ARROW FINANCIAL CORP (AROW) FY 2021 MD&A

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

Selected Quarterly Information

Dollars in thousands, except per share amounts

Share and per share amounts have been restated for the September 2021 3% stock dividend

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Selected Twelve-Month Information

Dollars in thousands, except per share amounts

Share and per share amounts have been restated for the September 2021 3% stock dividend

*See "Use of Non-GAAP Financial Measures" on page 4.

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Arrow Financial Corporation

Reconciliation of Non-GAAP Financial Information

(Dollars In Thousands, Except Per Share Amounts)

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CRITICAL ACCOUNTING ESTIMATES

The significant accounting policies, as described in Note 2 - Summary of Significant Accounting Policies to the Consolidated Financial Statements are essential in understanding the Management Discussion and Analysis. Many of the significant accounting policies require complex judgments to estimate the values of assets and liabilities. Arrow has procedures and processes in place to facilitate making these judgments. The more judgmental estimates are summarized in the following discussion. In many cases, there are numerous alternative judgments that could be used in the process of determining the inputs to the models. Where alternatives exist, Arrow has used the factors that are believed to represent the most reasonable value in developing the inputs. Actual performance that differs from estimates of the key variables could impact the results of operations.

Allowance for credit losses: The allowance for credit losses consists of the allowance for credit losses and the allowance for losses on unfunded commitments. As a result of the Arrow's January 1, 2021, adoption of Accounting Standards Updates (‘‘ASU’’) 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (‘‘CECL’’) and its related amendments, our methodology for estimating the reserve for credit losses changed significantly from December 31, 2020. The standard replaced the ‘‘incurred loss’’ approach with an ‘‘expected loss’’ approach known as current expected credit loss. The CECL approach requires an estimate of the credit losses expected over the life of an exposure (or pool of exposures). It removes the incurred loss approach’s threshold that delayed the recognition of a credit loss until it was ‘‘probable’' that a loss event was ‘‘incurred.’’ The estimate of expected credit losses under the CECL approach is based on relevant information about past events, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amounts. Historical loss experience is generally the starting point for estimating expected credit losses. Arrow then considers whether the historical loss experience should be adjusted for asset-specific risk characteristics or current conditions at the reporting date that did not exist over the period from which historical experience was used. Finally, Arrow considers forecasts about future economic conditions that are reasonable and supportable. The allowance for losses on unfunded commitments represents the expected credit losses on off-balance sheet commitments such as unfunded commitments to extend credit and standby letters of credit. However, a liability is not recognized for commitments unconditionally cancellable by Arrow. The allowance for losses on unfunded commitments is determined by estimating future draws and applying the expected loss rates on those draws. Arrow considers the accounting policy relating to the allowance for credit losses to be a critical accounting estimate given the uncertainty in evaluating the level of the allowance required to cover Arrow's estimate of all expected credit losses over the expected contractual life of our loan portfolio. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the then-existing loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for credit losses in those future periods. While management’s current evaluation of the allowance for credit losses indicates that the allowance is appropriate at this time, the allowance may need to be increased in the future due to changes in conditions or assumptions. The impact of utilizing the CECL approach to calculate the reserve for credit losses will be significantly influenced by the composition, characteristics and quality of our loan portfolio, as well as the prevailing economic conditions and forecasts utilized. Material changes to these and other relevant factors may result in greater volatility to the reserve for credit losses, and therefore, greater volatility to our reported earnings. Arrow's policies on the allowance for credit losses, pension accounting and provision for income taxes are disclosed in Note 1 to the consolidated financial statements of this Form 10-K.

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A. OVERVIEW

The following discussion and analysis focuses on and reviews Arrow's results of operations for each of the years in the three-year period ended December 31, 2021 and the financial condition as of December 31, 2021 and 2020.  The discussion below should be read in conjunction with the selected quarterly and annual information set forth above and the Consolidated Financial Statements and other financial data presented elsewhere in this Report.  When necessary, prior-year financial information has been reclassified to conform to the current-year presentation.

COVID-19 Pandemic:

Arrow continues to monitor the impact of the pandemic variants and all the challenges they present on our business and operations and the health and safety of our employees and customers are at the forefront of related decisions.

Arrow continues to comply with Federal and New York State guidelines and regulations. All employees and directors are vaccinated, subject to appropriate health and religious exemptions. Arrow continues to encourage remote work and minimize work-related travel and in-person meetings. A pandemic bonus to eligible employees, the second in two years, was awarded in recognition of the enduring and exceptional pandemic performance of Arrow's employees. Arrow managed to avoid widespread lobby closures for the majority of the year.

As Arrow cannot predict the duration or scope of the pandemic or its impact on economic and financial markets or its impact on the business, Arrow is unable to reasonably estimate the overall impact on the Company. For further discussion of the impact COVID-19 has had and may in the future have on Arrow and its financial results and operations, please refer to the Risk Factors included in Part I, Item 1A, beginning on page 14 of this Report.

Summary of 2021 Financial Results: For the year ended December 31, 2021, net income reached a record $49.9 million, up 22.1% over net income of $40.8 million for 2020. For 2021, revenue increased by $10.9 million and the provision for credit losses decreased by $9.0 million, which was partially offset by higher operating expenses and income taxes. Diluted EPS was $3.10 for 2021, up 21.2% from $2.56 in 2020.

Return on average equity (ROE) and return on average assets (ROA) were 14.09% and 1.28%, respectively, as compared to 12.77% and 1.17%, respectively, for 2020.

At December 31, 2021, total loan balances reached $2.7 billion, up $73 million, or 2.8%, from the prior-year level. Net of $70.1 million of PPP loans forgiven by the Small Business Administration in 2021, loans grew by $143.1 million for the year. The consumer loan portfolio grew by $60.8 million, or 7.1%, over the balance at December 31, 2020, primarily as a result of continued strength in the indirect automobile lending program. Net of approximately $52.1 million of loans sold in 2021, the residential real estate loan portfolio increased $23.0 million, or 2.5% from the prior year. Commercial loans, including commercial real estate, decreased $10.9 million, or 1.3%, over the balances at December 31, 2020. The decrease in commercial loans includes $70.1 million of PPP loans forgiven by the Small Business Administration in 2021.

At December 31, 2021, total deposit balances reached $3.6 billion, up by $315.8 million, or 9.8%, from the prior-year level. Noninterest-bearing deposits grew by $108.9 million, or 15.5%, during 2021, and represented 22.8% of total deposits at year-end as compared to the prior-year level of 21.7%. At December 31, 2021, total time deposits decreased $63.0 million from the prior-year level.

Net interest income for the year ending December 31, 2021, was $110.4 million, an increase of $11.2 million, or 11.2%, from the prior year. Interest and fees on loans were $105.0 million, an increase of 4.5% from the $100.5 million for the year ending December 31, 2020. Interest and fees related to PPP loans, included in the $105.0 million, were $7.8 million. Interest expense for the year ending December 31, 2021 was $5.2 million. This is a decrease of $7.5 million, or 59.1%, from the $12.7 million in expense for the year ending December 31, 2020. The net interest margin was 2.97% for the year ending December 31, 2021, as compared to 2.99% for the year ended December 31, 2020.

Noninterest income was $32.4 million for the year ending December 31, 2021, a decrease of 0.9% as compared to $32.7 million for the year ending December 31, 2020. Income from fiduciary activities in 2021 was $10.1 million, an increase of $1.3 million from 2020. Fees and other services to customers increased $1.5 million from 2020 to $11.5 million in 2021. Interchange fees related to increased customer activity of debit card usage was the largest driver of the increase. Gain on sales of loans decreased $1.5 million from 2020 to $2.4 million in 2021 as a result of the strategic decision in the second half of 2021 to retain more newly originated residential real estate loans. The decrease in other operating income from 2020 is primarily driven by the $1.4 million decrease in income related to interest rate swap agreements.

Noninterest expense for the year ending December 31, 2021, increased by $7.4 million, or 10.5%, to $78.1 million compared to $70.7 million in 2020. The largest component of noninterest expense is salaries and benefits paid to our employees, which totaled $44.8 million in 2021. Noninterest expense for the three-month period ended December 31, 2021, increased $2.7 million, or 14.7%, as compared to the fourth quarter of 2020. Other operating expenses increased from the prior comparable quarter as the result of $1.4 million in non-recurring litigation reserve expense.

In addition, during 2021, Arrow began to renovate a large portion of its Glens Falls headquarters, including workspace for support teams and the Main Office branch. Also, Arrow continued its branch optimization initiative. Saratoga National Bank consolidated two smaller branches into one larger, fully renovated branch at Wilton Square. Glens Falls National Bank consolidated two branches within a mile of each other in Fort Edward, allowing Arrow to serve the community from one central, updated location. Throughout the year, a combination of renovation, consolidation and relocation has allowed us to deliver an enhanced customer experience while streamlining expenses.

On the technology front, Arrow prepared a new online account opening platform, which launched in 2021 for Saratoga National Bank and will be followed later in 2022 at Glens Falls National Bank. Work also began in late 2021 on replacing our core technology in preparation for an upgrade in the summer of 2022.

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The changes in net income, net interest income and net interest margin between the current and prior year are discussed in detail under the heading "RESULTS OF OPERATIONS," beginning on page 30.

Regulatory Capital and Increase in Stockholders' Equity: As of December 31, 2021, Arrow continued to exceed all required minimum capital ratios under the current bank regulatory capital rules as implemented under Dodd-Frank (the "Capital Rules") at both the holding company and bank levels.  At that date, both subsidiary banks, as well as the holding company, continued to qualify as "well-capitalized" under the capital classification guidelines as defined by the Capital Rules.  Because of continued profitability and strong asset quality, the regulatory capital levels throughout recent years have consistently remained well in excess of the various required regulatory minimums in effect from time to time, as they do at present.

In 2020, federal bank regulators introduced an optional simplified measure of capital adequacy for qualifying community banking organizations (CBLR).  A qualifying community banking organization that opts into the CBLR framework and meets all the requirements under the CBLR framework will be considered to have met the well-capitalized ratio requirements under the “prompt corrective action” regulations and will not be required to report or calculate risk-based capital ratios.

The CBLR final rule became effective as of January 1, 2020, and Arrow and both subsidiary banks have opted out of utilizing the CBLR framework. Therefore, the Capital Rules promulgated under Dodd-Frank will remain applicable to Arrow and both subsidiary banks.

Total stockholders' equity was $371.2 million at December 31, 2021, an increase of $36.8 million, or 11.0%, from the year earlier level. The components of the change in stockholders' equity since year-end 2020 are presented in the Consolidated Statement of Changes in Stockholders' Equity on page 62. Total book value per share increased by 10.6% over the prior year level. At December 31, 2021, tangible book value per share, a non-GAAP financial measure calculated based on tangible book value (total stockholders' equity minus intangible assets including goodwill) was $21.66, an increase of $2.23, or 11.5%, over the December 31, 2020 amount. The increase in total stockholders' equity during 2021 principally reflected the following factors: (i) $49.9 million of net income for the year, plus (ii) $2.78 million of equity related to various stock-based compensation plans, plus (iii) $1.8 million of equity resulting from the dividend reinvestment plan, plus (iv) cumulative impact of adoption of ASU 2016-13 of $120 thousand and (v) other comprehensive income of $1.2 million reduced by (vi) cash dividends of $16.3 million and (vii) repurchases of common stock of $2.7 million. As of December 31, 2021, Arrow's closing stock price was $35.23, resulting in a trading multiple of 1.63 to Arrow's tangible book value. The Board of Directors declared and Arrow paid a cash dividend of $0.252 per share for the first three quarters of 2021, as adjusted for a 3% stock dividend distributed September 24, 2021, a cash dividend of $0.26 per share for the fourth quarter of 2021, and declared a $0.27 per share cash dividend for the first quarter of 2022.

Loan quality: Nonperforming loans were $11.7 million at December 31, 2021, an increase of $5.3 million, or 82.1%, from year-end 2020. The increase was due to two commercial real estate loans being classified as nonaccrual during 2021. The ratio of nonperforming loans to period-end loans at December 31, 2021 was 0.44%, an increase from 0.25% at December 31, 2020 and less than Arrow's peer group ratio of 0.55% at September 30, 2021. Loans charged-off (net of recoveries) against the allowance for credit losses was $923 thousand for 2021, a decrease of $351 thousand from 2020. The ratio of net charge-offs to average loans was 0.03% for 2021 and 0.05% for 2020, compared to the peer group ratio of 0.05% for the period ended September 30, 2021. At December 31, 2021, the allowance for credit losses was $27.3 million, representing 1.02% of total loans, a decrease of 11 basis points from the December 31, 2020 ratio.

Loan Segments: As of December 31, 2021, total loans grew $72.9 million, or 2.8%, as compared to the balance at December 31, 2020.

◦    Commercial and Commercial Real Estate Loans: Combined, these loans comprise 30.0% of the total loan portfolio at period-end. Commercial property values in Arrow's region have largely remained stable, however, there remains uncertainty surrounding market conditions due to the pandemic. Appraisals on nonperforming and watched CRE loan properties are updated as deemed necessary, usually when the loan is downgraded or when there has been significant market deterioration since the last appraisal.

◦    Consumer Loans: These loans (primarily automobile loans) comprised approximately 34.5% of the total loan portfolio at period-end. Consumer automobile loans at December 31, 2021, were $915.6 million, or 99.5% of this portfolio segment. In 2021, Arrow did not experience any significant increase in the delinquency rate or in the percentage of nonperforming loans in this segment. The vast majority of automobile loans are initiated through the purchase of vehicles by consumers with automobile dealers. As of December 31, 2021, demand was strong. However, supply constraints, with both new and used vehicles, may limit the potential growth in this category.

◦    Residential Real Estate Loans: These loans, including home equity loans, made up 35.5% of the total loan portfolio at period-end. The residential real estate market in Arrow's service area has been stable in recent periods. Arrow originated nearly all of the residential real estate loans currently held in the loan portfolio and applies conservative underwriting standards to loan originations. Arrow typically sells a portion of residential real estate mortgage originations into the secondary market. The ratio of the sales of originations to total originations tends to fluctuate from period to period based on market conditions and other factors. Sales were higher in the first half of 2021, due to a variety of factors, including strong demand for residential mortgages in our operating markets, favorable market conditions for mortgage sales and strategic balance sheet and interest-rate risk management decisions. In the second half 2021, sales decreased primarily as the result of the strategic decision to grow the residential loan portfolio. The rate at which mortgage loan originations are sold in future periods will depend on various circumstances, including prevailing mortgage rates, other lending opportunities, capital and liquidity needs, and the availability of a market for such transactions.

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Liquidity and access to credit markets: Arrow did not experience any liquidity problems or special concerns in recent years or in 2021. Arrow’s liquidity position provides the necessary flexibility to address any unexpected near-term disruptions.  Interest-bearing cash balances at December 31, 2021 were $430.7 million compared to $338.9 million at December 31, 2020.  Deposit growth provided an abundance of liquidity to fund Arrow's asset growth. However, contingent lines of credit are also available. Operating collateralized lines of credit are established and available through the FHLBNY and FRB, totaling $1.3 billion. The terms of Arrow's lines of credit have not changed significantly in recent periods (see the general liquidity discussion on page 48). Historically, Arrow has principally relied on asset-based liquidity (i.e., funds in overnight investments and cash flow from maturing investments and loans) with liability-based liquidity as a secondary source of funds (the main liability-based sources are an overnight borrowing arrangement with correspondent banks, an arrangement for overnight borrowing and term credit advances from the FHLBNY, and an additional arrangement for short-term advances at the Federal Reserve Bank discount window). Regular liquidity stress tests and tests of the contingent liquidity plan are performed to ensure that an adequate amount of available funds can be generated to meet a wide variety of potential liquidity crises.

Reference Rate Reform: On March 5, 2021, the ICE Benchmark Administration, the administrator of London Interbank Offered Rate (LIBOR) (the "IBA"), and the United Kingdom’s Financial Conduct Authority, the regulatory supervisor for the IBA, announced certain future dates that LIBOR settings will cease to be provided by any administrator. For Arrow, U.S. Dollar LIBOR indices utilized by its existing financial instruments will cease after June 30, 2023. In addition, regulators have issued statements indicating that financial institutions should not issue new LIBOR-based financial instruments after January 1, 2022. To prepare for the upcoming cessation of LIBOR, Arrow established a committee in 2020 comprised of bank management to prepare for the discontinuance of LIBOR, which is widely used to reprice floating rate financial instruments. Based on a review of existing floating rate financial instruments, management has determined that the financial products tied to LIBOR will not be subject to cessation until June 30, 2023. This review also identified that only a few legacy contracts do not include appropriate fallback language. Management anticipates that the appropriate fallback provisions for these contracts will be implemented and allow for an orderly transition prior to the June 30, 2023 cessation of U.S. Dollar LIBOR. As of December 31, 2021, Arrow no longer issues new LIBOR-based financial instruments. Furthermore, U.S. Dollar LIBOR indices utilized by Arrow's existing financial instruments shall cease on June 30, 2023. Beginning January 1, 2022, Arrow is using the CME Term Secured Overnight Financing Rate (SOFR) as the primary index for financial instruments and the Bloomberg Short Term Bank Yield Index (BSBY) as a secondary index.

Visa Class B Common Stock: Arrow's subsidiary bank, Glens Falls National, like other Visa member banks, bears some indirect contingent liability for Visa's direct liability arising out of certain antitrust claims involving merchant discounts to the extent that Visa's liability might exceed the amount funded in its litigation escrow account. On December 13, 2019 the Court granted final approval to a settlement in this class action lawsuit. But, on January 3, 2020 an appeal of the final-approved order was filed with the court. On December 16, 2021, the second circuit court of appeals has set oral argument regarding objections to final approval of the settlement for March 16, 2022. When the appeals process is resolved and assuming the balance in the litigation escrow account is sufficient to cover the litigation claims and related expenses, Arrow could potentially realize a gain on the receipt of Visa Class A common stock. At December 31, 2021, Glens Falls National held 27,771 shares of Visa Class B common stock, and utilizing the conversion ratio to Class A common stock at that time, these Class B shares would convert to approximately 45,000 shares of Visa Class A common stock. Since the litigation settlement is not certain, Arrow has not recognized any economic value for these shares.

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B. RESULTS OF OPERATIONS

The following analysis of net interest income, the provision for credit losses, noninterest income, noninterest expense and income taxes, highlights the factors that had the greatest impact on the results of operations for December 31, 2021 and the prior two years. For a comparison of the years ended December 31, 2019 and 2020, see Part II. Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in our Form 10-K for the year ended December 31, 2020.

I. NET INTEREST INCOME

Net interest income represents the difference between interest, dividends and fees earned on loans, securities and other earning assets and interest paid on deposits and other sources of funds.  Changes in net interest income result from changes in the level and mix of earning assets and sources of funds (volume) and changes in the yields earned and interest rates paid (rate). Net interest margin is the ratio of net interest income to average earning assets.  Net interest income may also be described as the product of average earning assets and the net interest margin.

CHANGE IN NET INTEREST INCOME

(Dollars In Thousands) (GAAP Basis)

Net interest income was $110.4 million in 2021, an increase of $11.2 million, or 11.2%, from the $99.2 million in 2020.  This is consistent with the increase of $11.2 million, or 12.7%, from 2019 to 2020.  Factors contributing to the year-to-year changes in net interest income over the three-year period are discussed in the following portions of this Section B.I.

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The following tables reflects the components of net interest income, setting forth, for years ended December 31, 2021, 2020 and 2019: (i) average balances of assets, liabilities and stockholders' equity, (ii) interest and dividend income earned on earning assets and interest expense incurred on interest-bearing liabilities, (iii) average yields earned on earning assets and average rates paid on interest-bearing liabilities, (iv) the net interest spread (average yield less average cost) and (v) the net interest margin (yield) on earning assets. The yield on securities available-for-sale is based on the amortized cost of the securities. Nonaccrual loans are included in average loans.

Average Consolidated Balance Sheets and Net Interest Income Analysis

(GAAP basis)

(Dollars in Thousands)

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Changes between periods are attributed to movement in either the average daily balances or average rates for both earning assets and interest-bearing liabilities.  Changes attributable to both volume and rate have been allocated proportionately between the categories.

Net Interest Income Rate and Volume Analysis

(Dollars in Thousands) (GAAP basis)

NET INTEREST MARGIN

Arrow's earnings are derived predominantly from net interest income, which is interest income, net of interest expense. Changes in balance sheet composition, including interest-earning assets, deposits, and borrowings, combined with changes in market interest rates, impact net interest income. Net interest margin is net interest income divided by average interest-earning assets. Interest-earning assets and funding sources are managed, including noninterest and interest-bearing liabilities, in order to maximize this margin.

2021 Compared to 2020: Net interest income increased $11.2 million, or 11.2%, to $110.4 million for the year ended December 31, 2021 from $99.2 million for the year ended December 31, 2020. The increase is due in part to $7.8 million of revenue related to PPP loans. Other factors offsetting net interest income include lower market rates and increased cash balances. The net interest margin was 2.97% for the year ended December 31, 2021 as compared to 2.99% for the year ended December 31, 2020.

Income on investment securities decreased $1.1 million, or 9.8%, between the years ended December 31, 2021 and December 31, 2020. Average balances on investment securities were higher for the year, but portfolio yields were lower, with fully taxable securities falling by 41 basis points and securities exempt from federal taxes falling by 8 basis points.

Interest income from loans increased $4.5 million, or 4.8%, to $105.0 million for the year ended December 31, 2021 from $100.5 million for the year ended December 31, 2020. Although the loan portfolio yield dropped a basis point in 2021, to 3.97%, continued loan growth pushed interest income higher. Net of $70.1 million of PPP loans forgiven by the Small Business Administration in 2021, loans grew by $143.1 million for the year. Average loan balances increased by $116.4 million, a 4.6% increase over 2020 average balances. Within the loan portfolio, the three principal segments are residential real estate loans,

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consumer loans (primarily through the indirect automobile lending program) and commercial loans. The consumer loan portfolio grew by $60.8 million, or 7.1%, over the balance at December 31, 2020. Net of approximately $52.1 million of loans sold in 2021, the residential real estate loan portfolio increased $23.0 million, or 2.5% from the prior year. Commercial loans, including commercial real estate, decreased $10.9 million, or 1.3%, over the balances at December 31, 2020. The decrease was primarily due to $70.1 million of PPP loans forgiven by the Small Business Administration in 2021.

Total interest expense on interest-bearing liabilities decreased $7.5 million, or 59.1%, to $5.2 million for the year ended December 31, 2021 from $12.7 million for the year ended December 31, 2020. Although average interest bearing deposit balances increased by $274.6 million, the total cost of interest-bearing deposits decreased to 13 basis points from 45 basis points. In addition, average demand deposits, which are non-interest bearing, increased by $154.3 million.

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II. PROVISION FOR CREDIT LOSSES AND ALLOWANCE FOR CREDIT LOSSES

Arrow considers the accounting policy relating to the allowance for credit losses to be a critical accounting policy, given the uncertainty involved in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio, and the material effect that such judgments may have on the results of operations.  The provision for credit losses for 2021 was $272 thousand, compared to the $9.3 million provision for 2020. The analysis of the method employed for determining the amount of the credit loss provision is explained in detail in Notes 2, Summary of Significant Accounting Policies, and 5, Loans, to the Consolidated Financial Statements.

SUMMARY OF THE ALLOWANCE AND PROVISION FOR CREDIT LOSSES

(Dollars In Thousands) (Loans, Net of Unearned Income)

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ALLOCATION OF THE ALLOWANCE FOR CREDIT LOSSES

(Dollars in Thousands)

Arrow adopted CECL on January 1, 2021. The transition adjustment recorded on January 1, 2021, decreased the allowance for credit losses by $1.3 million. The CECL approach requires an estimate of the credit losses expected over the life of a loan (or pool of loans). It replaces the incurred loss approach’s threshold that required the recognition of a credit loss when it was probable that a loss event was incurred. The allowance for credit losses is a valuation account that is deducted from, or added to, the loans’ amortized cost basis to present the net, lifetime amount expected to be collected on the loans. Loan losses are charged off against the allowance when Arrow believes a loan balance is confirmed to be uncollectible. Expected recoveries do not exceed the aggregate of amounts previously charged off and expected to be charged off.

Management estimates the allowance using relevant available information from internal and external sources related to past events, current conditions, and a reasonable and supportable single economic forecast. Historical credit loss experience provides the basis for the estimation of expected credit losses. Arrow's historical loss experience was supplemented with peer information when there was insufficient loss data for Arrow. Peer selection was based on a review of institutions with comparable loss experience as well as loan yield, bank size, portfolio concentration and geography. Adjustments to historical loss information are made for differences in current loan-specific risk characteristics such as differences in credit concentrations, delinquency level, collateral values and underwriting standards as well as changes in economic conditions or other relevant factors. Management judgment is required at each point in the measurement process.

Portfolio segment is defined as the level at which an entity develops and documents a systematic methodology to determine its allowance for credit losses. Upon adoption of CECL, management revised the manner in which loans were pooled for similar risk characteristics. Management developed portfolio segments for estimating loss based on type of borrower and collateral as follows:

Commercial Loans

Commercial Real Estate Loans

Consumer Loans

Residential Loans

Further details related to loan portfolio segments is included in Note 5, Loans, to the Consolidated Financial Statements.

Historical credit loss experience for both Arrow and segment-specific peers provides the basis for the estimation of expected credit losses. Arrow utilized regression analyses of peer data, of which Arrow is included, where observed credit losses and selected economic factors were utilized to determine suitable loss drivers for modeling lifetime probability of default (PD) rates. Arrow uses the discounted cash flow (DCF) method to estimate expected credit losses for the commercial, commercial real estate, and residential segments. For each of these loan segments, Arrow generates cash flow projections at the instrument level wherein payment expectations are adjusted for estimated prepayment speed, curtailments, time to recovery, PD, and segment-specific loss given default (LGD) risk factors. The modeling of expected prepayment speeds, curtailment rates, and time to recovery are based on historical internal data and adjusted, if necessary, based on the reasonable and supportable forecast of economic conditions.

For the loan segments utilizing the DCF method, (commercial, commercial real estate, and residential) management utilizes externally developed economic forecast of the following economic factors as loss drivers: national unemployment, gross domestic product and home price index (HPI). The economic forecast is applied over a reasonable and supportable forecast period. Arrow utilizes a six quarter reasonable and supportable forecast period with an eight quarter reversion to the historic mean on a straight-line basis.

The combination of adjustments for credit expectations (default and loss) and timing expectations (prepayment, curtailment, and time to recovery) produces an expected cash flow stream at the instrument level. Instrument effective yield is calculated, net of the impacts of prepayment assumptions, and the instrument expected cash flows are then discounted at that effective yield to produce an instrument-level net present value of expected cash flows (NPV). An allowance for credit loss is established for the difference between the instrument’s NPV and amortized cost basis. The contractual term excludes expected extensions, renewals, and modifications unless either of the following applies: management has a reasonable expectation at the reporting date that a troubled debt restructuring (TDR) will be executed with an individual borrower or the extension or renewal options are included in the original or modified contract at the reporting date and are not unconditionally cancellable by Arrow.

Arrow uses the vintage analysis method to estimate expected credit losses for the consumer loan segment. The vintage method was selected since the loans within the consumer loan segment are homogeneous, not just by risk characteristic, but by loan structure. Under the vintage analysis method, a loss rate is calculated based on the quarterly net charge-offs to the outstanding loan balance for each vintage year over the lookback period. Once this periodic loss rate is calculated for each quarter in the lookback period, the periodic rates are averaged into the loss rate. The loss rate is then applied to the outstanding

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loan balances based on the loan's vintage year. Arrow maintains, over the life of the loan, the loss curve by vintage year. If estimated losses computed by the vintage method need to be adjusted based on current conditions and the reasonable and supportable economic forecast, these adjustments would be incorporated over a six quarter reasonable and supportable forecast period, reverting to historical losses using a straight-line method over an eight quarter period. Based on current conditions, and the reasonable and supportable economic forecast, no adjustments are currently required.

The vintage and DCF models also consider the need to qualitatively adjust expected loss estimates for information not already captured in the quantitative loss estimation process. Qualitative considerations include limitations inherent in the quantitative model; trends experienced in nonperforming and delinquent loans; changes in value of underlying collateral; changes in lending policies and procedures; nature and composition of loans; portfolio concentrations that may affect loss experience across one or more components or the portfolio; the experience, ability and depth of lending management and staff; Arrow's credit review system; and the effect of external factors such as competition, legal and regulatory requirements. These qualitative factor adjustments may increase or decrease Arrow's estimate of expected credit losses so that the allowance for credit loss is reflective of the estimate of lifetime losses that exist in the loan portfolio at the balance sheet date.

The change in methodology from incurred loss to the expected loss over the life of the loan also impacted the allocation of the allowance for credit losses. The vintage approach combined with a shorter life of loan decreased the allowance needed for consumer loans. Residential real estate loans, due to their longer life of loan, have a higher allocation of the allowance of credit loans as compared to the incurred loss methodology.

Arrow's allowance for credit losses was $27.3 million at December 31, 2021, which represented 1.02% of loans outstanding, a decrease from 1.13% at year-end 2020.

See Note 5, Loans, to the Consolidated Financial Statements for the complete methodology used to calculate the provision for credit losses.

III. NONINTEREST INCOME

The majority of the noninterest income constitutes fee income from services, principally fees and commissions from fiduciary services, deposit account service charges, insurance commissions, net gains (losses) on securities transactions, net gains on sales of loans and other recurring fee income.

ANALYSIS OF NONINTEREST INCOME

(Dollars In Thousands)

2021 Compared to 2020:  Total noninterest income in 2021 was $32.4 million, a decrease of $289 thousand, or 0.9%, from total noninterest income of $32.7 million for 2020. Income from fiduciary activities increased $1.3 million from 2020 to 2021. Assets under trust administration and investment management at December 31, 2021 were $1.85 billion, an increase of $192.1 million, or 11.6%, from the prior year-end balance of $1.66 billion. Fees for other services to customers were $11.5 million for 2021, an increase of $1.5 million as compared to 2020. The largest factor in the growth was interchange fees related to increased customer activity of debit card usage. Insurance commissions decreased by $389 thousand, or 5.7% from 2020 to 2021. The decrease in insurance commissions as compared to the prior year is primarily related to continued competition and the loss of some employee benefit relationships. The continued competition and the ability to retain key personnel may continue to impact revenue into 2022. Expense control initiatives, including the reduction of support roles, are ongoing to ensure expenses appropriately align with the decrease in revenue. Net gain on securities in 2021, consisting of a change in the fair value of equity investments, was $111 thousand as compared to a loss of $464 thousand in 2020.

Net gains on the sales of loans decreased in 2021 to $2.4 million, from $3.9 million in 2020, a decrease of $1.5 million, or 38.5%. Sales decreased as a result of the strategic decision in the second half of 2021 to retain more newly originated residential real estate loans. The rate at which mortgage loan originations are sold in future periods will depend on various circumstances, including prevailing mortgage rates, other lending opportunities, capital and liquidity needs, and the availability of a market for such transactions. Therefore, Arrow is unable to predict what the retention rate of such loans in future periods may be. Servicing rights are generally retained for loans originated and sold, which also generates additional noninterest income in subsequent periods (fees for other services to customers).

Other operating income decreased by $1.7 million, or 48.8% between the two years primarily due to the decrease in fees received as part of interest rate swap agreements of $1.4 million in 2020. Arrow purchased additional bank owned life insurance during 2020 which generated an increase in income of $233.3 thousand from the prior year. Additionally in 2021, Arrow had a loss on the disposal of fixed assets of $220.2 thousand compared to a gain of $16.5 thousand in 2020. The loss on the disposal of fixed assets related to the branch optimization initiative. Saratoga National Bank consolidated its Jones Road and Ballard

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Road branches into one, larger new renovated branch at Wilton Square. Glens Falls National Bank consolidated two branches in Fort Edward. Although a loss of disposal took place, Arrow is confident that it will sustain lower operating costs in the future for these locations.

IV. NONINTEREST EXPENSE

Noninterest expense is the measure of the delivery cost of services, products and business activities of a company.  The key components of noninterest expense are presented in the following table.

ANALYSIS OF NONINTEREST EXPENSE

(Dollars In Thousands)

2021 compared to 2020:  Noninterest expense for 2021 amounted to $78.0 million, an increase of $7.4 million, or 10.4%, from 2020.  For 2021, the efficiency ratio was 54.16%. This ratio, which is a commonly used non-GAAP financial measure in the banking industry, is a comparative measure of a financial institution's operating efficiency. The efficiency ratio (a ratio where lower is better), as defined by Arrow, is the ratio of operating noninterest expense (excluding intangible asset amortization) to net interest income (on a tax-equivalent basis) plus operating noninterest income (excluding net securities gains or losses). See the discussion of the efficiency ratio in this Report under the heading “Use of Non-GAAP Financial Measures.”

Salaries and employee benefits expense increased $2.7 million or 6.5%, from 2020. A portion of the increase, $528 thousand, was the result of an increase in the reclassification between salaries and employee benefits and other operating expenses. Under ASU 2017-07, interest cost, expected return on plan assets, amortization of prior service cost and amortization of net loss are required to be reclassified out of salaries and employee benefits. Salaries and benefits were also impacted by increased benefit costs and incentive payments.

Technology expenses increased $1.9 million, or 14.6%, from 2020 due to variable costs related to increased utilization of consumer banking technology as well as additional expenses to optimize digital delivery channels. Some examples of the new channels include an enhanced Business Online Banking interface, SecurLOCK to help customers combat ongoing fraud, a new mortgage application platform to make it easier for customers to apply online and connect with originators and a new deposit online account opening platform.

Other operating expense increased $2.6 million, or 29.5%, from 2020. The increase is the result of the expense for estimated credit losses on off-balance sheet credit exposures of $685 thousand for 2021 as well as $1.5 million in non-recurring litigation reserve expenses recorded in the fourth quarter of 2021.

V. INCOME TAXES

The following table sets forth the provision for income taxes and effective tax rates for the periods presented.

INCOME TAXES AND EFFECTIVE RATES

(Dollars In Thousands)

The provisions for federal and state income taxes amounted to $14.5 million for 2021, $11.0 million for 2020, and $9.6 million for 2019. The effective income tax rates for 2021, 2020 and 2019 were 22.6%, 21.3% and 20.4%, respectively. The increase in the effective tax rate in 2021 over 2020 and 2019 was primarily due to the reduction of tax exempt investments held and the related investment income combined with the increase in the New York State corporate tax rate which was effective January 1, 2021.

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C. FINANCIAL CONDITION

I. INVESTMENT PORTFOLIO

During 2021, 2020 and 2019, Arrow held no trading securities.

The available-for-sale securities portfolio, held-to-maturity securities portfolio and the equity securities portfolio are further detailed below.

Securities Available-for-Sale:

The following table sets forth the carrying value of the securities available-for-sale portfolio at year-end December 31, 2021, December 31, 2020 and December 31, 2019.

SECURITIES AVAILABLE-FOR-SALE

(Dollars In Thousands)

In the periods referenced above, Mortgage-Backed Securities consisted solely of mortgage pass-through securities and Collateralized Mortgage Obligations ("CMOs") issued or guaranteed by U.S. federal agencies or by government-sponsored enterprises (GSEs). Mortgage pass-through securities provide to the investor monthly portions of principal and interest pursuant to the contractual obligations of the underlying mortgages. CMOs are pools of mortgage-backed securities, the repayments on which have generally been separated into two or more components (tranches), where each tranche has a separate estimated life and yield. Arrow's practice has been to purchase pass-through securities and CMOs that are issued or guaranteed by U.S. federal agencies or GSEs, and the tranches of CMOs purchased are generally those having shorter average lives and/or durations. Lower market interest rates and/or payment deferrals on underlying loans that make up mortgage-backed security collateral may impact cashflows.

In the periods referenced above, U.S. Government & Agency Obligations consisted solely of agency bonds issued by government-sponsored enterprises (GSEs). These securities generally pay fixed semi-annual coupons with principle payments at maturity. For some, callable options are included that may impact the timing of these principal payments. Arrow's practice has been to purchase Agency securities that are issued or guaranteed by GSEs with limited embedded optionality (call features). Final maturities are generally less than 5 years.

Arrow evaluates available-for-sale debt securities in unrealized loss positions at each measurement date to determine whether the decline in the fair value below the amortized cost basis (impairment) is due to credit-related factors or non-credit related factors. Any impairment that is not credit related is recognized in other comprehensive income, net of applicable taxes. Credit-related impairment is recognized within the allowance for credit losses on the balance sheet, limited to the amount by which the amortized cost basis exceeds the fair value, with a corresponding adjustment to earnings via credit loss expense. Arrow determined that at December 31, 2021, gross unrealized losses were primarily attributable to changes in interest rates, relative to when the investment securities were purchased, and not due to the credit quality of the investment securities. Arrow does not intend to sell, nor is it more likely than not that Arrow will be required to sell the security before recovery of its amortized cost basis, which may be at maturity. Therefore, Arrow carried no allowance for credit loss at December 31, 2021 and there was no credit loss expense recognized by Arrow with respect to the securities portfolio during year ended December 31, 2021.

For the years above, Arrow held no investment securities in the securities portfolio that consisted of or included, directly or indirectly, obligations of foreign governments or government agencies of foreign issuers.

The following table sets forth the maturities of the debt securities in the available-for-sale portfolio as of December 31, 2021.  Mortgage-Backed Securities are included in the table based on their expected average lives.

MATURITIES OF DEBT SECURITIES AVAILABLE-FOR-SALE

(Dollars In Thousands)

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The following table sets forth the tax-equivalent yields of the debt securities in the available-for-sale portfolio at December 31, 2021.

YIELDS ON SECURITIES AVAILABLE-FOR-SALE

(Fully Tax-Equivalent Basis)

The yields on obligations of states and municipalities exempt from federal taxation were computed on a tax-equivalent basis. The yields on other debt securities shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the amortized cost of the securities at December 31, 2021.

At December 31, 2021 and 2020, the weighted average maturity was 4.0 and 2.3 years, respectively, for debt securities in the available-for-sale portfolio.

At December 31, 2021, the net unrealized gains on securities available-for-sale amounted to $8.2 million.  The net unrealized gain or loss on such securities, net of tax, is reflected in accumulated other comprehensive income/loss.  The net unrealized gains on securities available-for-sale was $7.8 million at December 31, 2020.  For both periods, net unrealized gains were primarily attributable to changes in market rates between the date of purchase and the balance sheet date resulting in higher or lower valuations of the portfolio securities.

For further information regarding the portfolio of securities available-for-sale, see Note 4, Investment Securities, to the Consolidated Financial Statements.

Securities Held-to-Maturity:

The following table sets forth the carrying value of the portfolio of securities held-to-maturity at December 31 of each of the last three years.

SECURITIES HELD-TO-MATURITY

(Dollars In Thousands)

Arrow's held to maturity debt securities are comprised of U.S. government agencies, U.S. government-sponsored enterprises and state and municipal obligations. U.S. government agencies and U.S. government-sponsored enterprise securities carry the explicit and/or implicit guarantee of the U.S. government, are widely recognized as “risk free,” and have a long history of zero credit loss. Arrow determined that the expected credit loss on its held to maturity debt portfolio was immaterial and therefore no allowance for credit loss was recorded as of December 31, 2021.

For additional information regarding the fair value of the portfolio of securities held-to-maturity at December 31, 2021, see Note 4, Investment Securities, to the Consolidated Financial Statements.

The following table sets forth the maturities of the portfolio of securities held-to-maturity as of December 31, 2021.

MATURITIES OF DEBT SECURITIES HELD-TO-MATURITY

(Dollars In Thousands)

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The following table sets forth the tax-equivalent yields of the portfolio of securities held-to-maturity at December 31, 2021.

YIELDS ON SECURITIES HELD-TO-MATURITY

(Fully Tax-Equivalent Basis)

The yields shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the amortized cost of the securities at December 31, 2021.  Yields on obligations of states and municipalities exempt from federal taxation were computed on a fully tax-equivalent basis.

At December 31, 2021 and 2020, the weighted average maturity was 2.0 and 2.7 years, respectively, for the debt securities in the held-to-maturity portfolio.

EQUITY SECURITIES

(Dollars In Thousands)

The following table is the schedule of Equity Securities at December 31 of each of the last three years.

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II. LOAN PORTFOLIO

The amounts and respective percentages of loans outstanding represented by each principal category on the dates indicated were as follows:

a. Types of Loans

(Dollars In Thousands)

Commercial and Commercial Real Estate Loans: Substantially all commercial and commercial real estate loans in the loan portfolio were extended to businesses or borrowers located in Arrow's regional markets. A portion of the loans in the commercial portfolio have variable rates tied to market indices, such as Prime, LIBOR or FHLBNY. Included within the commercial loan portfolio are PPP loans. In 2021, over $91 million of additional loans were funded to assist over 900 customers. Since the program's inception in 2020, over $234 million loans have been originated. As of December 31, 2021, over 80% of the loans originated have been forgiven with the majority of the remaining outstanding loans to be forgiven in 2022.

Consumer Loans: At December 31, 2021, consumer loans (primarily automobile loans originated through dealerships located primarily in upstate New York and Vermont) represented 35% of loans in the loan portfolio, and continue to be a significant component of Arrow's business. Consumer loan originations have remained strong in 2021, with origination volume for the last three years at $452.1 million, $386.4 million and $407.4 million for 2021, 2020 and 2019, respectively.

For credit quality purposes, Arrow assigns potential automobile loan customers into one of four tiers, ranging from lower to higher quality in terms of anticipated credit risk. Arrow's experienced lending staff not only utilizes credit evaluation software tools but also reviews and evaluates each loan individually prior to the loan being funded. Arrow believes that this disciplined approach to evaluating risk has contributed to maintaining the strong credit quality in this portfolio.

Residential Real Estate Loans: Residential real estate and home equity loans have represented the largest single segment of the loan portfolio (comprising approximately 35.5% of the entire portfolio at December 31, 2021), slightly higher than the consumer loan portfolio (34.5% of the portfolio) and the commercial and commercial real estate loans (30.0%). Gross originations for residential real estate loans (including refinancings of mortgage loans) were $244.5 million, $250.1 million and $164.7 million for the years 2021, 2020, and 2019, respectively.

During each of these years, gross origination totals have continued to grow as a result of historically low interest rates and strong demand for residential real estate. Arrow continues to sell portions of these originations in the secondary market. In 2021, sales amounted to $52.1 million, or 28.6%, of total originations, while retaining the mortgage servicing rights. Sales of originations amounted to $83.9 million for 2020 and $24.5 million for 2019 which represented 43.7% and 16.9%, respectively of the gross originations for those years. Sales decreased in 2021 as the result of the strategic decision to grow the residential loan portfolio. The rate at which mortgage loan originations are sold in future periods will depend on a variety of factors, including demand for residential mortgages in our operating markets, market conditions for mortgage sales and strategic balance sheet and interest-rate risk management decisions.

The following table indicates the changing mix in the loan portfolio by including the quarterly average balances for the significant loan segments for the past five quarters.  The remaining quarter-by-quarter tables present the percentage of total loans represented by each category and the annualized yield of each category.

LOAN PORTFOLIO

Quarterly Average Loan Balances

(Dollars In Thousands)

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Percentage of Total Quarterly Average Loans

Quarterly Yield on Loans

The average yield on the loan portfolio decreased from 3.94% for the fourth quarter of 2020 to 3.82% for the fourth quarter of 2021. Historically low interest rates prevailed for much of 2021, which impacted new loan yields for both fixed and variable rate loans. PPP loans generated $7.8 million in revenue. The majority of PPP revenue, over $6.7 million, is the result of fees received, many accelerated due to over 80% of the PPP loan portfolio forgiven as of December 31, 2021. Residential real estate yields declined in each of the five quarters presented consistent with overall market behavior as well as the effect of variable home equity loans.

Loan Deferrals Related to COVID-19 Pandemic

In the following tables, loans deferred by industry sector as the result of the COVID-19 pandemic are presented and compared to total loans by sector as of December 31, 2021 and December 31, 2020. In accordance with the CARES Act, the deferrals listed below are not considered troubled debt restructurings. Arrow originated $142.7 million of PPP loans in 2020 and $91.5 million PPP loans in 2021. These loans are included in the loan balances by sector as listed below, however, these loans are not considered deferred as the result of the COVID-19 pandemic.

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PPP Loans

Arrow originated over $234.2 million of PPP loans in 2020 and 2021. The PPP loans have an interest rate of 1% and Arrow expects to earn approximately $9.7 million in fees related to the origination of these loans. The original term on the PPP loans is two years, however the borrower will have the option to apply for forgiveness. Subsequent to the funding of the loans, additional guidance was provided that the term of the loan may be extended to five years if both parties agree to the revised terms. Arrow will recognize the fees earned over the life of the loan and will accelerate recognition of the fees if the loan is forgiven by the Small Business Administration. Arrow expects the majority of the loans to be forgiven by the end of 2022.

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The following table indicates the respective maturities and interest rate structure of commercial loans and commercial real estate construction loans at December 31, 2021.  For purposes of determining relevant maturities, loans are assumed to mature at (but not before) their scheduled repayment dates as required by contractual terms.  Demand loans and overdrafts are included in the “Within 1 Year” maturity category.  Most of the commercial construction loans are made with a commitment for permanent financing, whether extended by us or unrelated third parties.  The maturity distribution below reflects the final maturity of the permanent financing.

b. Maturities and Sensitivities of Loans to Changes in Interest Rates

(Dollars in Thousands)