FARMERS & MERCHANTS BANCORP INC (FMAO) FY 2023 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 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's 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 Credit Losses (ACL), the valuation of its Loan Servicing Rights (LSR), Other Real Estate Owned (OREO) and goodwill as the accounting areas that require the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available.

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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 Bank did not have any OREO holdings as of December 31, 2023 and 2022.

The allowance for credit losses 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. 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 LSR. These rights are composed of servicing rights for 1-4 family real estate loans and agricultural real estate loans. The servicing rights, relating to fixed rate 1-4 family real estate loans and agricultural real estate loans that it has sold without recourse but services for others for a fee, represent an asset on the Company’s consolidated balance sheet. Loan servicing assets are initially recorded at fair value, based upon pricing multiples as determined by the purchaser, when the loans are sold. Loan 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.

The Company’s loan 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 sheets. The loan 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 loan servicing rights. There are a number of factors that can affect the ultimate value of the loan servicing rights to the Company. The expected and actual rates of 1-4 family real estate loan and agricultural loan prepayments are the most significant factors driving the potential for the impairment of the value of loan servicing assets. Increases in loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced, meaning that the present value of the servicing rights is less than the carrying value of those rights on the Company's consolidated balance sheet. For example, if the loan is prepaid, the Company will receive fewer servicing fees, meaning that the present value of the loan servicing rights is less than the carrying value of those rights on the Company’s consolidated balance sheet. Therefore, in an attempt to reflect an accurate expected value to the Company of the loan servicing rights, the Company receives a valuation of its loan servicing rights from an independent third party. The Company utilizes separate third party vendors to value 1-4 family real estate loan servicing rights and agricultural loan servicing rights. The independent third party’s valuations of the loan servicing rights are 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. For purposes of determining impairment, the loan servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. While the process is similar to the process for valuing 1-4 family real estate loan servicing rights, the agricultural real estate loan servicing valuation utilizes different strata, prepayment speeds and other assumptions in order to account for the differences in behavior between agricultural real estate loans and 1-4 family real estate loans. USDA rate indications, SBA market indications and Farmer Mac 3-month Cost of Funds Index adjustments are utilized in the quarterly valuation process. Management, with the advice from its third party valuation firms, reviews the assumptions related to prepayment speeds, discount rates, and capitalized loan servicing income on a quarterly basis.

Changes are reflected in the following quarter’s analysis related to the loan servicing asset. In addition, based upon the independent third party’s valuations of the Company’s loan servicing rights, management then establishes a valuation allowance by each strata, if necessary, to quantify the likely impairment of the value of the loan 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 loan 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 servicing rights.

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

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2023 in Review

2023 was a year of challenges and required additional resources with a shift in strategic thoughts and plans. The impact of the Federal Reserve raising of rates in 2022 and 2023, along with the bank failures in the first half of 2023, placed pressure on both the cost of funds gathering and liquidity. Net interest income was negatively impacted, by both these occurrences, as was the net interest margin that is used to measure it. The largest contributor to the decline was the cost of funds mentioned above aided by a substantial portion of the assets, specifically loans, not subject to repricing in 2023.

Liquidity concerns took precedence in 2023 as loan growth continued to outpace new deposit generation. The Bank responded by organizing a deposit campaign with the goal of paying off brokered CDs and other term borrowings maturing in the fourth quarter of 2023. The Bank successfully raised an additional $100 million as evidenced on the balance sheet and accomplished the goal. The re-emergence of time deposits, Certificates of Deposit “CDs” as a larger portion of our deposits was a big piece of the growth as depositors chose to lock in higher rates. Money market accounts were also favored by depositors which contributed to the increased cost of funds.

The Bank entered into three interest rate hedges in the fourth quarter of 2023 to adjust interest rate treatment of $100 million of our fixed rate real estate loans into variable treatment. A sizable portion of the loans were acquired from our acquisitions over last few years. The interest rate swaps cover time periods of 3, 4 and 5 years out. (For additional detail on the loan pool and rate marks, please see Note 18 to the consolidated financial statements, Derivative Financial Instruments.)

Commercial loan growth remained strong throughout the year, weighed more heavily in the first half of the year. Increased rates naturally slowed the growth and the start of 2024 shows a decreased appetite for loans by both our customers and the Bank.

1-4 family real estate loans were also slowed by the increase in lending rates in 2023. More customers leaned towards the variable home equity product in the thought the rate increases would stop and begin moving down in the coming year. The lower origination levels are evident in the decreased gain on sale of loans in 2023 as compared to prior years.

The Bank’s consumer portfolio decreased by normal payment activity with limited new originations. Loan growth was focused elsewhere in 2023, so no promotions were conducted in the retail installment space. The sale and conversion of the Bank’s credit card portfolio which had been initiated in 2022 was completed in 2023.

The agricultural sector, in large, performed well in 2023. It was aided by strong yields in the grain crop harvest and median pricing. 2023 represented the third consecutive year for sound profitability. The Bank expanded the recording of loan servicing rights, adding those from the partial sale of agricultural fixed rate real estate loans into the secondary market. The establishment of the asset created revenue in 2023 and will be offset with the amortization thereof over the life of the loans. (See Note 7 to the consolidated financial statements, Servicing, for more information.)

The Company began the year planning for an investment in our future. Technology, strengthening back-office support and a new branding project were the focus. Additional expense in team members and restructuring departments has enabled us to be better positioned for integrating past growth and for the future. Much of the work in 2023 will bear fruit in 2024. At the heart of the technology focus was an evaluation of our core operating system. The Bank utilized a third party to assist with the project as this partnership is vital to our ability to offer innovative digital products and services. A 60 month contract was signed in December 2023. Additional reviews of our technology vendors and processes will continue in 2024 now that the core software has been determined. Providing better customer service through communication channels and creating cost savings will be paramount.

Along with the strengthening of back-office teams, the Bank opened four full-service retail offices in Ohio: Oxford and Downtown Toledo, Indiana: Downtown Fort Wayne and Michigan: Birmingham. The Bank looks forward to helping people live their best lives in those communities and expanding the relationships begun from loan originations as two of the communities were serviced by loan production offices “LPO” prior. Two LPOs were opened in 2023 in Bryan and Perrysburg, Ohio. Both freed office space in the retail offices in their same communities. All locations are leased premises.

The Company and Bank changed its branding during 2023, completing a multi-year project to bring our logo and brand forward and differentiate Farmers & Merchants from the other similarly named 200+ financial institutions. We have long been shortened to F&M when our mature markets talked to others about their bank. Now, we use it in our signage as F&M Bank. The logo has also been modernized while still retaining the initials of F&M in its design. Legally, our names remain the same.

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In December, the Company dissolved our subsidiary, Farmers & Merchants Risk Management, Inc. This was done to mitigate the risk of an IRS ruling which would have enacted taxation of our captive insurance company with a 3 year look back period. The Company formed the captive for risk mitigation with insurance policies that provided pooled interests with other financial institutions along with less costly lower deductibles. In some instances, insurance coverage was put in place that was unavailable elsewhere when it was formed in 2014. The Company may form a new captive in the future.

The Company is proud of the accomplishments in 2023; it has been a remarkably busy year. Our team members were able to shift and focus on the unexpected challenges of the year. Credit quality remains strong and our team is prepared to adjust strategic focus in 2024, as necessary. The Company remains well capitalized and we continued our commitment to our shareholders by increasing our yearly declared dividends 4.62% over 2022’s, with the fourth quarter 2023 declaration. With a committed team and strong corporate infrastructure, we believe we are positioned for success in 2024 and the years to follow.

Material Changes in Results of Operations

Net Interest Income

The discussion now centers on the individual line items of the Company's 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.

One of the largest factors of the reduced earnings for 2023 as compared to 2022 was the decrease in net interest income of $5.4 million. Increases in average balances and interest rates led to an increase in interest income of approximately $38.7 million which was absorbed by an increase in interest expense of $44.0 million. Loan interest and associated fee income increased $35.1 million as compared to the prior year with 54.2% of it driven by volume. The growth in average loan balances of $417.8 million over 2022 was 5.0% related to organic growth within the Bank's broader markets and 4.5% directly attributable to the Company's recent acquisitions. The Company’s loan portfolio is 31.6% variable with 24.9% of total loans repricing within the next twelve months. Average balances on the security portfolio decreased $28.6 million as compared to 2022 with an increase in interest income of $612 thousand. As securities matured, the balances were used to fund loan growth. During the first quarter of 2023, securities of $21.6 million with an annual yield of $274 thousand were swapped at a loss of $891 thousand with securities with an annual yield of $1.6 million. In 2023 with the higher interest rates, interest income on fed funds sold and interest bearing bank deposits generated an additional $3.0 million over 2022.

2022's record earnings were primarily attributed to the $17.3 million improvement in net interest income as compared to 2021. Interest and fee income from loans were responsible for the improvement and increased $22.6 million in 2022 as compared to 2021 which included $4.5 million in loan interest and fee income from PPP loans. In 2022, the volume of loan growth, 21.4% organic and 5.1% attributed to acquisitions, was the largest contributing factor to the improved profitability. For 2021, the Company’s loan portfolio was 26.5% variable with 20.7% of total loans repricing within the next twelve months. The security portfolio increased $51.4 million in average during 2022 as compared to 2021 with associated interest income increasing $1.1 million over 2021. During 2021, cash funds from stimulus and acquisitions were placed in securities to earn a greater return. Beginning in March of 2022, the prime rate increased 25 basis points followed by a 50 basis point increase in May, four 75 basis point increases in June, July, September and November with a final 50 basis point increase in December to end the year at 7.50%. In 2023, there were four additional 25 basis point increases in February, March, May and July to the current prime rate of 8.50%. Overall, total interest income was $38.7 million higher for 2023 than 2022 on an additional $378.9 million in total average earning assets and was $24.3 million higher for 2022 than 2021 on an additional $511.4 million in total average earning assets.

Interest expense (which includes deposit, federal funds purchased, securities sold under agreement to repurchase, borrowed funds and subordinated notes) increased from all interest bearing funding sources in 2023 over the time period of 2022 and 2022 over the time period of 2021. Average interest bearing liabilities increased $366.4 million over 2022 with an additional $44.0 million of interest expense while average interest bearing liabilities increased $414.2 million over 2021 with an additional $7.0

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million of interest expense. 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 designed to assist in controlling interest expense in a rising rate environment. In 2023, liquidity needs and loan growth created the need to quickly generate deposits. The Bank raised $100 million through several deposit promotions during the last half of the year. Competition within the market areas forced us to increase rates for deposits in 2023 and 2022 while rates were lowered or remained flat in 2021 in response to the prime rate drop of 150 basis points in March 2020. Between 2022 and 2023, the prime rate increased 525 basis points. Average interest bearing deposits increased $230.4 million compared to 2022. During 2023, interest expense from deposits increased by $37.0 million from 2022 and 2022 increased by $4.5 million from 2021. The majority, approximately 95.5%, of the increased deposit expense of 2023 and 59.7%, of the increased expense of 2022 was influenced by rates rather than due to additional cost associated with deposit growth. Borrowed fund balances increased in 2023 and 2022 by $145.8 million and $44.9 million, respectively, as a means to fund the phenomenal loan growth which resulted in an additional interest expense of $6.7 million and $1.4 million, respectively. During 2021, the Company issued subordinated notes and incurred $1.1 million of interest expense in both 2023 and 2022. Refer to Note 10 of the Company’s consolidated financial statements for further discussion regarding subordinated notes.

Total interest expense totaled $58.4, $14.4 and $7.3 million for 2023, 2022 and 2021, respectively. The increased expense was approximately 87.2% attributable to the rising interest rate environment in 2023 as compared to 2022 and 43.2% attributable to the rising interest rate environment in 2022 as compared to 2021.

This concludes the discussion by the independent components of the ratios. 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 comparing 2021 to 2023. The increased interest expense resulted in a decrease in interest margin of 60 basis points and interest spread of 99 basis points compared to the prior year due to the cost of funds increasing more than the increase in asset yield. Interest margin increased by 1 basis point while interest spread decreased by 5 basis points in 2022 as compared to 2021 with the increased cost of funds only being partly offset by the higher asset yields. For 2023, average loan balances increased $417.8 million over the prior year with increased interest income of $35.1 million. In 2023, the Bank was able to see the impact of rate increases with 45.8% of the increased interest income related to rate changes as presented in the below charts. Average balances of fed funds sold and interest bearing deposits with other institutions decreased $10.3 million; however, increased interest rates generated an additional $3.0 million in interest income over 2022. The overall asset yield for 2023 increased 80 basis points as compared to 2022. Looking at the components behind the change in net interest margin for 2022 as compared to 2021, increased average balances in loans of $551.6 million stands out. Loans acquired with the one acquisition in 2022 were $101.8 million. The additional revenue of $22.6 million that those balances were responsible for was the largest contributor to the increased interest income of $24.3 million. In 2022 and 2021, loan revenue was negatively impacted by the change in the interest rate. Roughly 26.5% of the Bank's loans are variable with the majority of those loans with floor rates that had attained the point where rate increases would cause to go above the floor. As mentioned previously, 2022 had seven rate increases totaling 425 basis points. The large revenue gain in loan interest was aided by the increased earnings in securities of $1.1 million. Average balances of fed funds sold and interest bearing deposits decreased in average balances by $91.7 million as the funds were used for loan growth. The overall asset yield in 2022 increased by 26 basis points over 2021.

For 2023, interest expense continued to increase and was 306.7% higher than 2022 and was 87.2% impacted by changes in interest rates. Competition for deposits was extremely high and rate shopping between financial institutions was apparent. The Company’s goal is to increase core deposits which includes savings deposits and non-interest bearing demand deposits which increased $41.0 and $13.4 million in average balances, respectively as compared to 2022. In 2023, the Company ran several time deposit promotions which resulted in increased average balances of $189.4 million. The increased interest expense in 2023 for savings deposits and time deposits accounted for 84.1% of the total interest expense increase. Overall, cost of funds increased 179 basis points or 241.9% over 2022 with only 12.8% due to volume increases. The remaining 87.2% was related to changes in interest rates as the prime rate increased 525 basis points between 2022 and 2023. The increased interest expense in 2022 correlated to a much higher rate environment in which competition for deposits forced higher interest rates as compared to 2021 while the decreased interest expense in 2021 correlated to a much lower rate environment. In the area where the strategic plan was to gather core deposits, the average balance in savings grew by $189.6 million during 2022 as compared to 2021’s average balance. Interest bearing deposits acquired with the one acquisition were $104.7 million. The other average balance increase for core deposits was the change in non-interest bearing demand deposits. 2022’s average balance in this portfolio was $79.6 million higher than 2021’s average balance. Non-interest bearing demand deposits acquired with the one acquisition were $7.1 million. Overall, cost of funds increased 26 basis points for 2022 over 2021. The reason behind the increase was 43.2% due to rate increases and 56.8% due to volume increases.

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In comparing 2023 to 2022, net interest margin was 2.72% which decreased 60 basis points while net interest spread decreased 99 basis points to 2.14%. Loan volume accounted for $35.1 million or 90.7% of the increased interest income with an increased asset yield of 64 basis points. The asset yield on fed funds sold and interest bearing deposits increased 361 basis points year over year. Total asset yield increased 80 basis points while total cost of funds increased 179 basis points, creating the 99 basis point difference in spread. Overall yield improves when the balances of the highest yielding asset, which is loans, increases. Loans as a percentage of earning assets was 83.2% while loans to total assets was 78.0% for 2023. The goal is, as always, to improve the net interest margin and spread and thereby improve profitability.

The net interest margin for 2022 was 3.32% compared to 2021 which was 3.31%. The 0.01% increase for 2022 was related to the increased interest income which was greater than the increased interest expense. Net interest spread was 3.13% for 2022 compared to 2021’s 3.18%, creating a 5 basis point difference in the spread. Loans as a percentage of earning assets was 79.2% while loans to total assets was 74.7% for 2022.

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 the opportunity for fee dollars from services provided, is a top focus for 2024.

Total assets of the Company increased overall as did the earning assets in both average and year-end during 2023 and 2022. This matched the increase in interest dollars. The percentage of average earning assets to total average assets reflects the best utilization of funds. For 2023, the percentage at 93.80% was slightly lower than 2022 at 94.29%. 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 2022 was the percentage of average loans to total assets. For 2023 the average balance of loans to total average assets was 78.02%, 74.73% for 2022 and 68.26% for 2021. 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 a 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 2022 and 2023, the majority of loans have increased over the floors.

In terms of interest expense, 2023’s increase as compared to 2022 was approximately 87.2% due to the increase in rates. 2022’s increase was approximately 43.2% due to the increase in rates as compared to 2021.

The impact of the change in the portfolio mix was a factor in the liabilities as it was in the assets. In comparing to 2022, 2023 had increases in average balances of all interest bearing liabilities with the exception of fed funds purchased and securities sold under agreement to repurchase while 2022 as compared to 2021, had average balance increases in all categories. Refer to Note 10 for additional information on other borrowed money, which consists of both short and long term borrowings, and subordinated notes.

The following tables present net interest income, interest spread and net interest margin for the three years 2021 through 2023, 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, real estate loans held for sale and carrying value adjustments of $2.7 million related to interest rate swaps for 2023. 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 2023 was 2.53%, 179 basis points higher than 2022’s 0.74%.

The yield on tax-exempt investment securities shown in the following charts were computed on a tax equivalent basis. The yield on loans has also 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 within the net interest spread and margin. The adjustments were based on a 21% tax rate for all years. The tax-exempt interest income was $590, $614 and $551 thousand for 2023, 2022 and 2021, respectively which resulted in a federal income tax savings of $124, $129 and $116 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.

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Non-Interest Income

The discussion now focuses on the noninterest income and expense generated by the Company for the years ended 2021 through 2023. For 2023, noninterest income was $16.0 million an increase of 3.2% over 2022. Noninterest income decreased to $15.5 million, or 11.8% in total for 2022 as compared to 2021 which ended at $17.6 million.

Other service charges and fees increased $2.4 million during 2023 as compared to 2022. The establishment of agricultural real estate servicing rights during 2023 recognized $2.3 million of service charge income that was not present in prior years. Overdraft, returned check charges and recurring overdraft fees also increased during 2023 as compared to 2022. Customer service fees decreased $366 thousand during 2023 as compared to 2022. Decreased fee income from credit cards was the largest factor for the decrease. 2022 customer service fee revenue was $287 thousand higher than 2021, mostly due to increased credit card income.

The two line items of noninterest income on the consolidated income statement for 2022 which improved over 2021 were customer service fee revenue and other service charges and fees. 2022 customer service fee revenue was $287 thousand higher than 2021, mostly due to increased credit card income. The increase of other service charges and fees in 2022 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. Interchange revenue and fees collected on foreign ATM usage (noncustomers utilizing our ATMs) increased $323 thousand to $5.3 million during 2023 as compared to 2022. During 2022 the Bank collected interchange revenue, combined with fees collected on foreign ATM usage, of $5.0 million which was $149.3 thousand higher than 2021. 2023 included a Mastercard growth credit of $196.3 thousand. For 2022, the Mastercard growth credit was $188 thousand and $151 thousand for 2021. 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 over five years. The bonus is being recognized over 60 months with $350.8 thousand included in 2023, 2022 and 2021’s $5.3 million, $5.0 million and $4.8 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.

The Bank has seen a decrease in its mortgage production volume and the corresponding gains on the sale of these loans. Loan originations driven by refinance activity have decreased with the higher interest rates in 2023. Noninterest income from net gain on sales of loans was the highest in 2021 of the three year periods shown. Net gain on sales of loans was $699 thousand, $1.4 million and $3.9 million respectively in 2023, 2022 and 2021. 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. 84.3% of the gains were attributed to the residential loans in 2023, 37.6% in 2022 and 47.4% in 2021. In conjunction with

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these sales, the Bank maintains servicing rights. The income from one to four mortgage servicing rights was $415 thousand, $537 thousand and $1.4 million for 2023, 2022 and 2021 respectively. Agriculture mortgage servicing rights were $2.3 million in 2023.

The last item in the noninterest income section is the net gain or loss of sale of investments. During the first quarter of 2023, securities were swapped at a loss of $891 thousand with securities with a higher annual yield. The loss was recouped by the higher yield during the first eight months of 2023. The Bank did not sell any securities in 2022. The Bank had sold securities in 2021 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. The available for sale security portfolio switched from an unrealized gain position in 2020 into an unrealized loss position in 2021 that continued through 2023.

Non-Interest Expense

Noninterest expense increased 17.6% in 2023 as compared to 2022 and was preceded by a 5.7% increase in 2022 as compared to 2021. Represented in dollars, 2023 was $10.1 million higher than 2022 and 2022 was $3.1 million higher than 2021. Acquisition costs incurred in 2023 and 2022 totaled $207.6 thousand and $2.5 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 2023, an additional $4.2 million was spent over 2022 which correlates to an 18.6% increase. When making the same analysis for 2022 as compared to 2021, 2022’s costs increased $2.5 million or 12.5%. 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. 2023 saw an increase due to the investment in people for our strategic growth initiative and staffing of new offices. 2022 increased with the acquisition of Peoples Federal Savings and Loan offices. 2021 increased with the addition of one new office and the acquisition of Ossian State Bank and Perpetual Federal Savings Bank offices. Normal yearly increases to the employees would be included in all years. Base pay was up $4.7 million for 2023 over the previous year and 2022 was up $2.7 million over 2021. The full time equivalent number of employees at each year-end increased to 456 for 2023, to 431 for 2022 compared to 2021’s 385.

Incentive pay as it relates to performance was down $1.7 million in 2023 over 2022 and up $464.1 thousand in 2022 over 2021. The Return on Assets multiple used to award incentive pay decreased in 2023 to 0.36 compared to 1.196 in 2022 and 1.165 in 2021. In 2022 and 2021, acquisition costs were eliminated from the calculation. The expense for the restricted stock awards increased in 2023 due to more shares being granted to a slightly larger number of employees. 13,897 additional shares were awarded in 2023 with lower market values. The expense for 2023 increased by $381.8 thousand over 2022. The expense for the restricted stock awards increased in 2022 due to more shares being granted to a slightly larger number of employees and the market value of the shares increasing compared to 2021. 7,746 additional shares were awarded in 2022 with a higher value as compared to 2021. The expense for 2022 was higher by $77.4 thousand which included reduced expense due to retirement of $56.9 thousand as compared to 2021. 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.

Employee benefits expense increased in 2023 as compared to 2022. Employee group insurance accounted for the largest portion of the increase, which was an increase of $665.0 thousand over 2022. Acquisition related costs included in employee benefits expense were $143.9 thousand in 2023. The cost of the 401-K retirement plan decreased $215.7 thousand for 2023 as compared to 2022. The contribution portion relating to the discretionary profit-sharing percentage was 1.7% in 2023 compared to 5.5% in 2022. Overall, employee benefits increased $616.9 thousand or 8.9% from 2022.

Employee benefits expense decreased in 2022 as compared to 2021. Miscellaneous personnel expense accounted for the largest portion of the decrease, which was a decrease of $528.1 thousand over 2021. Acquisition related costs included in this line were $217.3 thousand. The cost of the 401-K retirement plan decreased $251.6 thousand for 2022 as compared to 2021. The contribution portion relating to the discretionary profit-sharing percentage was 5.5% in 2022 compared to 5.0% for 2021. Overall, employee benefits decreased $418.8 thousand or 5.7% from 2021.

Net occupancy expense typically increases as the Company expands. Net occupancy expense increased for 2023 $1.3 million and increased $381.8 thousand in 2022. 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. For 2023, building rent as generated from FM Investments decreased by $93.8 thousand. Rent is received in lieu of commissions. This revenue was able to partially offset increased building repair and maintenance expenses of $113.0 thousand and lease expense of $296.1 thousand and increased building depreciation expense of $367.3 thousand. Building rent

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as generated by FM Investments was higher by $106.5 thousand in 2022 which offset building repair and maintenance expenses of $14.0 thousand. Net occupancy expense increased for 2022 $381.8 thousand over 2021.

The 1-4 family real estate refinancing activity continued to decrease from 2022 with the increase 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 servicing rights. The amortization is the expense that offsets the income recognized when the loan is first made. Income is recorded when the real estate loan is first sold with servicing retained and is therefore recognized immediately. 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. Prior to 2023, servicing rights only included 1-4 family real estate loans. The establishment of agricultural real estate servicing rights, incorporated in the table below for 2023, included capitalized additions of $2.3 million and corresponding amortization of $123 thousand. For 2023, combined servicing rights yielded a net income of $2.1 million along with the establishment of a $7 thousand valuation allowance. 2022 had a net loss of $22 thousand which excluded the reversal of the $414 thousand valuation allowance established the prior year. The net income for 2021 was $251 thousand with a carrying value that was greater than the $3.2 million market value thus creating the need to establish a $414 thousand valuation allowance. Of course, the value (or income) of the servicing right when the loans are sold also impacts the net position. As of December 31, 2023, 3,749 1-4 family real estate loans and 593 agricultural loans are being serviced with corresponding balances of $367.8 million and $135.8 million, respectively. 2022 had 3,861 loans serviced with corresponding balances of $375.6 million. As of December 2021, 3,961 loans were being serviced with balances of $380.8 million. Refer to Note 7 for additional information on servicing rights.

The impact of 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 lower in 2023 as compared to 2022 by $808.3 thousand. Data processing costs were higher in 2022 as compared to 2021 by $454.2 thousand. Acquisition related data processing expense decreased $257.2 thousand in 2022 compared to 2021. 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.

ATM expense increased $394.1 thousand over 2022 while 2022 increased $371.2 thousand from 2021. Included in this line are the debit card fees incurred which offset the debit card income as discussed above.

The FDIC assessment increased from 2022 due to an increased assessment base while 2022 decreased as compared to 2021 due to a decreased assessment rate. With continued growth, the assessment base increases which leads to a greater expense. 2023’s assessment was $1.1 million over 2022. The assessment for 2022 was down $168.3 thousand compared to 2021 as a result of the decreased assessment rate.

Advertising and public relations increased in 2023 by $960.8 thousand and increased in 2022 by $210.1 thousand. With the addition of new offices and our new logo launch, 2023 was expected to increase over 2022. 2022 saw the celebration and promotion of the Bank's 125th anniversary.

The last line items with significant variation in noninterest expense to discuss is “consulting fees” and “other general and administrative.” Consulting fees decreased by $469.9 thousand in 2023 from 2022 and decreased $332.8 thousand in 2022 compared to 2021. Consulting expenses related to acquisitions were $542.9 thousand in 2022 and $892.1 thousand in 2021.

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Acquisition expenses included in the other general and administrative line were $45.6 thousand for 2023 and $590.3 thousand for 2022. Credit card expense increased $458.6 thousand over 2022. The conversion of our credit card platform in 2023 included $108 thousand of scorecard conversion expense. This represented awards earned by customers that the Company paid to honor rather than allowing them to be lost in the conversion. Auditing and exam fees increased $124.4 thousand in 2023 over 2022 which included $33.6 thousand of acquisition expense and 2022 increased $103.1 thousand over 2021 which included $77.3 thousand of acquisition related costs. Legal expenses decreased in 2023 by $226.4 thousand which included $4.0 thousand of acquisition expense. In 2022, loan and collection expenses increased $287.0 thousand over 2021 and legal expenses decreased $223.3 thousand from 2021 of which $205.1 thousand of the decrease was acquisition related.

Allowance for Credit Losses

Provision expense decreased by $2.9 million for 2023 as compared to 2022 and increased by $1.2 million for 2022 as compared to 2021. The increase in provision expense for 2022 was attributed to the net charge-off activity and significant loan growth. Sustained strong asset quality kept the provision expense lower than the growth alone would have warranted. 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 2023, 2022 and 2021 at $565, $418 and $814 thousand, respectively. Net charge-offs in the commercial and industrial portfolio were $481, $325 and $557 thousand in 2023, 2022 and 2021, respectively. Total net charge-offs were $551, $529 and $874 thousand for 2023, 2022 and 2021, respectively.

The allowance for credit losses (ACL) represents management’s estimate of probable credit losses inherent in the Bank’s loan portfolio and unfunded loan commitments at the report date. The ACL methodology is regularly reviewed for its appropriateness and is approved annually by the Board of Directors. This written methodology is consistent with Generally Accepted Accounting Principles which provides for a consistently applied analysis.

The ACL is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged off against the allowance when management believes the uncollectibility of a loan balance is confirmed. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged-off. The ACL reflects the Company’s estimated credit losses over the life of the loan. Management assesses changes in prepayment assumptions, interest rates, collateral values, portfolio composition, trends in non-performing loans, and other economic factors. In addition to an extensive internal loan monitoring process, the Company also aims to have an external, independent loan review of approximately 35% of its commercial and agricultural loan portfolio. Management in turn assesses the results from the reviews to make changes in internal risk ratings of loans and the related ACL.

The Bank’s methodology provides an estimate of the probable credit losses either by calculating a reserve per credit or by applying our methodology to groupings based on similar risk characteristics. The loan portfolio was grouped based on loans of similar type, including acquired loans. The loan groupings for the CECL calculation consist of Commercial Real Estate, Construction & Land Development, Multi-family real estate, Commercial & Industrial, Farmland, Agriculture, Single Family real estate, Home Equity Lines of Credit, and Consumer. All groups use the average charge-off method for calculating the ACL. This incorporates a historical loss period from March 2000, since Call Report data became more granular regarding loan groupings, and includes several economic cycles. As a percentage, the reserves are the highest against construction and development loans, while farmland loans have the lowest overall reserve due to having such low loss rates.

Due to the Company’s loss history not being sufficient enough to predict future losses, the Company is utilizing peer data from a peer group of 307 banks in the region with asset sizes less than $5 billion. The reserves are calculated at the loan level and based on the note characteristics, essentially balances times loss rate + Qualitative factors + forward look, with the forward looking forecast eliminated after 12 months. In order to provide a reasonable and supportable forward looking forecast, a regression analysis of the Bank’s historical loss rates against the Federal Open Market Committee (FOMC) quarterly economic projections for Change in real GDP and National Unemployment is completed. Annual projections are broken down using a straight-line approach for quarterly changes.

In addition to this quantitative analysis, management also utilizes qualitative analysis each quarter to assess the general reserve on the loan portfolio. The Qualitative factors include nine categories: ability of staff, changes in collateral values, changes in loan concentration levels, economic conditions, external factors such as regulatory, level and trends in non-accrual or adversely classified loans, loan review results, nature and volume of the portfolio and loan terms, and changes in lending policies and procedures. Items within these categories are ranked as baseline, low, medium, or high levels of risk, and the related risk level per categories dictates the level of qualitative factor that is used depending on the standard deviation level from historical loss.

Loans that do not share risk characteristics are evaluated on an individual basis. Loans evaluated individually are not included in the collective evaluation; reserves for expected credit losses for collateral dependent loans are based on the expected shortfall

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of the loan based on the discounted collateral value. This specific reserve portion of the ACL was $0.4 million at December 31, 2023, and $2.0 million at December 31, 2022. When management determines that foreclosure is probable, expected credit losses are based on the fair value of the collateral at the reporting date, adjusted for selling costs as appropriate. At 90 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency.

Expected credit losses are estimated over the contractual term of the loans, adjusted for expected prepayments when appropriate. 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 modification to a borrower experiencing financial difficulty 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 the Company.

Inherent in most estimates is imprecision. Bank regulatory agencies and external auditors periodically review the Bank’s methodology and adequacy of the ACL. Any required changes in the ACL or loan charge-offs by these agencies or auditors may have a material effect on the ACL. For more information regarding the estimates and calculations used to establish the ACL please see Note 1 to the consolidated financial statements provided herewith.

The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company. The allowance for credit losses on off-balance sheet credit exposures is adjusted as a provision for credit loss expense. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life. The loan categories of off-balance sheet exposures are the same as the loan categories for the ACL. The funding assumptions are updated each quarter based on expected utilization percentages.

Watch list loan balances are comprised of loans graded 5-8. At year-end December 31, 2023, these loans totaled $104.9 million and were $44.9 million higher than December 31, 2022. Commercial real estate, agricultural real estate and commercial loans comprised $68.6 million, $17.5 million and $8.8 million of the watch list loans, respectively. Grade 5 increased $54.9 million in 2023 as compared to 2022 and Grade 6 decreased $10.4 million in the same comparison. Grade 7 increased $257 thousand over 2022.

At year-end December 31, 2022, these loans totaled $60.0 million and were approximately $4.6 million higher than December 31, 2021. Grade 5 increased $2.6 million in 2022 as compared to 2021 and Grade 6 increased $2.0 million in the same comparison.

At year-end December 31, 2021 these loans totaled $55.4 million and were $1.0 million lower than December 31, 2020. Grade 5 increased $4.4 million in 2021 as compared to 2020 and Grade 6 decreased by $4.3 million in the same comparison. Grade 7 decreased $1.1 million in 2021 as compared to 2020.

Of the aggregate watch list loan balances, as of December 31, 2023, 75.8% of the watch list was classified as special mention, with an additional 23.8% classified as substandard and a small 0.2% or $257 thousand of the $104.9 million watch list was classified as doubtful.

At December 31, 2022, of the $60.0 million watch list loans, 41.0% were classified as special mention and 59.0% were classified as substandard. At year-end 2021, of the $55.4 million watch list loans, 39.7% were classified as special mention and 60.3% were classified as substandard.

In response to these fluctuations and the offset by loan growth during 2021 through 2023, the Bank’s ACL to outstanding loan coverage percentage changed to 0.97% as of December 31, 2023, 0.86% as of December 31, 2022 and 0.87% as of December 31, 2021. In addition, for 2023, 2022 and 2021, our allowance for credit losses does not include a $363 thousand, $785 thousand and $1.2 million credit mark associated with the Limberlost acquisition. For 2023, 2022 and 2021, our allowance for credit losses also does not include a $294 thousand, $480 thousand or $966 thousand credit mark associated with the Ossian acquisition. The credit mark not included in the allowance for credit losses associated with the Perpetual Federal Savings Bank acquisition for 2023, 2022 and 2021 was $2.8 million, $4.4 million and $5.5 million, respectively. 2023 and 2022 also include a $566 thousand and $798 thousand credit mark associated with the Peoples Federal Savings and Loan Bank acquisition. Together, all of the credit marks further support the current position of the ACL.

All commercial and agricultural relationships with lines of credit greater than $100,000 and aggregate loan exposure greater than $250,000 are reviewed annually by the Bank’s Credit Department. All commercial and agricultural relationships with term

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debt only and aggregate loan exposure greater than $1,000,000 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 $5.7 million during 2023 which included an increase to the allowance for credit losses of $3.6 million and unfunded loan commitments of $904 thousand with the adoption of CECL. The ACL increased $4.3 million and $3.0 million during 2022 and 2021, respectively. December 31, 2021 had the lowest loans past due 30+ day percentage at 0.09% in the last ten years. December 31, 2020 and 2022 were at respectable lows of 0.29% and 0.26%. At December 31, 2023, the loans past due 30+ day percentage was slightly higher but still respectable at 0.45%.

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

Income Taxes

Income tax expense was $2.4 million lower for 2023 than 2022 as result of approximately a $12.1 million decrease of pretax income. Effective tax rates were 19.63%, 19.67% and 20.35% for 2023, 2022 and 2021 respectively. The effect of tax-exempt interest from holding tax-exempt securities and Industrial Development Bonds (IDBs) was $149, $137 and $119 thousand for 2023, 2022 and 2021, respectively less the TEFRA adjustments of $20, $5 and $3 thousand respectively.

Material Changes in Financial Condition

The shifts in the balance sheet during 2021 through 2023 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, other time deposits and growth in other borrowings. The cost of funds beginning in 2022 has been impacted by the increase of both interest bearing liabilities, the pressure on rates from competition for funds and a rising rate environment. In 2023, the rate pressure from competition was extremely high with many depositors rate shopping. Going forward, there is a heightened focus on controlling the cost of funds. Loan growth contributed to an increase in profitability in 2021 through 2022.

Average earning assets increased in balances for all years during 2021 through 2023 with loan growth the primary factor for the increase.

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SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA

*ASU 2016-13 was adopted during the first quarter of 2023; therefore, 2019 through 2022 provision amounts reflect the incurred loss method.

**Based on weighted average number of shares outstanding.

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 our recent 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, 2023 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, 2023, the Bank also holds stock in the Federal Home Loan Bank of Cincinnati and Indianapolis at a cost of $14.8 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 gross loan portfolio, excluding loans held for sale, by category of loan as of December 31 of each year:

The following table shows the maturity of loans excluding fair value adjustments as of December 31, 2023:

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):

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The following tables present the Company's amortized cost of nonaccrual loans by class of loans as of December 31, 2023 and the recorded investment of nonaccrual, past due 90 days or more and still accruing loans, and accruing troubled debt restructurings as of December 31, 2022 through 2019:

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 $1.6 million for 2023, $157 thousand for 2022 and $502 thousand for 2021. Any collections of interest on nonaccrual loans are included in interest income when collected unless it is on a loan with expected credit loss and with a specific allocation. A collection of interest on a loan with an expected credit loss and 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 $43 thousand for 2023, $361 thousand for 2022 and $292 thousand for 2021.

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 $22.4 million at December 31, 2023 compared to balances of $4.7 million and $8.1 million as of year-end 2022 and 2021. All of the balances of nonaccrual loans for the past three years were collaterally secured.

As of December 31, 2023, the Bank had $102.8 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. Commercial real estate, agricultural real estate, commercial and agricultural loans comprised $69.2 million, $18.7 million, $8.7 million and $6.2 million respectively. At December 31, 2022, the Bank had $60.0 million of these loans and at December 31, 2021, the Bank had $55.4 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 determination of the allowance for credit losses at December 31, 2023, 2022 and 2021.

In extending credit to families, businesses and governments, banks accept a measure of risk against which an allowance for possible credit losses 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, 2023, the Bank had loans outstanding to individuals and firms engaged in the various fields of agriculture in the amount of $132.6 million with an additional $223.8 million in agricultural real estate loans which compared to $128.7 and $220.9 million respectively as of December 31, 2022. 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.

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As of December 31, 2023, the Bank had $357.3 thousand of its loans that were considered modified for borrowers experiencing financial difficulty, of which $254.8 thousand are included in nonaccrual loans. As of December 31, 2022, the Bank had $3.6 million of its loans that were classified as troubled debt restructurings, of which $2.5 million are included in nonaccrual loans. This compares to $7.6 million of troubled debt restructurings, of which $6.5 million are included in nonaccrual loans for 2021 and $6.5 million of troubled debt restructuring, of which $5.6 million are included in nonaccrual loans for 2020. 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.

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 its 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 as 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 Bank’s senior management and the Credit Analyst Department will meet to review all commercial credits either deemed to be impaired or on the Bank’s watch list. An external review by an independent firm of 35% of our larger credits is also completed annually. 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 ACL.

The Company adopted ASU 2016-13 on January 1, 2023, using the modified retrospective method for all financial assets measured at amortized cost and off-balance sheet credit exposures. ASU 2016-13 requires an expected credit losses approach, referred to as the Current Expected Credit Losses (CECL) approach to evaluating the allowance for credit losses. Results for reporting periods beginning after January 1, 2023 are presented under CECL while prior period amounts continue to be reported in accordance with the incurred loss accounting standards. The Company did not make any material changes to its business practices as a result of implementing the ASU.

The transition adjustment of the CECL adoption included an increase in the allowance for credit losses of $3.6 million, increase in the allowance for unfunded loan commitment and letters of credit of $0.9 million and a $3.4 million decrease to the retained earnings account to reflect the cumulative effect of adopting CECL on our consolidated balance sheets, with the $1.1 million tax impact portion being recorded as part of the deferred tax asset in other assets on our consolidated balance sheets. 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.

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As presented in the table on the next page, charge-offs increased to $990 thousand for 2023. 57.1% of the charge-offs stemmed from the commercial and industrial portfolio. Charge-offs were $827 thousand for 2022, $1.3 million for 2021, preceded by $720 thousand for 2020 and $841thousand for 2019. Recoveries were $439 thousand in 2023 compared to $298, $458, $183 and $156 thousand for 2022, 2021, 2020 and 2019, respectively. The net charge-offs for the last five years were all under $900 thousand with 2021 the highest at $874 thousand and 2022 the lowest at $529 thousand.

During 2023, controlled loan growth resulted in lower provision expense. Higher provision expense was used to fund the ACL for loan growth in 2022 and 2019. 2021 and 2020 had higher provision expense due to the uncertainty surrounding COVID-19 and its impact on individuals and businesses. Overall, the ACL increased from $7.2 million at year-end 2019 to $25.0 million at year-end 2023. After adding the allowance for unfunded loan commitments, the ACL ended 2023 at $27.2 million.

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The following table presents a reconciliation of the allowance for credit losses for the years ended December 31, 2023, 2022, 2021, 2020 and 2019:

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

The balance of loans at December 31, 2023 within this chart does not include a fair value basis adjustment for derivatives of $2.7 million.

ASU 2016-13 was adopted during the first quarter of 2023; therefore, 2019 through 2022 provision amounts reflect the incurred loss method.

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

*ASU 2016-13 was adopted during the first quarter of 2023; therefore, the 2022 through 2019 methodology reflects the incurred loss method.

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, 2023 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:

Liquidity

Liquidity remains a focus as a battle for deposits existed throughout 2023 and remains going into 2024. A special emphasis was placed on deposit growth in the 2nd and 3rd quarters of 2023 and the team responded when a deposit campaign was launched to

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raise an additional $100 million in deposits. As an industry, deposit growth from 2019 to 2022 was too easy with the additional funds funneled into the market from our government during COVID. 2023 reminded us deposits are as essential to our success as loan originations. As the competition for deposits has increased, the Company has increased emphasis on its liquidity position. The frequency of management liquidity meetings was increased to weekly to be more responsive to opportunities and threats as they arise. These have proven to be greatly beneficial and will continue. Deposits grew 5.61% or $138.6 million in 2023 as compared to year-end 2022. The largest growth was in time deposits which provides stability for liquidity. Our checking account balances, interest and noninterest bearing combined, grew $61.6 million in comparing December 31, 2023 to December 31. 2022. These represent true core balances and provide additional opportunities to benefit noninterest income.

After the first quarter, the Company had begun to experience a slowdown in its growth mode. It is partly due to a natural decrease in borrowers' loan demand as higher interest rates have made projected capital outlays too costly. The Bank has also experienced a more challenging environment in which to raise lower cost core deposits. Therefore, we also chose to participate out a portion of our larger loans with other financial institutions, both new loans and existing. The Bank has also maintained an emphasis on servicing existing clients and focus on prudent growth within our newer markets. Overall, loans grew 9.54% during 2023 or $224.8 million as compared to 2022.

Cash balances increased drastically, up 68.6% or $57.8 million over 2022 year-end levels. Holding cash at the Federal Reserve earned the Bank the highest rate for liquid assets due to the inverted yield curve. This holds true as we head into 2024. In addition to the high cash balance, the Bank has access to $128 million of unsecured borrowings through correspondent banks. Through the Federal Home Loan Bank, the Bank also has an additional $42.5 million available based on current collateral pledging and $150.1 million through the Cash Management Advance program. The Company and Bank combined has $102.7 million of unpledged securities which may be sold or used as collateral. In addition, securities with a carrying value of $61.7 million and a par value of $69.9 million were pledged to the Federal Reserve’s Bank Term Funding program to secure additional borrowing capacity. These borrowings utilize the par value of securities. The Company kept a line of credit in place, though changed the lender upon the maturity of the line in 4th quarter 2023. The Bank broadened our relationships with additional broker firms to strengthen our contingency funding position.

Short-term debt such as federal funds purchased and securities sold under agreement to repurchase also provides the Company with liquidity. These amounted to $28.2 million as of December 31, 2023, down from the $54.2 million as of December 31, 2022. The decrease was due to the elimination of need for federal funds purchased. The securities sold under agreement to repurchase accounts are used to provide a sweep product to the Bank’s commercial customers and for some term deposits.

Federal Home Loan Bank advances grew to $265.8 million as of December 31, 2023, from $127.5 million on December 31, 2022. The increase in advances helped to offset the difference for funding the loan growth which outpaced the deposit growth in both 2022 and 2023.

The Company will continue to develop our deposit gathering skills. The addition of four new retail offices will aid in establishing new relationships. Given that two of the retail offices are in communities where a loan production office was located should help to broaden those relationships with deposits. The Bank will continue to meet weekly to focus our strategic plans on increasing liquidity while improving profitability.

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.

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.

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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 $1.0 billion as of December 31, 2023. Time deposits, contractual agreements for certificates of deposits held by its customers, were $663.0 million. Securities sold under agreement to repurchase were $28.2 million. Short term debt, which consisted of a line of credit secured for the acquisition of Peoples Federal Savings and Loan Bank of $10.0 million, was paid off during the first quarter of 2023. There were no federal funds purchased as of December 31, 2023. Long term debt was comprised of borrowings with the Federal Home Loan Bank of $265.8 million and subordinated notes of $35.0 million. Short term and long term debt is further defined in Note 10 of the consolidated financial statements.

Capital Resources

Stockholder’s Equity was $316.5 million as of December 31, 2023, compared to $298.1 million on December 31, 2022. Dividends declared during 2023 were $0.85 per share totaling $11.5 million, up 4.6% from $0.8125 per share dividend declared in 2022, totaling $10.6 million. Throughout 2023, the Company awarded 64,225 shares to 113 employees compared to 59,496 shares awarded to 109 employees during 2022. The majority of shares were awarded under a 3-year cliff vesting restriction in both years. 6,350 shares were forfeited under the long-term incentive plan throughout 2023 and 8,000 shares were forfeited throughout 2022. At year-end 2023, the Company held 151,350 shares in unearned stock awards, an increase from the year-end 2022 number of shares held in unearned stock awards of 128,952. For a summary of activity as it relates to the Company’s restricted stock awards, please refer to Note 12: Employee Benefit Plans in the consolidated financial statements. The Company held 899,784 shares in Treasury stock as of December 31, 2023, compared to 956,003 shares in Treasury stock as of the same date in 2022. On January 16, 2024, the Company announced the authorization of 650,000 shares for the Company’s repurchase, either in the open market, or in privately negotiated transactions, of its outstanding common stock commencing January 16, 2024, and ending December 31, 2024, by our Board of Directors. At the 2023 annual meeting, our shareholders approved the Company’s ability to establish a new class of flexible preferred stock and to issue 100,000 shares of such preferred stock at the Board of Director’s discretion. No preferred stock was issued during the remainder of 2023.

The Company continues to have a strong capital base and maintains regulatory capital ratios that are above the defined regulatory capital ratios. On December 31, 2023, the Bank had total risk-based capital ratios of 11.73%. Core capital to risk-based asset ratio of 10.77% for the Bank, is more than regulatory guidelines. The Bank’s leverage ratio of 8.66% is also in excess of regulatory guidelines. Under Basel III, the common equity tier I capital to risk weighted assets ratio is also well above the required 4.5% and 6.5% well capitalized levels with the Bank at 10.77%. Adding on the required capital conservation buffer of 2.5% to the previous regulatory ratios and the Bank remains well above the requirements. The Bank’s capital conservation buffer is 3.73%. For further discussion and analysis of regulatory capital requirements, refer to Note 16 of the Consolidated Audited Financial Statements.

The Company’s subsidiary is 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 amounts.

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