FARMERS & MERCHANTS BANCORP INC (FMAO) FY 2021 MD&A

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

Critical Accounting Policies and Estimates

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants

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an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event.

All significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the notes to the consolidated financial statements and in the management discussion and analysis of financial condition and results of operations, provide information on how significant assets and liabilities are valued and how those values are determined for the financial statements. Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates and judgments underlying those amounts, management has identified the determination of the Allowance for Loan and Lease Losses (ALLL) and the valuation of its Mortgage Servicing Rights (MSR) and Other Real Estate Owned (OREO) as the accounting areas that requires the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available.

OREO, which is comprised of assets acquired by the Bank, through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value at the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell.

The ALLL represents management's estimate of credit losses inherent in the Bank's loan portfolio at the report date. The estimate is a composite of a variety of factors including experience, collateral value, and the general economy. ALLL includes a specific portion, a formula driven portion, and a general nonspecific portion. The collection and ultimate recovery of the book value of the collateral, in most cases, is beyond our control.

The Company is also required to estimate the value of its MSR.  The Company recognizes as separate assets rights to service fixed rate single-family mortgage loans that it has sold without recourse but services for others for a fee. Mortgage servicing assets are initially recorded at fair value, based upon pricing multiples as determined by the purchaser, when the loans are sold. Mortgage servicing assets are carried at the lower of the initial carrying value, adjusted for amortization, or estimated fair value. Amortization is determined in proportion to and over the period of estimated net servicing income using the level yield method. For purposes of determining impairment, the mortgage servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. The valuation is completed by an independent third party.

The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.

The Company’s mortgage servicing rights relating to loans serviced for others represent an asset of the Company. This asset is initially capitalized and included on the Company’s consolidated balance sheet. The mortgage servicing rights are then amortized as noninterest expense in proportion to, and over the period of, the estimated future net servicing income of the underlying mortgage servicing rights. There are a number of factors, however, that can affect the ultimate value of the mortgage servicing rights to the Company, including the estimated prepayment speed of the loan and the discount rate used to present value the servicing right. For example, if the mortgage loan is prepaid, the Company will receive fewer servicing fees, meaning that the present value of the mortgage servicing rights is less than the carrying value of those rights on the Company’s balance sheet. Therefore, in an attempt to reflect an accurate expected value to the Company of the mortgage servicing rights, the Company receives a valuation of its mortgage servicing rights from an independent third party. The independent third party’s valuation of the mortgage servicing rights is based on relevant characteristics of the Company’s loan servicing portfolio, such as loan terms, interest rates and recent national prepayment experience, as well as current national market interest rate levels, market forecasts and other economic conditions. Management, with the advice from its third party valuation firm, review the assumptions related to prepayment speeds, discount rates, and capitalized mortgage servicing income on a quarterly basis.  Changes are reflected in the following quarter’s analysis related to the mortgage servicing asset.  In addition, based upon the independent third party’s valuation of the Company’s mortgage servicing rights, management then establishes a valuation allowance by each strata, if necessary, to quantify the likely impairment of the value of the mortgage servicing rights to the Company. The estimates of prepayment speeds and discount rates are inherently uncertain, and different estimates could have a material impact on the Company’s net income and results of operations. The valuation allowance is evaluated and adjusted quarterly by management to reflect changes in the fair value of the underlying mortgage servicing rights based on market conditions.  The accuracy of these estimates and assumptions by management and its third party can be directly tied back to the fact that management has only been required to record minor valuation allowances through its income statement based upon the valuation of each stratum of serving rights.

For more information regarding the estimates and calculations used to establish the ALLL and the value of Mortgage Servicing Rights, please see Note 1 to the consolidated financial statements provided herewith.

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2021 in Review

2021 was highlighted by the execution of the second year of the Company’s strategic plan.  The growth goal of having a $3 billion asset size by 2023, is well within our reach due to the two bank acquisitions in 2021 complimented with extremely strong organic loan growth in assets.

F&M Commercial Banking Division completed the second round of PPP as it began 2021 and then moved into the forgiveness process.  F&M had strong loan demand in 2021 and most of this activity is spread throughout the tri-state footprint.  Client performance and impact from the pandemic was closely monitored during 2021.  Overall results were positive; however, our clients were still impacted by the availability of workforce and the general interruptions and delays in the supply chain.  Credit quality of the portfolio remains solid, and we analyzed most of the commercial portfolio.  Past dues and delinquencies were at record lows at December 31 and the watch list and criticized assets were managed well and reduced in 2021.  Interest income was boosted by PPP.  Outside of PPP, loan growth occurred both organically and through acquisitions.  The Bank grew loans 15.9%, excluding PPP balances and acquired loans, in 2021 as compared to 2020. The Bank’s three Loan Production Offices (LPO) led the way. The F&M commercial team performed very well during a time when the pandemic created much uncertainty.

The results of 2021 for most of our agricultural customer base were positive.  Favorable growing conditions provided average to above average yields.  Demand for commodities has been strong pushing prices to levels that are very profitable.  The livestock portion of our portfolio has been stable.  Agri-businesses have benefited from strong farm net income.  Rising input cost and supply issues are challenges moving forward, but commodity prices for 2022 are currently profitable.  The agriculture portfolio saw growth in 2021 and remains sound.

Home loan production and performance was stronger than anticipated in 2021 with rates remaining low. A slight uptick in rates is occurring in the long-term rates which may impact 2022 production. The rates, however, even slightly higher are still low in looking over the past 10 years. With the increased footprint of the Bank’s market area, home loan production is only expected to slow slightly.

Additional pieces to the execution of the strategic plan were implementation of four major new software programs. The software programs employed involved three main lines of business, transactional (teller), home loan and consumer loan processing, along with our employee experience with human resources. These investments, and the implementation of, will aid to improve operating efficiencies along with the decrease of paper usage, further developing our digital strategy.

Cost savings was also a focus to improve our efficiency ratio. The Bank closed four offices in the first half of 2021 while adding the same number for the year overall – three due to acquisition and one new office opening in Ft. Wayne, Indiana. There was minimal to no impact on customer service and retention as three of the offices were in communities where the Bank already had another office and ATMs were maintained at the discontinued locations.  The Bank is also analyzing its “Next 10 Project” in preparation for execution beginning in 2022. The Next 10 Project is the identification of the next 10 office locations for brick-and-mortar expansion to be opened in the next 3-5 years. Many factors were considered in developing the plan including potential growth, placement to better connect and service our entire existing footprint. This plan will supplement any future acquisitions. We have learned that it can take more than a year to open a new office.

Yields on earning assets decreased more than the cost of funds. Driving the larger decrease in the earning assets was the increased liquidity which grew cash and investment balances by $135.7 million or 27.5% at year-end 2021 as compared to 2020. Astounding is the $728.8 million growth in total assets during the same one-year time frame. As the liquidity decreases with loan growth, the asset yield percentage will improve. A larger cost of funds decrease was hampered by the higher cost of funds associated with the last acquisition and the additional borrowings needed in the last quarter by the Company to complete the acquisition.

The last piece to discuss of the Company’s strategic plan is Talent Optimization. The Company experienced the same effects of COVID to our workforce as most other companies. The Bank experienced higher compensation costs and faced challenges in finding skilled employees. This was an area that was helped with the acquisitions as the Bank was able to offer and retain more team members to fill much needed support staff.  Enhancements were completed and were implemented, or will be early in 2022, to our team members benefits such as an earlier and automatic inclusion into the 401-K and the combining of PTO and vacation days for ease of use.  The Bank also adjusted our base living wage. The Bank continues to analyze and adjust our structure and the development of our team members to help us realize our full potential and to handle our current and expected growth plans.

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Earnings were a record high with net income at $23.5 million. Tax adjusted acquisition costs of $3.1 million were offset by the tax adjusted net income from PPP activity of $3.5 million for 2021. The Company’s trend of increasing profitability year over year continued as evidenced by the 16.9% increase in net income for 2021 as compared to 2020. This followed a strong 2020 increase of 9.2% over 2019.   The Company continues to recognize the importance of our shareholders from the improved earnings as we have increased the declared dividends consistently over the last 27 years.  In 2021, declared dividends were 7.6% higher than 2020 at $8.2 million.

The Company is positioned to continue to provide strong earnings in 2022 with minimal impact from our prior acquisitions and PPP expected. The execution will continue as the Company prepares to update the strategic plan during the second half of 2022 with new expectations to focus for the next three to five years.

Material Changes in Results of Operations

Net Interest Income

The discussion now centers on the individual line items of the consolidated statement of income and their effect on net income. This section will focus on the most traditional source of revenue contributing to the profitability of the Company which is net interest income.

Net interest income is the difference between interest income earned on interest earning assets, such as loans and securities, and interest expense paid on interest bearing liabilities used to fund those assets, such as interest bearing deposits and other borrowings.  Net interest income is affected by changes in both interest rates and the amount and composition of earning assets and liabilities.  The change in net interest income is most often measured by two statistics – interest spread and net interest margin.  The difference between the yields earned on earning assets and the rates paid for interest bearing liabilities represents the interest spread. The net interest margin is the difference of funds (interest expense) between the yield on earning assets and the cost as a percentage of earning assets.  Because noninterest bearing sources of funds such as demand deposits and stockholders’ equity also support earning assets, the net interest margin exceeds the net interest spread.

The largest factor of the record earnings for 2021 was the $9.7 million improvement in net interest income as compared to 2020. In 2020, net interest income increased $6.2 million as compared to 2019. Interest and fee income from loans were responsible for the improvement. Interest income from loans, including fees, increased $6.3 million in 2021 as compared to 2020. This was preceded by an increase in 2020 of $3.1 million as compared to 2019. The underlying factors for the reason of the increase differed between the two time periods. 2019 was aided by prime rate increases which drove the effective interest rates on the Bank’s variable loans over their floor rates. During the second half of 2019, the prime rate decreased 75 basis points in a 91-day time period which was followed by a decrease of 50 basis points on March 3rd and a decrease of 100 basis points on March 15th. In 2021 and 2020, PPP loans generated $4.5 and $2.8 million in loan interest and fee income, respectively. 2019 loan interest income included $1.985 million for the reversal of a credit loss established for two commercial purchased credit-impaired loans that were paid off during the second quarter. In both 2021 and 2020, the volume of loan growth was the largest contributing factor to the improved profitability. The security portfolio increased $152.3 million in average during 2021 as compared to 2020, and $47.1 million in average over 2019 average balances.  Increased cash funds from stimulus and acquisitions were placed in securities to earn a greater return.  Interest income from that balance sheet component increased $250 thousand over 2020 while 2020 increased $119 thousand over 2019. Overall, total interest income was $6.7 million higher for 2021 than 2020 and was $1.9 million higher for 2020 than 2019.

Interest expense decreased from all interest bearing funding sources in 2021 over the time period of 2020. During 2021, the Company issued subordinated notes and incurred $490 thousand of interest expense.  Refer to Note 9 for further discussion regarding subordinated notes.  During 2020, interest expense decreased in all interest bearing funding sources with the exception of federal funds purchased and securities sold under agreement to repurchase as compared to 2019. Overall, the funding goal the last three years has been to grow core deposits. Two strategies have been employed through the years, one of allowing expensive time deposits to run off until needed for funding and secondly to offer new non-interest bearing deposit products. Both of these strategies were to assist in controlling interest expense in a rising rate environment. Competition forced us to increase rates for deposits in 2019 while rates were lowered in 2020 in response to the prime rate drop of 150 basis points. Rates have continued to be reviewed and adjusted as necessary in 2021.  Even with the interest rate decreases, average interest bearing deposits increased $307.7 million compared to 2020. During 2021, interest expense from deposits decreased by $3.2 million from 2020 and 2020 decreased $4.3 million from 2019.  The majority, approximately 160.0%, of the decreased expense of 2021 and approximately137.4%, of the decreased expense of 2020 was influenced by decreased rates rather than due to additional cost associated with deposit growth.

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Total interest expense (which includes deposit, federal funds purchased, securities sold under agreement to repurchase, borrowed funds and subordinated notes) totaled $7.3, $10.4 and $14.8 million for 2021, 2020 and 2019 respectively. The decreased expense is approximately 189.9% attributable to the falling interest rate environment in 2021 as compared to 2020 and approximately 134.1% in the 2020 to 2019 comparison. Borrowed fund balances increased in January of 2019, as a result of the acquisition of Bank of Geneva, and in October of 2021 with the acquisition of Perpetual Federal Savings Bank.

The success in improving net interest income confirmed that management’s long term strategy of repositioning the balance sheet and increasing loan balances was the correct approach. Funding loan growth with internal funds, whether from the liquidation of investment securities or core deposits, was a beneficial move.

This concludes the discussion by dollar amount of the improvement. Now the discussion moves on to the percentages and the change in the net interest margin and spread.

Overall, we have seen a decrease in the net interest margin and spread from 2019 to 2021. Interest margin and spread decreased in 2021 as compared to 2020 with the lower asset yields only being partly offset by the decreased cost of funds. Looking at the components behind the change in net interest margin for 2021 as compared to 2020, increased average balances in loans of $208.4 million stands out.  Loans acquired with the two acquisitions were $387.1 million.  The additional revenue of $6.3 million that those balances were responsible for was the largest contributor to the increased interest income of $6.7 million. In 2019, loan revenue was positively impacted by the change in the interest rate. The majority of variable loans with floor rates attained the point where rate increases caused the rate to go above the floor. 2019 had three rate decreases of 25 basis points. As mentioned previously, March of 2020 had two rate decreases of 50 and 100 basis points. The large revenue gain in loan interest was aided by the increased earnings in securities of $250 thousand.  The overall asset yield in 2021 decreased by 59 basis points over 2020.

The decreased interest expense in 2021 correlated to the lower rate environment which differed from 2019’s high rate environment in which competition for deposits forced higher interest rates. In the area where the strategic plan was to gather core deposits, the average balance in savings grew by $266 million during 2021 as compared to 2020’s average balance. Interest bearing deposits acquired with the two acquisitions were $390.1 million.  The other average balance increase for core deposits was the change in non-interest bearing demand deposits.  2021’s average balance in this portfolio was $96.5 million higher than 2020’s average balance. Non-interest bearing demand deposits acquired with the two acquisitions were $36.5 million.  Overall, cost of funds decreased 39 basis points for 2021 over 2020.  The reason behind the decrease was largely due to rate decreases, not the volume increases.

The net interest margin for 2021 was 3.31% compared to 2020 which was 3.62%.  The 0.31% decrease for 2021 was directly related to the decreased interest income which was greater than the decreased interest expense. Net interest spread was 3.18% for 2021 compared to 2020’s 3.38%, creating a 20 basis point difference in the spread.  Loans as a percentage of earning assets was 72.3% while loans to total assets was 68.3% for 2021.  The goal is, as always, to improve the net interest margin and spread and thereby improve profitability.

In comparing 2020 to 2019, loan volume was primarily responsible for the improvement in interest income; however, the yield on the overall loan portfolio decreased 53 basis points during 2020. All categories of asset yield decreased in 2020.  Overall, asset yield decreased 60 basis points in 2020 as compared to 2019.

The net interest margin fell in 2020, ending 18 basis points below 2019. Asset yield decreased 60 basis points while the cost of funds decreased 55 basis points. The yields on the individual segments did not cause improvement as all decreased in 2020 from 2019. In addition, loans as a percentage of earning assets increased to 79.3% in 2020 compared to 79.9% in 2019. Loans to total assets also increased to 74.2% for 2020 compared to 2019’s 75.3%.  Overall yield improves when the balances of the highest yield asset increases, which is loans.

With respect to the cost of funds, the Bank’s goal is to grow the least expensive category of funding sources. The largest average balance increase for 2020 was $158.8 million in savings deposits over 2019’s average balances. This growth was mostly responsible for the decrease in funding expense of 57 basis points when comparing 2020 to 2019.

The Company will always prefer to see improvement in real dollars over percentages. The strategy for increasing core deposits, in order to mitigate the higher cost of funds and to continue to establish the opportunity for fee dollars from services provided, remains for 2022.

Total assets of the Company increased overall as did the earning assets in both average and year-end during 2021 and 2020. This matched the movement in interest dollars. The percentage of average earning assets to total average assets reflects the best

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utilization of funds.  For 2021, the percentage at 94.41% was slightly higher than 2020 at 93.60%.  The addition of new offices increased the non-earning assets with cash balances held at the new offices and also the investment in the capital assets of their building and furniture. One of the things that helped to improve the profitability of 2021 was the percentage of average loans to total assets.  For 2021 the average balance of loans to total average assets was 68.26%, for 2020, 74.21%, for 2019, 75.32%.  Loans are the highest yielding asset for the Company.

Net interest spread is the difference between what the Company earns on its assets and what it pays on its liabilities.  It is generally from this spread that the Company must fund its operations and generate profit.  When the asset yield decreases so must funding costs in order to maintain profitability.  It becomes increasingly challenging as the asset yield gets closer to the prime lending rate, or the break-even point, of operations. In a rising rate environment, the challenge is to hold the cost steady while allowing time for the asset portfolio to rise. Floors and ceilings on variable products also impact the level of increase in either scenario. The floors provide yield protection in the current lower rate environment while the rising rates will not benefit the asset yield until the spread plus prime is higher than the floor. The challenge is to increase the spread during renewals and on new loans. After the rate hikes in 2017 and 2018, the majority of the loans were now either equal to or over the floors which contributed to the increased asset yield in 2019. With the rate decreases in 2019 and 2020, many loans reverted back to the floors.

In terms of interest expense, 2021’s decrease as compared to 2020 was approximately 189.9% due to the decrease in rates.  2020’s decrease was approximately 134.1% due to the decrease in rates as compared to 2019.

The impact of the change in the portfolio mix was a factor in the liabilities as it was in the assets. In comparing to 2020, 2021 had movements as average balances increased in savings deposits, time deposits, other borrowed money and subordinated notes.  Other borrowed money, consisting of both short and long term borrowings, and subordinated notes increased with the acquisition of Perpetual Federal Savings Bank. Federal funds purchased and securities sold under agreement to repurchase decreased in 2021 from 2020.  In comparing to 2019, 2020 had movements as average balances increased in savings deposits, federal funds purchased, and securities sold to repurchase.  Other borrowed money decreased as advances were paid down or matured. The advances were part of the acquisition of Bank of Geneva with the final advance maturing in 2028.  Time deposits decreased $219 thousand compared to 2019.

The following tables present net interest income, interest spread and net interest margin for the three years 2019 through 2021, comparing average outstanding balances of earning assets and interest bearing liabilities with the associated interest income and expense.  The tables show the corresponding average rates of interest earned and paid.  Average outstanding loan balances include non-performing loans and mortgage loans held for sale.  Average outstanding security balances are computed based on carrying values including unrealized gains and losses on available-for-sale securities.  The average cost of funds for 2021 was 0.48%, 39 basis points lower than 2020’s 0.87% for interest bearing liabilities.

The yield on tax-exempt investment securities shown in the following charts were computed on a tax equivalent basis.  The yield on loans has been tax adjusted for the portion of tax-exempt IDB loans included in the total.  Total interest earning assets is therefore also reflecting a tax equivalent yield in both line items, also with the net interest spread and margin.  The adjustments were based on a 21% tax rate for all years.  The tax-exempt interest income was $551, $694 and $813 thousand for 2021, 2020 and 2019, respectively which resulted in a federal income tax savings of $116, $146, and $171 thousand, respectively.

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The following tables show changes in interest income, interest expense and net interest resulting from changes in volume and rate variances for major categories of earnings assets and interest bearing liabilities.

Non-Interest Income

The discussion now focuses on the noninterest income and expense generated by the Company for the years ended 2019 through 2021.  Noninterest income increased by 4.9% in total for 2021 as compared to 2020, ending at $17.6 million.  2020 had noninterest income of $16.8 million which exceeded 2019’s $11.8 million by 42.0%.

The two line items of noninterest income on the consolidated income statement for 2021 which improved over both 2020 and 2019 were customer service fee revenue and net gain (loss) on sale of available-for sale-securities which will be discussed in a separate paragraph.  2021 customer service fee revenue was $778.0 thousand higher than 2020, mostly due to increased debit card income while 2020 was $2.2 million higher than 2019, mainly due to increased mortgage servicing rights income, debit

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card income and mortgage release fees. In 2020, the Bank purchased additional bank owned life insurance policies which contributed $302.5 thousand of income in 2021.  2020 included a one-time $429.9 thousand gain on the settlement of a bank owned life insurance contract. Other service charges and fees increased $146.0 thousand from 2020 which decreased $841.3 thousand over 2019’s $4.4 million. The majority of the increase for 2021 was related to services charges from business and consumer accounts while the decrease for 2020 was attributed to overdraft, returned check charges and recurring overdraft fees from combined business accounts and consumer accounts. Upgrades to our digital products and services continue to occur in both retail and business lines.

The Bank has long promoted the use of debit cards by its customers and continues to build on that philosophy with the introduction of new products. During 2021 the Bank collected interchange revenue, combined with fees collected on foreign ATM usage (noncustomers utilizing our ATMs), of $4.8 million which was $938.5 thousand higher than 2020 and $518.2 thousand higher than 2019.  2021 included a Mastercard growth credit of $151 thousand.  In December of 2019, the Bank became a principal with MasterCard and received a $1.75 million signing bonus. The signing bonus is based on achieving $1.1 billion in signature transactions within the next five years. The bonus is being recognized over 60 months with $350.8 thousand included in 2021 and 2020’s $4.8 million and $3.9 million, respectively. While this revenue stream continues to improve with more depositors using electronic methods for purchasing, the expense attributable to card fraud has offset a portion of the revenue gain. Further discussion can be found in the noninterest expense section regarding the net effect of debit card activity.

Noninterest income from net gain on sales of loans was the highest in 2020 of the three year periods shown. The change was related to the decrease in rates after a couple of years of a rising interest rate environment. The net gain on sale of loans is derived from sales of real estate loans into the secondary market. Of these loan types, the Bank sells 100% of the residential loans and 90% of the agricultural loans. 47.4% of the gains were attributed to the residential loans in 2021, 65.2% in 2020 and 56.0% in 2019. In conjunction with these sales, the Bank maintains servicing rights and those income amounts during all three years are included in the customer service fee income line item and accounted for $1.4 million in 2021, $1.7 million in 2020 and $731.4 thousand in revenue for 2019.

The last item in the noninterest income section is the net gain of sale of investments. The Bank has sold securities over the last three years for two main purposes: to provide funds for loan growth and to take advantage of the position of the yield curve when a gain can be recognized on sales without extending the duration of the portfolio longer than wanted. In March of 2021, the Company sold and recognized a gain on the sale of securities from the holding company of $293 thousand in preparation for the acquisition of Ossian State Bank.  In February of 2020, the Bank completed security swap transactions that resulted in a gain of $270 thousand. 2019 had limited sales for gain recognition due to the flatness of the yield curve which began to occur in second half of 2017. The Bank will not increase short-term gains at the sacrifice of long-term profitability. The Bank recognized net losses of $26.3 thousand in 2019.  The Company also recognized a gain on sale of securities from the holding company of $0.4 thousand in 2019. The net effect of the consolidated number is what shows on the line item of net loss of $26 thousand for 2019.  The available for sale security portfolio switched from an unrealized gain position in 2019 and 2020 into an unrealized loss position in 2021.

Non-Interest Expense

Noninterest expense increased 22.1% in 2021 as compared to 2020 and was preceded by a 7.0% increase in 2020 as compared to 2019. Represented in dollars, 2021 was $9.8 million higher than 2020 and 2020 was $2.9 million higher than 2019.  Acquisition costs incurred in 2021 and 2019 totaled $3.9 million and $1.3 million, respectively with expenses being recorded in multiple line items.  The largest factor behind the increase in both years was the expense of employee salaries and wages. During 2021, an additional $1.7 million was spent over 2020 which correlates to a 9.2% increase. When making the same analysis for 2020 as compared to 2019, 2020’s costs increased $2.2 million or 13.2%.  Three main components flow into salaries and wages: base salary, deferred costs, and incentives comprised of the expense of restricted stock awards and performance incentives.  2021 increased with the addition of one new office and the acquisition of Ossian State Bank and Perpetual Federal Savings Bank offices.  Base pay increased in 2020 with the creation of pay grades and a minimum living wage of $26,000 or $12.50 per hour. 2019 increased with the addition of the six offices acquired from Bank of Geneva. Normal yearly increases to the employees would be included in all years. Base pay was up $1.2 million for 2021 over the previous year and 2020 was up $2.9 million over 2019. The full time equivalent number of employees at each year-end increased to 385 for 2021, to 367 for 2020 compared to 2019’s 357.

Incentive pay as it related to performance was up $320.9 thousand in 2021 over 2020 and up $194.0 thousand in 2020 over 2019.  The Return on Assets multiple used to award incentive pay increased in 2021 to 1.165 compared to 2020 and 2019’s 1.0.  In 2021, acquisition costs were eliminated from the calculation and 2020 excluded the accelerated net fee income

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recognized with the forgiveness of PPP loans.  The effect of acquisition costs and fair value accretions/amortizations were removed in 2019 for the calculation.  The expense for the restricted stock awards decreased in 2021 even though more shares have been granted to a slightly larger number of employees and the market value of the shares increased compared to 2020; however down from 2019 and 2018 awards. 11,368 additional shares were awarded in 2021 with a higher value as compared to 2020; however, the expense for 2021 was lower by $201.6 thousand which included accelerated expense due to retirement of $32.6 thousand as compared to 2020. 718 less shares were awarded in 2020 with a lower value as compared to 2019; therefore, the expense for 2020 was lower by $63.9 thousand which included accelerated expense due to retirement and other of $163.4 thousand as compared to 2019.  The awards incorporate a three year vesting period so the increase of any one year carries forward through the next two years. This expense should continue to increase as the Company continues its expansion strategy. For further discussion in incentive pay and restricted stock awards, see Note 11 of the consolidated financial statements.

Along with the salary and wage increase was an increase in employee benefits in 2021 as compared to 2020. Miscellaneous personnel expense accounted for the largest portion of the cost, which was an increase of $774.3 thousand over 2020.  Acquisition related costs included in this line were $825.5 thousand.  The cost of the 401-K retirement plan increased $856.5 thousand for 2021 as compared to 2020. 2021 included $345 thousand for 2020’s employer match.  The contribution portion relating to the discretionary profit-sharing percentage was 5.0% in 2021 compared to 4.6% for 2020. Workers compensation increased $184 thousand compared to 2020 with the bureau issuing three dividend checks totaling $185.9 thousand in 2020. Overall, employee benefits increased $1.7 million or 30.7% from 2020.

Along with the salary and wage increase was a slight increase in employee benefits in 2020 as compared to 2019. Employee group insurance accounted for the largest portion of the cost, which was an increase of $441.6 thousand over 2019. This was due to an increase in the cost to provide to a larger number of employees along with a higher level of medical claims. The cost of the 401-K retirement plan decreased $185.1 thousand for 2020 as compared to 2019. The contribution portion relating to the discretionary profit-sharing percentage was 4.6% in 2020 compared to 5.25% for 2019. Workers compensation decreased $173.1 thousand compared to 2019 due to the bureau issuing three dividend checks. Overall, employee benefits increased $43.0 thousand or 0.8% from 2019.

Net occupancy expense typically increases as the Company expands; however, a decrease occurred for 2021 through 2019. One factor that can offset occupancy expense is the receipt by the Company of building rent as it is netted out of occupancy expense. The greatest contributor to building rent comes from the division of FM Investments within the Bank. This division experienced a stronger 2021 than 2020 and a stronger 2020 than 2019. The acquisition of Adams County Financial Resources has contributed to this improvement.  For 2021, building rent as generated from FM Investments was higher by $407.9 thousand.  Rent is received in lieu of commissions. This increase of revenue was able to offset increased building repair and maintenance expenses of $230.9 thousand and lease expense of $57.6 thousand thus contributing to the decreased net occupancy expense of $87 thousand for 2021 as compared to 2020.  Building rent as generated by FM Investments was higher by $24.8 thousand in 2020 which contributed along with decreased automobile expenses of $64.2 thousand and building repair and maintenance expenses of $69.7 thousand  to the overall decrease to net occupancy of $46.0 thousand in 2020 as compared to 2019.

The 1-4 family mortgage refinancing activity continued to see an increase in 2021 with the decline in interest rates. 2020 accounted for the largest number of loans being closed in the Bank’s history. A correlating expense to that activity as it relates to loans sold to the secondary market, is the amortization of mortgage servicing rights. The amortization is the expense that offsets the income recognized when the loan is first made. Income is recorded when the mortgage loan is first sold with servicing retained and is therefore recognized within one year. The amortization, however, is calculated over the life of the loan and accelerated as loans are paid off early. An increase in this expense can be driven by two activities: an increase in the number of sold loans and/or by the acceleration of the expense from payoff and refinance activity. The best picture of the bottom line impact is achieved by netting the income with the expense each year. The net income for 2021 was $251 thousand; The carrying value was greater than the market value of $3.2 million which created the need to establish a $414 thousand valuation allowance during 2021.  2020 had net income of $691 thousand and was preceded by net income of $244 thousand for 2019. Of course, the value (or income) of the mortgage servicing right when the loans are sold also impacts the net position. As of December 31, 2021, 3,961 loans are being serviced with corresponding balances of $380.8 million. 2020 had 4,034 loans serviced with corresponding balances of $377.5 million. As of December 2019, 3,691 loans were being serviced with balances of $303.9 million.

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The impact of mortgage servicing rights to both noninterest income and expense is shown in the following table:

Furniture and equipment steadily increase as we continue to add facilities and invest in technology. Annual maintenance costs continue to grow and become a greater piece of the overall cost. As new services are provided to our customers, the backroom cost to supply them continues to rise. The Company accepts it is an expected cost of doing business and keeping our services relevant to the industry.

Data processing costs were higher in 2021 as compared to 2020 by $1.7 million of which $1.4 million was acquisition related for termination fees. As the pricing on many services is based on number of accounts which the Bank fully expects to increase with the growth from the newer offices and overall Bank growth, data processing costs are expected to increase.  Data processing expense decreased by $785.0 thousand during 2020 as compared to 2019 of which $867.6 thousand was acquisition related for termination fees incurred in 2019.

ATM expense increased $156.0 thousand over 2020 while 2020 decreased $25.0 thousand from 2019.  Included in this line are the debit card fees incurred which offset the debit card income as discussed above.

The FDIC assessment increased over 2020 while 2020 increased as compared to 2019. This line item speaks to the health of the Bank and the financial industry. With continued growth, the assessment base increases which leads to a greater expense.  2021’s assessment was $440 thousand over 2020.  The assessment for 2020 was up $450.0 thousand compared to 2019 as a result of the total assessment base increasing. In 2020, Small Bank Assessment Credits of $125.9 thousand were applied to first quarter’s invoice. Credits in the amount of $204.2 thousand were applied to third and fourth quarter 2019’s invoice.

Advertising and public relations increased in 2021 by $104.0 thousand and decreased in 2020 by $237.0 thousand with many events canceled due to the pandemic.  With the addition of new offices, 2021 was expected to increase. The Bank also celebrates the anniversary of office openings with a special event in each community.

The last line items with significant variation in noninterest expense to discuss is “consulting fees” and “other general and administrative.” Consulting fees increased by $666.0 thousand in 2021 over 2020 and increased $300.0 thousand in 2020 compared to 2019. In 2021, $892.1 thousand was paid to firms for acquisition assistance, $150 thousand was paid as the final payment for the 2019 profit enhancement project, $36.6 thousand for market studies and $51.4 thousand for PPP loan administrative assistance.  In 2020, $167.0 thousand was paid to the firm who assisted with identifying profit enhancements, $48.0 thousand for Chief Information Officer search, $25.0 thousand to Kasasa for contract termination and $34.0 thousand to develop a predictive customer behavior model. During 2019, consultants were used to complete a pay study review, assist with developing a three year strategic plan and to identify profit enhancement initiatives. Acquisition expenses included in the other general and administrative line were $743.3 thousand for 2021 and $199.8 thousand for 2019.  Customer list intangible expense which is included in the other general and administrative line increased in 2021 compared to 2020 by $107.0 thousand with the acquisition of Adams County Financial Resources in November of 2020.  Loan and collection expenses increased $326.0 thousand over 2020 and legal expenses increased $409.8 thousand over 2020 of which $398.5 thousand was acquisition related.  Auditing and exam fees increased $210.3 thousand which included $81.1 thousand of acquisition related costs over 2020 and 2020 increased $82.5 thousand over 2019.

Allowance for Credit Losses

Provision expense decreased by $3.5 million for 2021 as compared to 2020 and increased by $5.8 million for 2020 as compared to 2019. The large increase in provision expense for 2020 was attributable to the uncertainties associated with COVID-19 and its effects on the ability of individuals, businesses and other entities to meet their financial obligations. Therefore, it was prudent to incorporate the impact of COVID-19 in the evaluation of the adequacy of Allowance for Loan and Lease Losses (ALLL). The restaurant and hospitality sectors have been hit especially hard. Risk in the Consumer and 1-4 Family Portfolio has increased but the full impact remains unknown. Increases to the Bank’s ALLL centered around current customers and businesses that are particularly vulnerable and qualitative factors were adjusted accordingly. The portfolios for

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which we had concerns with the COVID-19 impact in 2020 have performed and recovered nicely and have allowed us not to continue to allocate funds to the ALLL in 2021.  The majority of the uncertainties have decreased though we do continue to keep a watchful eye on the situation.  Management continues to monitor asset quality, making adjustments to the provision as necessary. The commercial and industrial portfolio had the highest level of charge-off activity in 2021 at $814 thousand while the consumer portfolio had the highest levels of charge-off activity in 2020 and 2019 at $380 and $491 thousand respectively.  Net charge-offs in the commercial and industrial portfolio were $557 thousand in 2021 while the consumer portfolio net charge-offs were $240 and $371 thousand for 2020 and 2019 respectively. Total net charge-offs were $874, $537 and $685 thousand for 2021, 2020 and 2019, respectively.

The Company segregates its Allowance for Credit Losses (ACL) into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total ACL. The AUCL is included in other liabilities on the consolidated balance sheets.

The Bank’s ALLL methodology captures trends in leading, current, and lagging indicators which will directly affect the Bank’s allocation amount. The Bank monitors trends in such leading indicators as delinquency, unemployment changes in the Bank’s service area, experience and ability of staff, regulatory trends, and credit concentrations. A current indicator such as the total watch list loan amount to Capital, and a lagging indicator such as the charge-off amount are referenced as well. A matrix formed by loan type from these indicators is used in making ALLL adjustments.

Watch list loan balances are comprised of loans graded 5-8.  At year-end December 31, 2021, these loans totaled $55.4 million and were approximately $1.0 million lower than December 31, 2020.  Grade 5 increased $4.4 million in 2021 as compared to 2020 and Grade 6 decreased $4.3 million in the same comparison.  Grade 7 decreased $1.1 million in 2021 as compared to 2020.

At year-end December 31, 2020 these loans totaled $56.3 million and were $3.9 million lower than December 31, 2019. Grade 5 decreased $6.1 million in 2020 as compared to 2019 and Grade 6 increased by $2.2 million in the same comparison. Grade 7 increased a mere $29 thousand in 2020 as compared to 2019.

At year-end December 31, 2019, the watch list loans totaled $60.2 million.  Grade 5 loans were $23.7 million, Grade 6 were $35.4 million and Grade 7 loans were $1.1 million.  Much of the total increase in 2019, $33.4 million, is in the agricultural real estate portfolio which expanded with the acquired loan portfolio.

At December 31, 2021, 39.7% of the watch list was classified as special mention, with an additional 60.3% classified as substandard of the $56.2 million watch list was classified as doubtful. At year-end 2020, 31.2% of the watch list was classified as special mention, with an additional 66.8% classified as substandard and a small 2.0% or $1.1 million of the $56.3 million watch list was classified as doubtful.

Of the aggregate watch list loan balances, as of December 31, 2019, 39.3% of the watch list was classified as special mention, with an additional 58.9% classified as substandard. A small 1.8% or $1.1 million of the $60.2 million watch list was classified as doubtful.

In response to these fluctuations and loan growth during 2019 through 2020, the Bank’s ALLL to outstanding loan coverage percentage changed to 0.87% as of December 31, 2021, 1.05% as of December 31, 2020 and 0.59% as of December 31, 2019.  In addition, for 2021, 2020 and 2019, our allowance for loan and lease losses does not include a $1.2, $1.7 and $2.1 million credit mark, respectively associated with the Limberlost acquisition.  For 2021, our allowance for loan and lease losses also does not include a $966 thousand credit mark associated with the Ossian acquisition or a $5.5 million credit mark associated with the Perpetual Federal Savings Bank acquisition which further supports the current position of the ALLL.

The above indicators impacting the ALLL are reviewed at a minimum quarterly. Some of the indicators are quantifiable and, as such, will automatically adjust the ALLL once calculated.  These indicators include the ratio of past due loans to total loans, loans past due greater than 30 days, and the ratio of watch list loans to capital, with the watch list made up of loans graded 5, 6 or 7 on a scale of 1 (best) to 7 (worst). Other indicators consist of more subjective data used to evaluate the potential for inherent losses in the Bank’s loan portfolio.  For example, the economic indicator uses the unemployment statistics from the communities in our market area to help determine whether the ALLL should be adjusted.  At the end of 2019, improvements were noted in unemployment figures. In 2020, a COVID-19 factor was added and adjusted during the year.

All commercial and agricultural relationships with lines of credit greater than $50,000 and aggregate loan exposure greater than $250,000 are reviewed annually by the Bank’s Credit Department. All commercial and agricultural relationships with

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term debt only and aggregate loan exposure greater than $750,000 are also reviewed by the Bank’s Credit Department. These reviews are conducted to identify early signs of deterioration.

To establish the specific reserve allocation for real estate, a discount to the market value is established to account for liquidation expenses.   The discounting percentage used for real estate mirrors the discounting of real estate as provided for in the Bank’s Loan Policy.   However, unique or unusual circumstances may be present which will affect the real estate value and, when appropriately identified, can adjust the discounting percentage at the discretion of management.

The ACL increased $3.0 million during 2021 while increasing $6.6 million and $658 thousand during 2020 and 2019 respectively. The percentage of ACL to the total loan portfolio was 0.63% as of December 31, 2019 and 1.1% as of December 31, 2020, and 0.93% as of December 31, 2021. December 31, 2018 and 2021 had the lowest loans past due 30+ day percentage at 0.09% in the last ten years. December 31, 2019 and 2020 were still at respectable lows of 0.18% and 0.29%.

Please see Note 4 in the consolidated financial statement for additional tables regarding the composition of the ACL.

Income Taxes

Income tax expense was $891 thousand more for 2021 than 2020 as result of approximately $4.3 million of additional income.  The Tax Cuts and Jobs Act, which was signed into law on December 22, 2017, became effective for the Company’s 2018 fiscal year and created a single corporate tax rate of 21%.  Effective tax rates were 20.35%, 20.28% and 19.15% for 2021, 2020 and 2019 respectively. The effect of tax-exempt interest from holding tax-exempt securities and Industrial Development Bonds (IDBs) was $119, $150 and $182 thousand for 2021, 2020 and 2019, respectively less the TEFRA adjustments of $3, $4 and $12 thousand respectively. One of the benefits from the establishment of the Captive subsidiary was a lower effective tax rate.

Material Changes in Financial Condition

The shifts in the balance sheet during 2021 through 2019 have positioned the Company for continued improvement in profitability. On the asset side, interest income increased primarily from loan growth with funding for the increase provided by growth in core deposits and growth in other borrowings primarily related to the acquisition of the Bank of Geneva and Perpetual Federal Savings Bank.  The cost of funds has been impacted by the increase of both interest bearing liabilities and the pressure on rates from competition for funds. In 2020, the rate pressure from competition basically subsided. Increased balances in non-interest bearing deposits aided in profitability also. Loan growth and a widened net interest margin contributed to improved profitability in 2019 while loan growth contributed to an increase in profitability in 2020 and 2021.  With the rate decreases in 2020, net interest margin decreased 18 basis points compared to 2019 and 31 basis points compared to 2020.

Average earning assets increased in balances through 2021 and 2020. Loan growth in both years was the main factor.

Securities

The investment portfolio is primarily used to provide overall liquidity for the Bank.  It is also used to provide required collateral for pledging to the Bank’s Ohio public depositors for amounts on deposit in excess of the FDIC coverage limits.  It may also be used to pledge for additional borrowings from third parties.  Investments are made with the above criteria in mind while still seeking a fair market rate of return and looking for maturities that fall within the projected overall strategy of the Bank. The possible need to fund future loan growth is also a consideration.

The Bank uses Promontory’s ICS product which utilizes a nation-wide bank network to provide FDIC insurance coverage to the Bank’s depositors to protect balances over $250 thousand. The Bank is using the product to replace pledging securities for the Bank’s Ohio public customers and commercial sweep customers; thereby increasing liquidity.

All of the Bank’s security portfolio is categorized as available for sale and as such is recorded at market value.

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Our cash position increased with each of the acquisitions and the excess cash was partially invested in the security portfolio.  Security balances as of December 31 are summarized below:

The following table sets forth the maturities of investment securities as of December 31, 2021 and the weighted average yields of such securities calculated on the basis of cost and effective yields weighted for the scheduled maturity of each security.  Tax-equivalent adjustments, using a twenty-one percent rate, have been made in yields on obligations of state and political subdivisions.  Stocks of domestic corporations have not been included. Maturities of mortgage-backed securities are based on the stated maturity date of the security. Due to prepayments, actual maturities may be different.

As of December 31, 2021, the Bank also holds stock in the Federal Home Loan Bank of Cincinnati and Indianapolis at a cost of $7.3 million. This is required in order to obtain Federal Home Loan Bank loans.

Loan Portfolio

The Bank’s various loan portfolios are subject to varying levels of credit risk.  Management mitigates these risks through portfolio diversification and through standardization of lending policies and procedures.

Risks are mitigated through an adherence to the Bank’s loan policies, with any exception being recorded and approved by senior management or committees comprised of senior management. The Bank’s loan policies define parameters to essential underwriting guidelines such as loan-to-value ratio, cash flow and debt-to-income ratio, loan requirements and covenants, financial information tracking, collection practice and others. The maximum loan amount to any one borrower is limited by the Bank’s legal lending limits and is stated in policy. On a broader basis, the Bank restricts total aggregate funding in comparison to Bank capital to any one business or agricultural sector by an approved sector percentage to capital limitation.

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The following table shows the Bank’s loan portfolio, excluding loans held for sale, by category of loan as of December 31st of each year, net of deferred fees and costs:

The following table shows the maturity of loans excluding fair value adjustments as of December 31, 2021:

The following table presents the total of loans excluding fair value adjustments due after one year which has either 1) predetermined interest rates (fixed) or 2) floating or adjustable interest rates (variable):

The following table summarizes the Company’s nonaccrual, past due 90 days or more and still accruing loans, and accruing troubled debt restructurings as of December 31 for each of the last five years:

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Although loans may be classified as non-performing, some pay on a regular basis, and many continue to pay interest irregularly or at less than original contractual rates.  Interest income that would have been recorded under the original terms of these loans would have aggregated $502 thousand for 2021, $272 for 2020 and $193 thousand for 2019. Any collections of interest on nonaccrual loans are included in interest income when collected unless it is on an impaired loan with a specific allocation.  A collection of interest on an impaired loan with a specific allocation is applied to the loan balance to decrease the allocation. Total interest collections, whether on an accrued or cash basis, amounted to $292 thousand for 2021, $269 thousand for 2020 and $117 thousand for 2019.

Loans are placed on nonaccrual status in the event that the loan is in past due status for more than 90 days or payment in full of principal and interest is not expected.  The Bank had nonaccrual loan balances of $8.1 million at December 31, 2021 compared to balances of $9.4 million and $3.4 million as of year-end 2020 and 2019. All of the balances of nonaccrual loans for the past three years were collaterally secured.

As of December 31, 2021, the Bank had $55.4 million of loans which it considers to be “potential problem loans” in that the borrowers are experiencing financial difficulties which are not reflected in the table above. At December 31, 2020, the Bank had $56.3 million of these loans and at December 31, 2019, the Bank had $60.2 million of these loans.  These loans are subject to constant management attention and are reviewed at least monthly. The amount of the potential problem loans was considered in management’s review of the loan loss reserve at December 31, 2021 and 2020.

In extending credit to families, businesses and governments, banks accept a measure of risk against which an allowance for possible loan loss is established by way of expense charges to earnings. This expense is determined by management based on a detailed monthly review of the risk factors affecting the loan portfolio, including general economic conditions, changes in the portfolio mix, past due loan-loss experience and the financial condition of the Bank’s borrowers.

As of December 31, 2021, the Bank had loans outstanding to individuals and firms engaged in the various fields of agriculture in the amount of $118.4 million with an additional $198.3 million in agricultural real estate loans which compared to $94.4 and $189.2 million respectively as of December 31, 2020.  The ratio of this segment of loans to the total loan portfolio is not considered unusual for a bank engaged in and servicing rural communities.

Interest rate modification to reflect a decrease in market interest rates or maintain a relationship with the debtor, where the debtor is not experiencing financial difficulty and can obtain funding from other sources, is not considered a troubled debt restructuring. As of December 31, 2021, the Bank had $7.6 million of its loans that were classified as troubled debt restructurings, of which $6.5 million are included in nonaccrual loans.  This compares to $6.5 million of troubled debt restructurings, of which $5.6 million are included in nonaccrual loans for 2020 and $956.3 thousand of troubled debt restructuring, of which $50.3 thousand are included in nonaccrual loans for 2019.

Updated appraisals are required on all collateral dependent loans once they are deemed impaired.  The Bank may also require an updated appraisal of a watch list loan which the Bank monitors under their loan policy. On a quarterly basis, Bank management reviews properties supporting asset dependent loans to consider market events that may indicate a change in value has occurred.

To determine observable market value, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate.  In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the existing collateral value used.

Performing “non-watch list” loans secured in whole or in part by real estate, do not require an updated appraisal unless the loan is rewritten and additional funds advanced.  Watch List loans secured in whole or in part by real estate require updated appraisals every two years.  All loans are subject to loan to values as found in the Bank’s loan policies irrespective of their grade.  The Bank’s watch list is reviewed on a quarterly basis by management and any questions to value are addressed at that time.

The majority of the Bank’s loans are made in the market by lenders who live and work in the market.  Thus, their evaluation of the independent valuation is also valuable and serves as a double check.

On extremely rare occasions, the Bank will make adjustments to the recorded values of collateral securing commercial real estate loans without acquiring an updated appraisal for the subject property. The Bank has no formalized policy for determining when collateral value adjustments between regularly scheduled appraisals are necessary, nor does it use any specific methodology for applying such adjustments. However, on a quarterly basis as part of its normal operations, the

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Bank’s senior management and the Loan Review Committee will meet to review all commercial credits either deemed to be impaired or on the Bank’s watch list. In addition to analyzing the recent performance of these loans, management and the Enterprise Risk Management Committee will also consider any general market conditions that might warrant adjustments to the value of particular real estate collateralizing commercial loans. In addition, management conducts annual reviews of all commercial loans exceeding certain outstanding balance thresholds. In each of these situations, any information available to management regarding market conditions impacting a specific property or other relevant factors are considered, and lenders familiar with a particular commercial real estate loan and the underlying collateral may be present to provide their opinion on such factors. If the available information leads management to conclude a valuation adjustment is warranted, such an adjustment may be applied on the basis of the information available. If management concludes that an adjustment is warranted but lacks the specific information needed to reasonably quantify the adjustment, management will order a new appraisal on the subject property even though one may not be required under the Bank’s general policies for updating appraisal.

Note 4 of the Consolidated Financial Statements may also be reviewed for additional tables dealing with the Bank’s loans and ALLL.

ALLL is evaluated based on an assessment of the losses inherent in the loan portfolio.  This assessment results in an allowance consisting of two components, allocated and unallocated.

Management considers several different risk assessments in determining ALLL. The allocated component of ALLL reflects expected losses resulting from an analysis of individual loans, developed through specific credit allocations for individual loans and historical loss experience for each loan category.  For those loans where the internal credit rating is at or below a predetermined classification and management can reasonably estimate the loss that will be sustained based upon collateral, the borrowers operating activity and economic conditions in which the borrower operates, a specific allocation is made.  For those borrowers that are not currently behind in their payment, but for which management believes, based on economic conditions and operating activities of the borrower, the possibility exists for future collection problems, a reserve is established.  The amount of reserve allocated to each loan portfolio is based on past loss experiences and the different levels of risk within each loan portfolio.  The historical loan loss portion is determined using a historical loss analysis by loan category.

The unallocated portion of the reserve for loan losses is determined based on management’s assessment of general economic conditions as well as specific economic factors in the Bank’s marketing area.  This assessment inherently involves a higher degree of uncertainty.  It represents estimated inherent but undetected losses within the portfolio that are probable due to uncertainties in economic conditions, delays in obtaining information, including unfavorable information about a borrower’s financial condition and other current risk factors that may not have yet manifested themselves in the Bank’s historical loss factors used to determine the allocated component of the allowance.

Actual charge-off of loan balances is based upon periodic evaluations of the loan portfolio by management.  These evaluations consider several factors, including, but not limited to, general economic conditions, financial condition of the borrower, and collateral.

As presented in the table on the next page, charge-offs increased to $1.3 million for 2021. 61.1% of the charge-offs stemmed from the commercial and industrial portfolio. Charge-offs were $720 thousand for 2020, $841 thousand for 2019, preceded by $580 thousand for 2018 and $288 thousand for 2017.  Recoveries were $458 thousand in 2021 compared to $183, $156, $163 and $150 thousand for 2020, 2019, 2018 and 2017, respectively. The net charge-offs for the last five years were all under $900 thousand with 2021 the highest at $874 thousand and 2017 the lowest at $138 thousand.

Higher provision expense was used to fund the ALLL for loan growth in 2019. 2021 and 2020 had higher provision expense due to the uncertainty surrounding COVID-19 and its impact on individuals and businesses. For 2017 and 2018, the provision was used to replenish the balance decreased by the net charge-off activity. Overall, the ALLL increased from $6.9 million at year-end 2017 to $16.2 million at year-end 2021. After adding the allowance for unfunded loan commitments, the ACL ended 2021 at $17.3 million. As the ratios on the bottom of the following table show, the trends for each have improved or remained constant over the five years shown. Asset quality and the ACL are both strong and emphasize the level of credit quality.

In reviewing the bigger picture of the allowance for loan and lease loss, the years with the higher percentage of ALLL to total nonperforming loans ratio account for the lower level of nonaccrual loans. This demonstrates the extended time period with which it has taken to achieve resolution and/or collection of these loans. The ratio of ALLL to nonperforming loans increased beginning in 2017 with a significant drop in 2019 followed by a slight drop in 2020 and a slight increase in 2021. 2020’s provision expense was the highest of the five years shown largely due to the uncertainty surrounding COVID-19.  Loan growth in 2021, 2020 and 2019 reached double-digit percentage increases for all three years. The ALLL to nonperforming loans for all years remained more than adequate and emphasizes the existing strong level of credit quality.

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The following table presents a reconciliation of the allowance for credit losses for the years ended December 31, 2021, 2020, 2019, 2018 and 2017:

*Nonperforming loans are defined as all loans on nonaccrual, plus any loans past due 90 days not on nonaccrual.

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Allocation of ALLL per Loan Category in terms of dollars and percentage of loans in each category to total loans is as follows:

Deposits

The amount of outstanding time certificates of deposits and other time deposits in amounts of $100,000 or more by maturity both in total and uninsured greater than $250,000 as of December 31, 2021 are as follows:

The following table presents the average amount of and average rate paid on each deposit category:

Uninsured deposits greater than $250,000 are presented by year in the table below:

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Liquidity

Liquidity remains adequate and up from prior years as the Bank has increased the investment portfolio in 2020 and 2021.  The Bank has access to $69.0 million of unsecured borrowings through correspondent banks, $94.2 million through a Cash Management Advance with the Federal Home Loan Bank and $313.6 million of unpledged securities which may be sold or used as collateral. The amount of unpledged securities increased almost $106.9 million as compared to 2020.  For the Bank, an additional $91.2 million is also available from the Federal Home Loan Bank based on current collateral pledging.  At the present time, only 1-4 family and home equity portfolios are pledged.  Additional borrowings would be available if additional portfolios (i.e. commercial real estate) were pledged.

Maintaining sufficient funds to meet depositor and borrower needs on a daily basis continues to be among management’s top priorities. This is accomplished not only by immediate liquid resources of cash, due from banks and federal funds sold, but also by the Bank’s available for sale securities portfolio. The average aggregate balance of these assets was $396.3 for 2021, $244.0 for 2020 and $196.9 million for 2019. This represented 17.8%, 13.8%, and 13.1% of total average assets, respectively.  Of the almost $420.9 million of debt securities in the Bank’s portfolio as of December 31, 2021, $8.8 million, or 0.2% of the portfolio, is expected to receive payments or mature in 2022. This liquidity provides the opportunity to fund loan growth by analysis of the lowest cost and source of funds whether by increasing deposits, sales or runoff of investments or utilizing debt.

In addition to the Bank’s investment portfolio, the Company has $9.0 million held in the holding company’s investment portfolio. $703.3 thousand of those investments will mature or receive payments in the next twelve months. These funds provide liquidity to the Company. The Bank has been declaring additional dividends each quarter to provide this liquidity to the Company.  The Captive has also upstreamed dividends to the Company and is expected to continue annually as long as reserve levels are adequately provided for. This provides additional liquidity for Company activities.

Historically, the primary source of liquidity has been core deposits that include noninterest bearing and interest bearing demand deposits, savings, money market accounts and time deposits of individuals. Core deposit balances increased in all categories as of December 31, 2021 compared to same date 2020.  Average total savings balances increased $266.0 million in 2021 as compared to 2020.  Core deposit balances as of year-end 2020 increased in all categories except for time deposits as compared to 2019. Overall deposits increased an average of $219.3 million in 2020 and $299.7 million in 2019. The Bank did not purchase Federal Funds during 2021; however, did purchase Federal Funds at times during 2019 through 2020. The average balance for 2020 was $2.2 million and for 2019 $2.1 million. The Bank is comfortable accessing these funds on a regular basis.

Historically, the primary use of new funds is placing the funds back into the community through loans for the acquisition of new homes, consumer products and for business development.  The use of new funds for loans is measured by the loan to deposit ratio.  The Bank’s average loan to deposit ratio was 82.1% for 2021, 90.7% for 2020 and 91.8% for 2019.  The Bank’s goal is for this ratio to be higher in the 80-90 percent range with loan growth being the driver.  The Bank ended the year 2021 at an 84.8% loan to deposit ratio.

Short-term debt such as federal funds purchased, and securities sold under agreement to repurchase also provides the Company with liquidity. Short-term debt for both federal funds purchased, and securities sold under agreement to repurchase amounted to $29.3 million at December 31, 2021, $30.2 million at December 31, 2020, and $48.1 million at the end of 2019. These accounts are used to provide a sweep product to the Bank’s commercial customers and for some term deposits. The repurchase agreements are for term deposits only.

“Other borrowings” are also a source of funds.  Other borrowings consist of loans from the Federal Home Loan Bank of Cincinnati and Indianapolis and a correspondent bank.  These funds are then used to provide loans in our community. On January 1, 2019, the Bank acquired $49.5 million of borrowings from the Federal Home Loan Bank of Indianapolis.  During 2021, 2020 and 2019, $157.8 thousand, $7.5 million and $23.9 million, respectively either matured and was paid off or was paid down.  On October 1, 2021, the Bank acquired $6.0 million of borrowings due in 2024 from the Federal Home Loan Bank of Cincinnati.

Asset/Liability Management

The primary functions of asset/liability management are to assure adequate liquidity and maintain an appropriate balance between interest earning assets and interest bearing liabilities.  It involves the management of the balance sheet mix, maturities, re-pricing characteristics and pricing components to provide an adequate and stable net interest margin with an acceptable level of risk.  Interest rate sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates.

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Changes in net income, other than those related to volume arise when interest rates on assets re-price in a time frame or interest rate environment that is different from that of the re-pricing period for liabilities. Changes in net interest income also arise from changes in the mix of interest-earning assets and interest-bearing liabilities.

Historically, the Bank has maintained liquidity through cash flows generated in the normal course of business, loan repayments, maturing earning assets, the acquisition of new deposits, and borrowings. The Bank's asset and liability management program is designed to maximize net interest income over the long term while taking into consideration both credit and interest rate risk. Interest rate sensitivity varies with different types of interest-earning assets and interest-bearing liabilities. Overnight federal funds on which rates change daily and loans that are tied to the market rate differ considerably from long-term investment securities and fixed rate loans. Similarly, time deposits over $100,000 and money market certificates are much more interest rate sensitive than passbook savings accounts. The Bank utilizes shock analysis to examine the amount of exposure an immediate rate change of 100, 200, 300 and 400 basis points in both increasing and decreasing directions would have on the financials. Acceptable ranges of earnings and equity at risk are established and decisions are made to maintain those levels based on the shock results.

Impact of Inflation and Changing Prices

The consolidated financial statements and notes thereto presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company’s operations. Unlike most industrial companies, nearly all the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and service.

Contractual Obligations

Contractual Obligations of the Company totaled $603.7 million as of December 31, 2021. Time deposits, contractual agreements for certificates of deposits held by its customers, were $471.5 million. Securities sold under agreement to repurchase were $29.3 million.  Short term debt, two loans secured for the acquisition of Perpetual Federal Savings Bank, was $40.0 million while long term debt, borrowings with the Federal Home Loan Bank and subordinated notes, was 59.1 million.  Short term and long term debt is further defined in Note 9 of the Consolidated Financial Statements.

Capital Resources

Stockholders’ equity was $297.2 million as of December 31, 2021 compared to $249.2 million at December 31, 2020. Dividends declared during 2021 were $0.71 per share totaling $8.2 million and dividends declared during 2020 were $0.66 per share totaling $7.3 million. Throughout 2021, the Company awarded 48,750 shares of restricted stock awards to 96 employees. During 2020, the Company awarded 37,382 shares of restricted stock to 92 employees. For a summary of activity as it relates to the Company’s restricted stock awards, please refer to Note 11: Employee Benefit Plans in the consolidated financial statements. On December 31, 2021 the Company held 997,766 shares in Treasury Stock and 111,131 unvested shares of restricted stock.   At year-end 2020, the Company held 1,032,456 shares in Treasury stock and 88,226 unvested shares of restricted stock. On January 25, 2022 the Company announced the authorization by its Board of Directors for the Company’s repurchase, either on the open market, or in privately negotiated transactions, of up to 600,000 shares of its outstanding common stock commencing January 25, 2022 and ending December 31, 2022. The Company has a history of approving a similar resolution to be in effect each year for at least the last five years.

The Company continues to have a strong capital base and maintains regulatory capital ratios that are above the defined regulatory capital ratios. At December 31, 2021, the Bank had total risk-based capital ratio of 15.22%. Core capital to risk-based asset ratio of 14.26% for the Bank, is well in excess of regulatory guidelines.  The Bank’s leverage ratio of 10.25% is also substantially in excess of regulatory guidelines. Under Basel III, the common equity Tier 1 Capital to risk-weighted assets ratio is also well above the required 4.50% and the 6.50% well capitalized levels with the Bank at 14.26%. As a result of the passage of the Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA) in 2018, the Company is no longer subject to regulatory capital ratio requirements as long as its total consolidating assets are less than $3.0 billion. For further discussion and analysis of regulatory capital requirements, refer to Note 15 of the Audited Financial Statements.

The Company’s subsidiaries are restricted by regulations from making dividend distributions in excess of certain prescribed amounts. Upon prior regulatory approval, the Bank may be allowed to pay above the prescribed amount.

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