital-grade cleaning solution and foggers, increased the frequency of cleaning and issued personal protective equipment, including N-95 and disposable face masks, face shields, sneeze guards, gloves and thermometers, to employees, along with specific instructions for use, to enhance their safety. The Company also installed disinfecting protective strips to high touch areas, placed free-standing air filter machines throughout our facilities, purchased COVID-19 instant test kits for on-site testing and provided antibody testing options to all employees. Management provides frequent email communications and social media updates regarding COVID-19, helpful tips and status of Company initiatives, as well as warning customers of potential scams during this pandemic.

The Company’s preparedness resulted in minimal impact to the Company’s operations as a result of the COVID-19 pandemic. Effective and thorough business continuity planning allowed for successful deployment of most employees to work in a remote environment. No material operational or internal control risks have been identified to date, and the Company has enhanced fraud-related controls.

Application of Critical Accounting Policies and Critical Accounting Critical Estimates

The accounting and reporting policies followed by the Company conform, in all material respects, to GAAP and to general practices within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Company bases estimates on historical experience, current information, and other factors deemed to be relevant, actual results could differ from those estimates.

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The Company considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Company’s financial statements. The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of financial condition and results of operations.

Following are the accounting policies and estimates that the Company considers as critical:

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Loans acquired in a business combination: Acquired Loans are classified as either (i) purchased credit-impaired loans or (ii) purchased performing loans and are recorded at fair value on the date of acquisition. PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. When determining fair value, PCI loans are aggregated into pools of loans based on common risk characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the “nonaccretable difference.” Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the “accretable yield” and is recognized as interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows.

On a semi-annual basis, the Company evaluates the estimate of cash flows expected to be collected on PCI loans. Estimates of cash flows for PCI loans require significant judgment. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses resulting in an increase to the allowance for loan losses. Subsequent significant increases in cash flows may result in a reversal of post-acquisition provision for loan losses or a transfer from nonaccretable difference to accretable yield that increases interest income over the remaining life of the loan or pool(s) of loans. Disposals of loans, which may include sale of loans to third parties, receipt of payments in full or in part from the borrower or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount.

PCI loans are not classified as nonperforming loans by the Company at the time they are acquired, regardless of whether they had been classified as nonperforming by the previous holder of such loans, and they will not be classified as nonperforming so long as, at semi-annual re-estimation periods, we believe we will fully collect the new carrying value of the pools of loans.

The Company accounts for purchased performing loans using the contractual cash flows method of recognizing discount accretion based on the Acquired Loans’ contractual cash flows. Purchased performing loans are recorded at fair value, including a credit discount. The fair value discount is accreted as an adjustment to yield over the estimated lives of the loans. There is no allowance for loan losses established at the acquisition date for purchased performing loans. A provision for loan losses may be required for any deterioration in these loans in future periods.

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Allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that are inherent in the loan portfolio. Accounting policies related to the allowance for loan losses are considered to be critical, as these policies involve considerable subjective judgment and estimation by management. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” The level of the allowance reflects management’s continuing evaluation of: industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions; and unidentified losses inherent in the current loan portfolio, as well as trends in the foregoing. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. See the section captioned “Allowance for Loan Losses” elsewhere in this discussion and Note 4 – Loans and Note 5 – Allowance for Loan Losses in the Notes to Consolidated Financial Statements, included in Item 8. Financial Statements and Supplementary Data, elsewhere in this report for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.

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Impaired loans are loans so designated when, based on current information and events, it is probable the Company will be unable to collect all amounts when due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net of the impairment, using either the present value of estimated future cash flows at the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income. Additional information on impaired loans, which includes both TDRs and

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non-accrual loans, is included in Note 4 – Loans and Note 5 – Allowance for Loan Losses, in the Notes to Consolidated Financial Statements.

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Fair value measurements are used by the Company to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realized value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Additional discussion of valuation methodologies is presented in Note 17 – Fair Value Measurements, in the Notes to Consolidated Financial Statements.

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Other-than-temporary impairment of securities accounting policies require a periodic review by management to determine if the decline in the fair value of any security appears to be other-than-temporary. Factors considered in determining whether the decline is other-than-temporary include, but are not limited to: the length of time and the extent to which fair value has been below cost; the financial condition and near-term prospects of the issuer; and the Company’s intent to sell. See Note 1 – Summary of Significant Accounting Policies and Note 3 – Securities, in the Notes to Consolidated Financial Statements, for further details on the accounting policies for other-than-temporary impairment of securities and the methodology used by management to make this evaluation.

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Intangible asset accounting policies require that goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually, or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed. Intangible assets with definite useful lives are amortized over their estimated useful lives, which range from 3 to 10 years, to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the Company’s Consolidated Balance Sheets. Additional discussion of the accounting policies and composition of goodwill and other intangibles assets is presented in Note 1 – Summary of Significant Accounting Policies, Note 2 - Business Combinations and Note 8 – Goodwill and Other Intangible Assets, in the Notes to Consolidated Financial Statements.

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Income tax accounting policies have the objective to recognize the amount of taxes payable or refundable for the current year and the deferred tax assets and liabilities for future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could impact the Company’s consolidated financial condition or results of operations.

See Note 1 – Summary of Significant Accounting Policies and Note 11 – Income Taxes, in the Notes to Consolidated Financial Statements, for further detail on the accounting policies for income taxes and for components of the deferred tax assets and liabilities.

Non-GAAP Presentations

The accounting and reporting policies of the Company conform to GAAP and prevailing practices in the banking industry. However, certain non-GAAP measures are used by management to supplement the evaluation of the Company’s performance. These include adjusted ROAA, adjusted ROAE, adjusted net income, adjusted earnings per share, adjusted ALLL to total loans, tangible book value per share and the following fully-taxable equivalent measures: net interest income-FTE, efficiency ratio-FTE and net interest margin-FTE. Interest on tax-exempt loans and securities is presented on a taxable-equivalent basis (which converts the income on loans and investments for which no income taxes are paid to the equivalent yield as if income taxes were paid) using the federal corporate income tax rate of 21 percent that was applicable for all periods presented.

​Management believes that the use of these non-GAAP measures provides meaningful information about operating performance by enhancing comparability with other financial periods, other financial institutions, and between different sources of interest income. The non-GAAP measures used by management enhance comparability by excluding the effects of (1) items that do not reflect ongoing operating performance, such as merger and merger-related expenses, (2) items that do not reflect the implicit percentage of the ALLL to total loans, such as the impact of fair value adjustment and PPP loans, (3) balances of intangible assets, including goodwill, that vary significantly between institutions, and (4) tax benefits that are not consistent across different opportunities for investment. These non-GAAP financial measures should not be considered an alternative to GAAP-basis financial statements, and other banks and bank holding companies may define or calculate these or similar measures differently. Net income is discussed in Management’s Discussion and Analysis on a GAAP basis unless noted as “non-GAAP.”

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A reconcilement of the non-GAAP financial measures used by the Company to evaluate and measure the Company's performance to the most directly comparable GAAP financial measures is presented below:

1 References to merger expenses include merger and merger-related expenses and are net of tax.

2 FTE calculations use a Federal income tax rate of 21%.

3 The efficiency ratio, GAAP basis, is computed by dividing noninterest expense by the sum of net interest income and noninterest income.

4 The efficiency ratio, FTE, is computed by dividing noninterest expense by the sum of net interest income (FTE) and noninterest income.

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Results of Operations

Consolidated Return on Assets and Equity and Other Key Ratios

The ratio of net income to average total assets and average shareholders' equity and certain other ratios for the years indicated are as follows:

Net income for the year ended December 31, 2021 was $10.1 million, or $2.14 per diluted share, a 26.2% increase compared to $8.0 million, or $2.95 per diluted share for the year ended December 31, 2020. This $2.1 million increase was primarily the result of a $21.1 million increase in net interest income, a $3.9 million increase in noninterest income, and a $608 thousand reduction in provision for loan losses. Negatively affecting net income for 2021 compared to 2020 was a $23.7 million increase in noninterest expense. Each component of such year-over-year changes are described in more detail below.

The efficiency ratio (FTE) was 76.3% for the year ended December 31, 2021, compared to 61.4% for the same period of 2020, increasing due primarily to the one-time impact of merger and merger-related expenses.

The Company has four reportable segments: the Bank, VNB Trust and Estate Services, Sturman Wealth and Masonry Capital.

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Bank - The Bank’s commercial banking activities involve making loans, taking deposits and offering related services to individuals, businesses and charitable organizations. Loan fee income, service charges from deposit accounts, and other non-interest-related revenue, such as fees for debit cards and ATM usage and fees for treasury management services, generate additional income for this segment.

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Sturman Wealth Advisors – This segment offers wealth and investment advisory services. Revenue for this segment is generated primarily from investment advisory and financial planning fees, with a small and decreasing portion attributable to brokerage commissions. During February 2016, the Company purchased the book of business, including interest in the client relationships, (“Purchased Relationships”), from a current officer (the “Seller”) of the Company pursuant to an employment and asset purchase agreement (the “Purchase Agreement”). Prior to becoming an employee of the Company and until the effective date of the sale, the Seller provided services to the Purchased Relationships as a sole proprietor. Under the terms of the Purchase Agreement, the Company will receive all future revenue for investment management, advisory, brokerage, insurance, consulting, and related services performed for the Purchased Relationships. More information on this purchase can be found under Goodwill and Other Intangible Assets in Note 8 of the Notes to Consolidated Financial Statements, which is found in Item 8. Financial Statements and Supplementary Data.

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VNB Trust and Estate Services - This segment offers corporate trustee services, trust and estate administration, IRA administration and custody services and offers in-house investment management services. Revenue for this segment is generated from administration, service and custody fees, as well as management fees which are derived from Assets Under Management. Investment management services currently are offered through affiliated and third-party managers.

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Masonry Capital - Masonry Capital offers investment management services for separately managed accounts and a private investment fund employing a value-based, catalyst-driven investment strategy. Revenue for this segment is generated from management fees which are derived from Assets Under Management and incentive income which is based on the investment returns generated on performance-based Assets Under Management.

The Bank segment earned net income of $9.0 million in 2021, a $708 thousand increase over the $8.3 million netted in 2020. Sturman Wealth earned $384 thousand in 2021 compared to $48 thousand in the prior year. VNB Trust and Estate Services realized net income of $162 thousand in 2021, compared to a net loss of $52 thousand in 2020. Masonry Capital realized net income of $561 thousand in 2021, compared to a net loss of $274 thousand in 2020.

Details of the changes in the various components of net income are further discussed below.

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Net Interest Income

Net interest income is computed as the difference between the interest income on earning assets and the interest expense on deposits and other interest bearing liabilities. Net interest income represents the principal source of revenue for the Company and accounted for 81.1% of the total revenue in 2021. Net interest margin (FTE) is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income (FTE) and net interest margin (FTE).

The following table details the average balance sheet, including an analysis of net interest income (FTE) for earning assets and interest bearing liabilities, for the years ended December 31, 2021, 2020, and 2019.

Consolidated Average Balance Sheets and Analysis of Net Interest Income (FTE)

(1)
Tax-exempt income for investment securities has been adjusted to a fully tax-equivalent basis (FTE), using a Federal income tax rate of 21%. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP Presentations earlier in this section.

(2)
Interest rate spread is the average yield earned on earning assets less the average rate paid on interest-bearing liabilities.

(3)
Net interest margin (FTE) is net interest income (FTE) expressed as a percentage of average earning assets.

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The purpose of the volume and rate analysis below is to describe the impact on the net interest income (FTE) of the Company resulting from changes in average balances and average interest rates for the periods indicated. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Interest income is reported on a tax-equivalent basis.

Volume and Rate Analysis

2021 compared to 2020

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2020 compared to 2019

For 2021, net interest income (FTE) of $45.3 million was recognized, an increase of $21.3 million over 2020. Net interest income (FTE) for 2020 totaled $24.0 million and was $2.0 million increase over the 2019 total of $22.0 million. Average earning assets increased $783.1 million or 103.5% in 2021 compared to 2020 and increased $140.6 million or 22.8% in 2020 compared to 2019. The increases in volume of real estate and commercial loans from 2020 to 2021 were the primary contributing factors of the increase in net interest income. The declines in rates paid on deposits over the same period also positively impacted net interest income. The average balance for loans as a percentage of earnings assets for 2021 was 66.1%, compared to 79.4% and 85.1% in 2020 and 2019, respectively.

The 2021 net interest margin (FTE) declined 23 bps to 2.94% from 3.17% in 2020. The 2020 net interest margin (FTE) declined 40 bps from 3.57% in 2019. The tax-equivalent yield on average earning assets for 2021 of 3.15% was 47 bps lower than the 2020 yield of 3.62%. The 2019 tax-equivalent yield on average earning assets of 4.27% was 65 bps higher than the comparable 2020 yield. Loan yields for 2021 were 4.32%, improving 17 bps from the loan yield of 4.15% for 2020. Average loans for 2021 of $1.0 billion were $416.4 million higher than the 2020 average of $600.9 million, due to the Merger. 2020’s average loan balances were $77.1 million higher than the 2019 average of $523.8 million due to the origination of PPP loans during 2020.

Interest expense as a percentage of average earning assets declined to 21 bps for 2021, compared to 44 and 69 bps for 2020 and 2019, respectively. Net interest margin will be impacted by future changes in short-term and long-term interest rate levels on deposits, as well as the impact from the competitive environment. A continuing primary driver of the Company’s low cost of funds is the Company’s level of non-interest bearing demand deposits and low-cost deposit accounts. Following is a table illustrating the average balances of deposit accounts as a percentage of total deposit account balances.

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Provision for Loan Losses

The level of the allowance reflects changes in the size of the portfolio or in any of its components, as well as management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, and economic, political and regulatory conditions. Additional information concerning management’s methodology in determining the adequacy of the allowance for loan losses is contained later in this section under Allowance for Loan Losses, in addition to Note 1 and Note 5 of the Notes to Consolidated Financial Statements, found in Item 8. Financial Statements and Supplementary Data.

Based on management’s continuing evaluation of the loan portfolio in 2021, the Company recorded a provision for loan losses of $1.0 million, compared to a provision of $1.6 million in 2020 and $1.4 million in 2019. The decrease in 2021 is the result of the Company releasing of a portion of the reserves that were added during 2020 since the credit deterioration was not experienced to the extent previously anticipated. The increase in the 2020 provision for loan losses was largely the result of worsening economic qualitative factors associated with COVID-19.

The allowance for loan losses as a percentage of total loans was 0.56% at December 31, 2021 compared to 0.90% at December 31, 2020.

The following is a summary of the changes in the allowance for loan losses for the years ended December 31, 2021, 2020, and 2019:

Noninterest Income

The major components of noninterest income are detailed below. Year-to-year variances are shown for each noninterest income category.

Noninterest income of $10.5 million for the year ended December 31, 2021 experienced a net increase over the prior year of $3.9 million, as a result of the following variances:

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Debit/credit card and ATM fees, Trust and estate services fees, deposit accounts fees, advisory and brokerage income and investment management income increased $1.5 million, $1.2 million, $808 thousand, $454 thousand and $379 thousand, respectively, due primarily to the Merger and the addition of Fauquier's customers in each of the respective areas;

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Performance fees on assets under management increased $789 thousand due to improved market conditions period over period;

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Earnings from bank owned life insurance increased $271 thousand primarily as a result of the addition of the Fauquier policies;

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The above increases were offset by:

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Loan swap fee income decreased $1.2 million, as a result of decreased demand of such product due to the interest rate environment, and

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Gains on sales and calls of securities decreased $743 thousand, as no securities were sold in 2021.

Noninterest Expense

Noninterest expense of $42.5 million reported for 2021 increased $23.7 million or 126.4% from the $18.8 million for 2020. The major components of noninterest expense are detailed below. Year-over-year variances are shown for each noninterest expense category.

Salaries and employee benefits accounted for the largest increase, increasing 70.4% from $9.5 million in 2020 to $16.1 million in 2021. This increase was due to the Merger and the addition of Fauquier's employees effective April 1, 2021, offset by a reduction in salaries for redundant positions, occurring through the year. At December 31, 2021, the Company had 173 full-time equivalent employees compared to 86 at year-end 2020.

Merger expenses accounted for the next largest increase, amounting to $7.4 million in 2021, compared to $988 thousand in 2020. These expenses included investment banker fees, expenses related to the integration of systems and operations, change of control payments, severance and stay-put bonuses, and legal and consulting expenses, which have been expensed as incurred.

Core deposit intangible amortization expense is a result of the Merger and amounted to $1.4 million in 2021.

Provision for Income Taxes

The provision for income taxes is based upon the results of operations, adjusted for the effect of certain tax-exempt income and non-deductible expenses. In addition, certain items of income and expense are reported in different periods for financial reporting and tax return purposes. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit. Deferred tax assets or liabilities are computed based on the difference between the financial statement and the income tax bases of assets and liabilities using the applicable enacted marginal tax rate.

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For 2021, the Company provided $1.8 million for Federal income taxes, resulting in an effective income tax rate of 15.5%. In 2020, the Company provided $2.1 million for Federal income taxes, resulting in an effective income tax rate of 20.6%. The effective tax rate is lower in 2021 due to the impact of low-income housing tax credits acquired during the Merger, offset by the non-deductibility of certain merger-related expenses for tax purposes. Additionally, the effective income tax rates for 2021 and 2020 were lower than the U.S. statutory rate of 21% due to the effect of tax-exempt income from municipal bonds and bank owned life insurance policies.

More information on income taxes, including net deferred taxes can be found in Note 11 – Income Taxes of the Notes to Consolidated Financial Statements which is found in Item 8. Financial Statements and Supplementary Data.

BALANCE SHEET ANALYSIS

Securities

The investment securities portfolio has a primary role in the management of the Company’s liquidity requirements and interest rate sensitivity, as well as generating significant interest income. Investment securities also play a key role in diversifying the Company’s balance sheet. In addition, a portion of the investment securities portfolio is pledged as collateral for public fund deposits. Changes in deposit and other funding balances and in loan production will impact the overall level of the investment portfolio.

As of December 31, 2021, the Company’s investment portfolio totaled $308.8 million, with obligations of U.S. government corporations and government-sponsored enterprises amounting to $202.5 million, or approximately 66% of the total. The Company’s investment portfolio totaled $177.1 million as of December 31, 2020.

During the year ended December 31, 2021, there were no sales of securities. For the year ended December 31, 2020, proceeds from the sales of securities amounted to $69.5 million, and gross realized gains on these securities were $742 thousand. An additional $1 thousand gain was realized from a call of a security during 2020. Management proactively manages the mix of earning assets and cost of funds to maximize the earning capacity of the Company.

In accordance with ASC 320, “Investments - Debt and Equity Securities,” the Company has categorized its unrestricted securities portfolio as Available for Sale. Securities classified as AFS may be sold in the future, prior to maturity. Any decision to sell a security classified as AFS would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company’s assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors. AFS securities are carried at fair value. Net aggregate unrealized gains or losses on these securities are included, net of taxes, as a component of shareholders’ equity. All of the Company’s unrestricted securities were investment grade or better as of December 31, 2021. Given the generally high credit quality of the Company’s AFS investment portfolio, management expects to realize all of its investment upon market recovery or the maturity of such instruments and thus believes that any impairment in value is interest-rate-related and therefore temporary. AFS securities included gross unrealized gains of $1.4 million and gross unrealized losses of $4.2 million as of December 31, 2021.

All mortgage-backed securities included in the above tables were issued by U.S. government agencies and corporations. At December 31, 2021, the securities issued by political subdivisions or agencies were highly rated with 100% of the municipal bonds having AA or higher ratings. Approximately 65% of the municipal bonds are general obligation bonds, and issuers are geographically diverse. The Company held no issues that exceeded 10% of the Company’s shareholders' equity at December 31, 2021.

The Company’s holdings of restricted securities totaled $5.0 million and $3.0 million at December 31, 2021 and December 31, 2020, respectively, and consisted of stock in the Federal Reserve Bank, stock in the FHLB, and stock in CBB Financial Corporation, the holding company for Community Bankers’ Bank, and an investment in an SBA loan fund. The Bank is required to hold stock in the Federal Reserve Bank and the FHLB as a condition of membership with each of these correspondent banks. The amount of stock required to be held by the Bank is periodically assessed by each bank, and the Bank may be subject to purchase or surrender stock held in these banks, as determined by their respective calculations. The amount of FHLB stock held decreased $2.0 million from December 31, 2020 to December 31, 2021, as stock was relinquished due to the paydown of advances during the period. Stock ownership in the bank holding company for Community Bankers’ Bank provides the Bank with several benefits that are not available to non-shareholder correspondent banks. None of these stock issues are traded on the open market and can only be redeemed by the respective issuer. Restricted stock holdings are recorded at cost.

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The table shown below details the amortized cost and fair value of AFS securities at December 31, 2021 based upon contractual maturities, by major investment categories. Expected maturities may differ from contractual maturities because issuers have the right to call or prepay obligations. The tax-equivalent yield is based upon a federal tax rate of 21%. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP Presentations section earlier in Item 7.

Maturity Distribution and Average Yields

Weighted average yield is calculated based on the relative amortized cost of the securities. Yields on tax-exempt securities have been computed on a tax-equivalent basis using the federal corporate income tax rate of 21 percent.

As stated, the preceding table reflects the distribution of the contractual maturities of the investment portfolio at December 31, 2021. Management’s investment portfolio strategy is to structure the portfolio so that it is a constant source of liquidity for the balance sheet. In order to achieve greater liquidity in the portfolio, securities that have a monthly flow of principal repayments become a key component. To illustrate the difference between contractual maturity and average life, consider the difference for the fixed rate mortgage-backed securities (MBS) component of this portfolio. At December 31, 2021, the weighted average maturity of the fixed rate MBS sector was 18.75 years, and the projected average life for this group of securities is 5.0 years.

Another indication of the investment portfolio’s liquidity potential is shown by the projected annual principal cash flow from maturities, callable bonds, and monthly principal repayments. For the next three years, the principal cash flows are estimated to be $27.9 million for 2022, $29.2 million for 2023, and $26.9 million for 202, based upon rates remaining at current levels. This represents approximately 28% of the investment portfolio’s AFS balance at December 31, 2021 that will be available to support the future liquidity needs of the Company. Cash flow projections are subject to change based upon changes to market interest rates.

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Loan Portfolio

The Company’s loan portfolio totaled $1.1 billion as of December 31, 2021 or 53.8% of total assets. Loan balances increased $451.8 million, or 74.1%, from the balance of $609.4 million as of December 31, 2020. Note that all loan balances are presented net of credit and other fair value discounts, when applicable. The table below shows the composition of the loan portfolio:

During 2020 and 2021, the Company assisted nonprofit organizations and local businesses by funding $207.5 million of PPP loans, which were designed to provide economic relief to small businesses adversely impacted by the COVID-19 pandemic. These loans carry a 1% annual interest rate; however, in addition, the Company recognized $2.3 million and $2.1 million in PPP loan origination fees in 2021 and 2020, respectively. As of December 31, 2021, 89% of the total dollars of PPP loans had been forgiven by the SBA, with $20.7 million outstanding.

The addition of purchased loans in connection with the Merger with Fauquier accounted for the bulk of the $451.8 million increase from December 31, 2020 to December 31, 2021.

At December 31, 2021, the loan-to-deposit ratio stood at 59.1%, compared to 83.4% at December 31, 2020.

The Company’s objective is to maintain the historically strong credit quality of the loan portfolio by maintaining rigorous underwriting standards. These standards coupled with regular evaluation of the creditworthiness of, and the designation of lending limits for, each borrower has helped the Company achieve this objective. The primary portfolio strategy includes seeking industry and loan size diversification in order to minimize credit exposure and originating loans in markets with which the Company is familiar. The predominant market area for loans includes Charlottesville, Albemarle County, Fauquier County, Prince William County, Winchester, Frederick County, Manassas, Richmond and areas in the Commonwealth of Virginia that are within a 75 mile radius of any Virginia National Bank location.

Based on underwriting standards, loans may be secured in whole or in part by collateral such as liquid assets, accounts receivable, equipment, inventory and real property. The collateral securing any loan may depend on the type of loan and may vary in value based on market conditions.

The Company’s real estate loan portfolio increased by $478.5 million to a balance of $911.1 million at December 31, 2021 from $432.6 million at December 31, 2020. This category comprised 85.9% of all loans, and these loans are secured by mortgages on real property located principally in Virginia. Of this amount, approximately $358.2 million represented loans on residential properties. Commercial real estate loans totaled $473.6 million as of December 31, 2021. Sources of repayment are from the borrower’s operating profits, cash flows and liquidation of pledged collateral. The remaining real estate loans were comprised of construction and land development loans which totaled $79.3 million as of December 31, 2021, an increase of $56.8 million compared to the December 31, 2020 balance of $22.5 million as a result of the addition of Fauquier loans as part of the Merger.

As of December 31, 2021, the Company’s commercial and industrial loan portfolio totaled $96.7 million, a $22.0 million decline from the $118.7 million balance at year-end 2020. This category, representing approximately 9.1% of all loans, includes loans made to individuals and small to medium-sized businesses, as well as loans purchased on the syndicated and government guaranteed markets. As discussed previously, the Company participated in the PPP loan initiative during 2020 and 2021 with balances of $54.2 million and $20.7 million as of December 31, 2020 and December 31, 2021, respectively. Forgiveness of a significant amount of loans during 2021 caused the overall decline.

Consumer loans, comprised of student loans purchased, revolving credit, and other fixed payment loans, totaled $53.4 million as of December 31, 2021 or 5.0% of all loans. Consumer loans ended 2021 with balances $4.7 million lower than the prior year-end, primarily due to normal amortization within the student loan portfolio.

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The following table presents the maturity/repricing distribution of the Company’s loans at December 31, 2021. The table also presents the portion of loans that have fixed interest rates or variable/floating interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index such as the Wall Street Journal prime rate, LIBOR rates, or U.S. Treasury bond indices.

Maturities and Sensitivities of Loans to Changes in Interest Rates

Total loans at December 31, 2021 included loans purchased in connection with the Merger. These loans were recorded at estimated fair value on the date of acquisition without the carryover of the related ALLL. The following table presents the outstanding principal balance and the carrying amount of purchased loans:

For a description of the Company's accounting for purchased performing and PCI loans, see "Critical Accounting Estimates" earlier in Item 7.

Loan Asset Quality

Intrinsic to the lending process is the possibility of loss. While management endeavors to minimize this risk, it recognizes that loan losses will occur and that the amount of these losses will fluctuate depending on the risk characteristics of the loan portfolio, which in turn depend on current and future economic conditions, the financial condition of borrowers, the realization of collateral, and the credit management process.

Generally, loans are placed on non-accrual status when management believes, after considering economic and business conditions and collections efforts, that it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement, or when the loan is past due for 90 days or more, unless the debt is both well-secured and in the process of collection.

At December 31, 2021 and 2020, the Company had loans classified as non-accrual with balances of $495 thousand and $8 thousand, respectively. The non-accrual balance as of December 31, 2021 consists of only one loan. Acquired Loans which otherwise would be in non-accrual status are not included in this figure, as they earn interest through the yield accretion.

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Loans 90 days or more past due and still accruing interest amounted to $801 thousand as of December 31, 2021, compared to $137 thousand as of December 31, 2020. The 2021 balance includes a government-guaranteed loan in the amount of $548 thousand and $115 thousand of defaulted PPP loans for which claims have been filed with the SBA. The portfolio only includes eight non-insured student loans that are 90 days or more past due and still accruing interest, amounting to $83 thousand. Loans acquired during the Merger which are greater than 90 days past due and still accruing interest are included in this figure, net of their fair value mark.

TDRs occur when the Company agrees to modify the original terms of a loan by granting a concession that it would not otherwise consider due to the deterioration in the financial condition of the borrower. These concessions are done in an attempt to improve the paying capacity of the borrower, and in some cases to avoid foreclosure, and are made with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. These concessions could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. TDRs that are considered to be performing continue to accrue interest under the terms of the restructuring agreement. TDRs that have been placed in non-accrual status are considered to be nonperforming.

Total performing TDR balances declined to $1.0 million as of December 31, 2021 compared to $1.3 million as of December 31, 2020. Based on regulatory guidance issued in 2016 on Student Lending, the Company classified 58 of its student loans purchased as TDRs for a total of $935 thousand as of December 31, 2021 and 75 of its student loans purchased as TDRs for a total of $1.2 million as of December 31, 2020. Nonperforming TDR balances increased to $495 thousand as of December 31, 2021 compared to $8 thousand as of December 31, 2020.

The table below summarizes the Company's credit ratios as of December 31, 2021 and 2021:

In accordance with 2020 regulatory guidance and the CARES Act, the Bank has approved for certain customers who have been adversely affected by the COVID-19 pandemic to defer principal-only, or principal and interest, payments for a 90- to 180-day period. Such short-term modifications, which were made on a good faith basis in response to the COVID-19 pandemic to borrowers who were current prior to any relief, are not to be considered TDRs. While interest will continue to accrue to income, in accordance with GAAP, if the Bank ultimately incurs a credit loss on these deferred payments, interest income would need to be reversed and therefore, interest income in future periods could be negatively impacted. A total of $59.0 million in loan deferments have been approved since the beginning of the pandemic. As of December 31, 2021, $57.8 million, or 98.0%, of the total loan deferments approved have returned to normal payment schedules and are now current.

See Note 4 – Loans and Note 5 – Allowance for Loan Losses in the accompanying Notes to Consolidated Financial Statements included in Item 8. Financial Statements and Supplementary Data for further details regarding the Company’s loan asset quality measurements.

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Allowance for Loan Losses

In general, the Company determines the adequacy of its allowance for loan losses by considering the risk classification and delinquency status of loans and other factors. Management may also establish specific allowances for loans which management believes require allowances greater than those allocated according to their risk classification. The purpose of the allowance is to provide for losses inherent in the loan portfolio. Since risks to the loan portfolio include general economic trends as well as conditions affecting individual borrowers, the allowance is an estimate. The Company is committed to determining, on an ongoing basis, the adequacy of its allowance for loan losses.

The Company applies historical loss rates to various pools of loans based on risk rating classifications. In addition, the adequacy of the allowance is further evaluated by applying estimates of loss that could be attributable to any one of the following eight qualitative factors:

1)
Changes in national and local economic conditions, including the condition of various market segments;

2)
Changes in the value of underlying collateral;

3)
Changes in volume of classified assets, measured as a percentage of capital;

4)
Changes in volume of delinquent loans;

5)
The existence and effect of any concentrations of credit and changes in the level of such concentrations;

6)
Changes in lending policies and procedures, including underwriting standards;

7)
Changes in the experience, ability and depth of lending management and staff; and

8)
Changes in the level of policy exceptions.

Management utilizes a loss migration model for determining the quantitative risk assigned to unimpaired loans in order to capture historical loss information at the loan level, track loss migration through risk grade deterioration, and increase efficiencies related to performing the calculations by further segmenting the loan classes. The quantitative risk factor for each loan class primarily utilizes a migration analysis loss method based on loss history for the prior twelve quarters.

See Note 4 – Loans and Note 5 – Allowance for Loan Losses in the Notes to Consolidated Financial Statements, included in Item 8. Financial Statements and Supplementary Data, for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.

Activity for the allowance for loan losses is provided in the following table:

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As of December 31, 2021, the ALLL was $6.0 million, a net increase of $529 thousand from $5.5 million at December 31, 2020. Management’s estimates for the ALLL resulted in the Company’s allowance to total loans outstanding ratio of 0.56% at December 31, 2021, compared to 0.90% at December 31, 2020 and 0.78% at December 31, 2019. The primary reason that the ALLL as a percentage of loans decreased from December 31, 2020 to December 31, 2021 was due to the addition of TFB loans effective with the Merger, which do not require an ALLL based on the fair value mark. Note that without the impact of acquired loans and the fair value mark, the ALLL to total loans outstanding would have been 0.95% as of December 31, 2021 (for reconcilement of this non-GAAP measure, see the “Non-GAAP Presentation” section earlier in Item 7).

During 2021, there were $835 thousand in loan balances charged off, with a total of $350 thousand in recoveries of previously charged-off balances, resulting in net charge-offs of $485 thousand. During 2020, there were $805 thousand in loan balances charged off, with a total of $429 thousand in recoveries of previously charged-off balances, resulting in net charge-offs of $376 thousand. The ratio of net charge-offs to average loans was 0.05% and 0.06% for 2021 and 2020, respectively.

The table below provides an allocation of year-end allowance for loan losses by loan type; however, allocation of a portion of the allowance to one loan category does not preclude its availability to absorb losses in other categories.

Allocation of the Allowance for Loan Losses

Deposits

Depository accounts represent the Company’s primary source of funding and are comprised of demand deposits, interest-bearing checking accounts, money market deposit accounts and time deposits. These deposits have been provided predominantly by individuals, businesses and charitable organizations in the Charlottesville/Albemarle County, Fauquier County, Manassas, Prince William County, Richmond and Winchester areas.

Depository accounts held by the Company as of December 31, 2021, totaled $1.8 billion, an increase of $1.0 billion or 145.8% compared to the December 31, 2020 total of $730.8 million.

At December 31, 2021, the balances of non-interest bearing demand deposits were $522.3 million or 29.1% of total deposits, a 149.0% increase from $209.8 million at December 31, 2020. Interest-bearing transaction and money market accounts totaled $1.1 billion at December 31, 2021, an increase of $690.0 million compared to $421.9 million at December 31, 2020. The Company offers ICS®, which allows customers access to multi-million-dollar FDIC insurance on funds placed into demand deposit and/or money market deposit accounts. As of December 31, 2021, the reciprocal ICS® balances included in demand deposit and money market accounts were $39.2 million and $225.9 million, respectively. The Company’s low-cost deposit accounts, which include both non-interest and interest bearing checking accounts as well as money market accounts, represented 91.0% of total deposit account balances at December 31, 2021 and compared favorably to the 86.4% of total deposit account balances at December 31, 2020.

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Certificates of deposit and other time deposit balances increased $62.9 million to $162.0 million at December 31, 2021 from the balance of $99.1 million at December 31, 2020. Included in this deposit total were reciprocal relationships under CDARS™, whereby depositors can obtain FDIC insurance on deposits up to $50 million. These reciprocal CDARS™ deposits totaled $6.1 million and $8.5 million at December 31, 2021 and 2020, respectively.

As of December 31, 2021 and 2020, the estimated amounts of total uninsured deposits were $585.6 million and $276.4 million, respectively.

Maturities of time deposits in excess of FDIC insurance limits as of December 31, 2021 were as follows:

Borrowings

Borrowings, consisting primarily of FHLB advances and federal funds purchased, are additional sources of funds for the Company. The level of these borrowings is determined by various factors, including customer demand and the Company's ability to earn a favorable spread on the funds obtained.

The Company has a collateral dependent line of credit with the FHLB. During the third quarter of 2021, the Company prepaid 100% of its outstanding FHLB advances, which positively impacted interest expense by $416 thousand as a result of accelerating the accretion of the fair value purchase mark on such acquired Fauquier debt. A prepayment penalty in the amount of $243 thousand was incurred and is reported in noninterest expense, netting to an overall gain on the transaction of $173 thousand. Due to this repayment, at December 31, 2021, the Company had no outstanding borrowings from the FHLB. As of December 31, 2020, the Company had outstanding balances of $30.0 million from three FHLB advances with $10 million maturing in each of the years 2021, 2023, and 2025. The Company had no outstanding borrowings as of December 31, 2019.

As of December 31, 2021, the Company had a letter of credit for $60.0 million issued in favor of the Commonwealth of Virginia Department of the Treasury to secure public fund depository accounts and collateralized against these pledged commercial mortgages.

Additional borrowing arrangements maintained by the Bank include formal federal funds lines with five correspondent banks. The Company had no outstanding balances in federal funds purchased as of December 31, 2021, 2020, or 2019.

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Total borrowings consist of the following as of December 31, 2021, 2020, and 2019:

Details on available borrowing lines can be found later under Liquidity in the Asset/Liability Management section.

Junior Subordinated Debt

In 2006, a subsidiary of Fauquier, Fauquier Statutory Trust II, privately issued $4.0 million face amount of the trust’s Floating Rate Capital Securities in a pooled capital securities offering. Simultaneously, the trust used the proceeds of that sale to purchase $4.0 million principal amount of the Fauquier’s Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. As of December 31, 2021, total capital securities were $3.4 million, as adjusted to fair value as of the date of the Merger. The interest rate on the capital security resets every three months at 1.70% above the then current three-month LIBOR and is paid quarterly. Management is in communication with the issuer regarding the alternative reference rate that will apply after the discontinuance of LIBOR.

The Trust II issuance of capital securities and the respective subordinated debentures are callable at any time. The subordinated debentures are an unsecured obligation of the Company and are junior in right of payment to all present and future senior indebtedness of the Company. The capital securities are guaranteed by the Company on a subordinated basis.

ASSET/LIABILITY MANAGEMENT

The Company’s primary earnings source is its net interest income; therefore, the Company devotes significant time and resources to assist in the management of interest rate risk and asset quality. The Company’s net interest income is affected by changes in market interest rates and by the level and composition of interest-earning assets and interest-bearing liabilities. The Company’s objectives in its asset/liability management are to utilize its capital effectively, to provide adequate liquidity and to enhance net interest income, without taking undue risks or subjecting the Company unduly to interest rate fluctuations. The Company takes a coordinated approach to the management of its liquidity, capital and interest rate risk. This risk management process is governed by policies and limits established by the Bank’s Asset/Liability Committee, which are reviewed and approved by the Bank’s Board of Directors. This committee, which is comprised of directors and members of management, meets to review, among other things, economic conditions, interest rates, yield curves, cash flow projections, expected customer actions, liquidity levels, capital ratios and repricing characteristics of assets, liabilities and financial instruments.

Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market indices such as interest rates. The Company’s principal market risk exposure is interest rate risk. Interest rate risk is the exposure to changes in market interest rates. Interest rate sensitivity is the relationship between market interest rates and net interest income due to the repricing characteristics of assets and liabilities. The Company monitors the interest rate sensitivity of its balance sheet positions by examining its near-term sensitivity and its longer-term gap position. In its management of interest rate risk, the Company utilizes several financial and statistical tools including traditional gap analysis and sophisticated income simulation models.

A traditional gap analysis is prepared based on the maturity and repricing characteristics of interest-earning assets and interest-bearing liabilities for selected time bands. The mismatch between repricings or maturities within a time band is commonly referred to as the “gap” for that period. A positive gap (asset sensitive) where interest rate sensitive assets exceed interest rate sensitive liabilities generally will result in the net interest margin increasing in a rising rate environment and decreasing in a falling rate environment. A negative gap (liability sensitive) will generally have the opposite result on the net interest margin. The Company’s balance sheet structure is primarily short-term in nature with a substantial portion

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of rate-sensitive assets and rate-sensitive liabilities repricing or maturing within one year, as shown in the Gap Interest Sensitivity Analysis table below.

Gap Interest Sensitivity Analysis

As of December 31, 2021

The Company utilizes the gap analysis to complement its income simulations modeling. However, the traditional gap analysis does not assess the relative sensitivity of assets and liabilities to changes in interest rates and other factors that could have an impact on interest rate sensitivity or net interest income.

ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon. It also utilizes additional tools to monitor potential longer-term interest rate risk. The income simulation models measure the Company’s net interest income volatility or sensitivity to interest rate changes utilizing statistical techniques that allow the Company to consider various factors which impact net interest income. These factors include actual maturities, estimated cash flows, repricing characteristics, deposit growth/retention and, most importantly, the relative sensitivity of the Company’s assets and liabilities to changes in market interest rates. This relative sensitivity is important to consider as the Company’s core deposit base has not been subject to the same degree of interest rate sensitivity as its assets. The core deposit costs are internally managed and tend to exhibit less sensitivity to changes in interest rates than the Company’s adjustable rate assets whose yields are based on external indices and generally change in concert with market interest rates. The Company’s interest rate sensitivity is determined by identifying the probable impact of changes in market interest rates on the yields on the Company’s assets and the rates that would be paid on its liabilities. This modeling technique involves a degree of estimation based on certain assumptions that management believes to be reasonable. Utilizing this process, management projects the impact of changes in interest rates on net interest margin. The Company has established certain policy limits for the potential volatility of its net interest margin assuming certain levels of changes in market interest rates with the objective of maintaining a stable net interest margin under various probable rate scenarios. Management generally has maintained a risk position well within the policy limits.

As market conditions vary from those assumed in the income simulation models, actual results will also differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate change caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other variables. Furthermore, this sensitivity analysis does not reflect actions that the ALCO might take in responding to or anticipating changes in interest rates.

In simulating the effects of upward and downward changes in market rates to net interest income over a rolling two-year horizon, the model utilizes a “static” balance sheet approach where balance sheet composition or mix as of the measurement date is maintained over the two-year horizon. Similarly, the base case simulation performed assumes interest rates on the measurement date are unchanged for the next 24 months. Then the simulation assumes all rate indices are instantaneously shocked upward and downward by 100 bps to 400 basis points, in 100 basis point increments. Due to the low level of

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interest rates, the shock down analysis where the rates fall 300 basis points or more are not considered meaningful and are therefore not shown in the results below as of December 31, 2021.

In addition to monitoring the effects to interest income, the model computes the effects to the economic value of equity using the same “static” balance sheet with immediate and parallel rate changes for the same rate change horizons. The Asset/Liability Committee monitors the results compared to policy limits that have been established.

As individual rate indices have not historically moved to the same degree, non-parallel rate shocks are also performed to add a degree of sophistication over the parallel rate shocks. In these analyses, the effects to net interest income and market value of equity are computed using eight different scenarios. Changing slopes and twists of the yield curve are achieved by incorporating both likely and unlikely change across different tenors. Since Federal funds rates may not change to the same degree or direction that longer term Treasury bonds may move, the different scenarios are analyzed so that management and the Asset/Liability Committee can monitor risks as they more severely stress the Company’s balance sheet.

The shape of the yield curve can cause downward pressure on net interest income. In general, if and to the extent that the yield curve is flatter (i.e., the differences between interest rates for different maturities are relatively smaller) than previously anticipated, then the yield on the Company’s interest earning assets and its cash flows will tend to be lower. Management believes that a relatively flat yield curve could continue to affect adversely the Company’s net interest income in 2022.

Liquidity

Liquidity represents the Company’s ability to provide funds to meet customer demand for loan and deposit withdrawals without impairing profitability. Effective management of balance sheet liquidity is necessary to fund growth in earning assets and to pay liability maturities and depository customers’ withdrawal requirements. The Company maintains a Liquidity Management Policy that is approved by the Board of Directors. The policy sets limits in a number of areas, including limits on the amount of non-core liabilities, and funding long-term assets with non-core liabilities.

The Bank’s customer base has provided a stable source of funds and liquidity. Limits contained within the Bank’s Investment Policy also provides for appropriate levels of liquidity through maturities and cash flows within the securities portfolio. Other sources of balance sheet liquidity are obtained from the repayment of loan proceeds and overnight investments. The Bank has numerous secondary sources of liquidity including access to borrowing arrangements from a number of correspondent banks. Available borrowing arrangements maintained by the Bank include formal federal funds lines with five major regional correspondent banks, access to advances from the Federal Home Loan Bank and access to the discount window at the Federal Reserve Bank.

Borrowing Lines

As of December 31, 2021

As of December 31, 2021, the Company had no outstanding advances with the FHLB.

Any excess funds are sold on a daily basis in the federal funds market or maintained on account at the Federal Reserve. The Company maintained an average of $109.1 million outstanding in federal funds sold, an average of $161.0 million at the Federal Reserve and an average of less than $1 thousand in federal funds purchased during 2021 due to annual testing of the federal funds lines. On December 31, 2021 the Company had no balance outstanding in federal funds purchased. The Company intends to maintain sufficient liquidity at all times to meet its funding commitments.

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Capital

The Basel III Capital Rules require banks and bank holding companies to comply with the following minimum capital ratios: (i) a ratio of common equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7%); (ii) a ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum Tier 1 capital ratio of 8.5%); (iii) a ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum total capital ratio of 10.5%); and (iv) a leverage ratio of 4%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).

The Tier 1, common equity Tier 1, total capital to risk-weighted assets, and leverage ratios of the Bank were 14.15%, 14.15%, 14.72% and 7.69%, respectively, as of December 31, 2021, exceeding the minimum requirements.

With respect to the Bank, to be “well capitalized” under the PCA regulations, a bank must have the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of at least 6.5%; (ii) a Tier 1 capital to risk-weighted assets ratio of at least 8.0%; (iii) a total capital to risk-weighted assets ratio of at least 10.0%; and (iv) a leverage ratio of at least 5.0%. The Bank exceeds the thresholds to be considered well capitalized as of December 31, 2021.

On September 17, 2019 the FDIC finalized a rule that introduced an optional simplified measure of capital adequacy for qualifying community banking organizations, referred to as, the community bank leverage ratio framework, as required by the EGRRCPA. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework.

In order to qualify for the CBLR framework, a community banking organization must have a Tier 1 leverage ratio of greater than 9 percent, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well-capitalized ratio requirements under the PCA regulations and will not be required to report or calculate risk-based capital.

The CBLR framework was made available for community banking organizations to use in their March 31, 2020 Call Report. The Company has not opted into the CBLR framework.

The Basel III capital regulations and CBLR framework are discussed in greater detail under the caption “Supervision and Regulation,” found earlier in this report under “Item 1. Business.” In addition, information regarding the Company’s risk-based capital at December 31, 2021 and December 31, 2020 is presented in Note 15 – Capital Requirements of the Notes to Consolidated Financial Statements, contained in Item 8. Financial Statements and Supplementary Data. Using the most recent capital requirements, the Bank’s capital ratios remain above the levels designated by bank regulators as "well capitalized" at December 31, 2021.

Impact of Inflation and Changing Prices

The Company’s financial statements included herein have been prepared in accordance with GAAP, which requires the financial position and operating results to be measured principally in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. Inflation affects the Company’s results of operations mainly through increased operating costs, but since nearly all of the Company’s assets and liabilities are monetary in nature, changes in interest rates affect the financial condition of the Company to a greater degree than changes in the rate of inflation. Although interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. The Company’s management reviews pricing of its products and services, in light of current and expected costs due to inflation, to mitigate the inflationary impact on financial performance.

Off-Balance Sheet Arrangements

The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Additional information concerning the Company’s off-balance sheet arrangements is contained in Note 13 of the Notes to Consolidated Financial Statements, found in Item 8. Financial Statements and Supplementary Data.

Related Party Transactions

The Company and its subsidiaries have business dealings with companies owned by directors and beneficial shareholders of the Company. In 2021 and 2020, leasing/rental expenditures of $520 thousand and $511 thousand respectively, (including reimbursements for taxes, insurance, and other expenses) were paid to an entity indirectly owned by a director of the Company.

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Contractual Commitments

In the normal course of business, the Company and its subsidiaries enter into contractual obligations, including obligations on lease arrangements, contractual commitments for capital expenditures, and service contracts. The significant contractual obligations include the leasing of certain of its banking and operations offices under operating lease agreements on terms ranging from 1 to 10 years, most with renewal options.

Following is a schedule of future minimum rental payments under non-cancelable operating leases that have initial or remaining terms in excess of one year as of December 31, 2021: