ORRSTOWN FINANCIAL SERVICES INC (ORRF) FY 2023 MD&A

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

The following discussion and analysis is intended to assist readers in understanding the consolidated financial condition and results of operations of the Company and should be read in conjunction with our Consolidated Financial Statements and notes thereto included in this Annual Report on Form 10-K. Certain prior period amounts presented in this discussion and analysis have been reclassified to conform to current period classifications. These reclassifications did not have a material impact on the Company's consolidated financial condition, results of operations or statement of consolidated cash flows.

Overview

The Company, headquartered in Shippensburg, Pennsylvania, is a one-bank holding company that has elected status as a financial holding company. The consolidated financial information presented herein reflects the Company and its wholly-owned subsidiary, the Bank. At December 31, 2023, the Company had total assets of $3.1 billion, total liabilities of $2.8 billion and total shareholders' equity of $265.1 million as reported in the consolidated balance sheets.

The Company's primary source of income is net interest income, which is the difference between interest earned on its interest earning assets, such as loans and investment securities, and interest paid on its interest-bearing liabilities that includes deposits and borrowings. The Company's results of operations are impacted by economic conditions and market interest rates. Our profitability for the years ended December 31, 2023, 2022 and 2021 was primarily influenced by our continued organic growth and ongoing expansion into targeted markets and the rising interest rate environment.

On December 12, 2023, the Company entered into an agreement and plan to merge with Codorus Valley. For the year ended December 31, 2023, the Company incurred merger-related expenses of $1.1 million, which was included in non-interest expenses in the consolidated statements of income under Part II, Item 8, "Financial Statements and Supplemental Data."

During 2022, the Company agreed to settle a litigation matter, which resulted in a provision for legal settlement ("legal settlement") of $13.0 million, before the tax effect, and the Company announced that five branch locations in Pennsylvania would be closing and staffing model adjustments would be made to drive long-term growth and improve operating efficiencies in 2023 and forward. As a result of these initiatives, the Company recorded a pre-tax restructuring charge of $3.2 million. Both the legal settlement and the restructuring charge were included in non-interest expenses in the consolidated statements of income under Part II, Item 8, "Financial Statements and Supplemental Data."

Critical Accounting Estimates

The Company's consolidated financial statements are prepared in accordance with GAAP and follow general practices within the financial services industry. The most significant accounting policies followed by the Company are presented in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." In applying those accounting policies, the Company's management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. Certain of the critical accounting estimates are more dependent on such judgment and, in some cases, may contribute to volatility in our reported financial performance should the assumptions and estimates used change over time due to changes in circumstances. Some of the more significant areas in which the Company's management applies critical assumptions and estimates include the following:

Accounting for Credit Losses - Loans

The ACL represents the amount that, in management’s judgment, appropriately reflects credit losses inherent in the loan portfolio at the balance sheet date. A provision for credit losses is recorded to adjust the level of the ACL as determined by management. On January 1, 2023, the Company adopted ASU 2016-13, the current expected credit losses accounting standard commonly referred to as "CECL," which replaces the incurred loss model with the lifetime expected loss model. The CECL methodology requires an organization to measure all expected credit losses over the contractual term for financial assets measured at amortized cost based on historical credit loss experience, current conditions, and reasonable and supportable forecasts.

Determining the ACL inherently involves a high degree of subjectivity and requires the Company to make significant estimates of current credit risks and trends, all of which may undergo material changes, including expected probabilities of default, expected loss given default, the timing of expected future cash flows including the impact from unexpected changes in prepayment speeds, estimated losses based on historical credit loss experience and forecasted economic conditions. To the

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extent actual results differ from management's estimates, additional provisions for credit losses may be required that could adversely impact results of operations and regulatory capital in future periods.

The ACL is maintained at a level considered appropriate to absorb credit losses over the expected life of the loan. The ACL for expected credit losses is determined based on a quantitative assessment of two categories of loans: collectively evaluated loans and individually evaluated loans. In addition, the ACL also includes a qualitative component, which adjusts the CECL model results for risk factors that are not considered within the CECL model, but are relevant in assessing the expected credit losses within the loan classes.

The ACL on loans is measured on a collective basis when similar risk characteristics exist within the Company's loan segments between commercial and consumer. Each of these loan segments are broken down into multiple loan classes, which are characterized by loan type, collateral type, risk attributions and the manner in which management monitors the performance of the borrower. The risks associated with lending activities differ and are subject to the impact of changes in interest rates, market conditions, the collateral securing the loans, and general economic conditions.

The ACL for loans collectively evaluated is measured using a lifetime expected loss rate model that considers historical loss performance and past events in addition to forecasts of future economic conditions. Based on management's analysis, adjustments may be applied for additional factors impacting the risk of loss in the loan portfolio beyond the quantitatively calculated reserve on collectively evaluated loans. As the quantitative reserve calculation incorporates historical conditions, management may consider an additional or reduced reserve is warranted through qualitative risk factors based on current and expected conditions. Management uses the best available information to complete these evaluations; however, future adjustments to the ACL may be necessary if conditions significantly differ from the assumptions used in making the evaluations.

Utilizing a third-party vendor, the ACL for loans collectively evaluated is measured using a lifetime expected loss rate model under the vendor's neutral scenario that considers historical loss performance and past events in addition to forecasts of future economic conditions. The Company elected to use the discounted cash flow ("DCF") methodology for the quantitative analysis for the majority of its loan segments, which applies the probability of default to future cash flows, using a loss driver model and loss given default factors, and then adjusts to the net present value to derive the required reserve. The probability of default estimates are derived through the application of reasonable and supportable economic forecasts to the regression models, which incorporates the Company's and peer loss-rate data, unemployment rate and GDP and can be obtained from the Federal Reserve Economic Database. The reasonable and supportable forecasts of the selected economic metrics are then input into the regression model to calculate an expected default rate. The expected default rates are then applied to expected loan balances estimated through the consideration of contractual repayment terms and expected prepayments. The prepayment and curtailment assumptions adjust the contractual terms of the loan to arrive at the expected cash flows, which are obtained from the third-party vendor. The model incorporates an annualized prepayment rate and a twelve-month rate for curtailment based on a "statistical tendency to repay." Changes in the prepayment and curtailment speeds that vary from the current model inputs could result in an inaccurate of expected credit losses. The development and validation of credit models also included determining the length of the reasonable and supportable forecast and regression period and utilizing national peer group historical loss rates, which a four-quarter forecast period followed by a four-quarter straight-line reversion period were applied.

Management selected the national unemployment rate and GDP as the drivers of the quantitative portion of collectively evaluated reserves on loan classes reliant upon the DCF methodology, primarily as a result of high correlation coefficients identified in regression modeling, which represents a significant judgment in determining the ACL; however, changes in the macroeconomic forecast could significantly impact the calculated ACL. For the consumer loan segment, the quantitative reserve was calculated using the remaining life methodology where the average historical bank-specific and peer loss rates are applied to expected loan balances over an estimated remaining life of loans. The estimated remaining life is calculated using historical bank-specific loan attrition data.

See Note 1, Summary of Significant Accounting Policies, and Note 4, Loans and Allowance for Credit Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplemental Data," for details on the ACL evaluation.

Accounting for Income Taxes

The Company is subject to federal and state income taxes in the jurisdictions in which it operates. Due to the complexity of the tax laws, management may make judgments in computing income tax expense, which are subject to varying interpretations by management and the taxing authorities, and could result in changes upon final determination. Income tax expense is based upon income before taxes, adjusted for the effect of certain tax-exempt income, non-deductible expenses and credits. Temporary differences may occur as a result of certain income and expense items being reported in different periods for financial reporting and tax purposes. Deferred taxes are calculated, using the applicable enacted marginal tax rate, based on the differences between the tax basis and carrying value of the asset or liability on the financial statement. The Company

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recognizes, when applicable, interest and penalties related to unrecognized tax benefits in income tax expense in the consolidated statements of income. Under FASB ASC 740, Income Taxes, the Company must apply a more likely than not probability threshold on its tax positions before a financial statement benefit is recognized. A valuation allowance would be recognized if any deferred tax assets were determined to be more likely than not unrecoverable. See Note 8, Income Taxes, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplemental Data," for details on our income tax expense and deferred tax assets and liabilities.

Readers of the Company's consolidated financial statements should be aware that the estimates and assumptions used may need to be updated in future financial presentations for changes in circumstances, business or economic conditions, in order to fairly represent the condition of the Company at that time.

Economic Climate, Inflation and Interest Rates

Preliminary real GDP for the fourth quarter of 2023 increased 3.2% on an annualized basis, which is a decline from 4.9% during the third quarter of 2023; however, it represents an improvement from the annualized increase of 2.7% during the fourth quarter of 2022. The preliminary GDP during the fourth quarter of 2023 reflected increases across multiple sectors including consumer spending and goods, residential fixed assets, exports, federal government spending and private inventory investment. The increase in consumer spending and goods was notable within food services, accommodations, health care, and pharmaceutical products. The increase in residential fixed assets was from new residential structures. Within exports, petroleum and recreational goods and vehicles were the leading factors. Compared to the third quarter of 2023, the offsetting factors resulting in deceleration in real GDP during the fourth quarter included slowdowns in consumer spending, residential fixed assets, private inventory investment and federal government spending. Fluctuation in real GDP in recent periods, due to inflation, credit conditions, supply chain challenges and geopolitical tensions, continues to create uncertainty in the current economic environment. The personal consumption expenditures ("PCE") price index increased by 1.9% in the fourth quarter of 2023, compared to an increase of 2.9% for the final estimate in the third quarter of 2023. Excluding food and energy prices, the PCE price index remained at 2.0% in the fourth quarter of 2023 as compared the third quarter of 2023.

The national unemployment rate was 3.7% in December 2023 compared to 3.8% in September 2023 and 3.5% in December 2022. However, within the Company's geographic footprint, the unemployment rate has decreased considerably in Pennsylvania from 4.3% in December 2022 to 3.5% in December 2023, and decreased in Maryland from 3.0% in December 2022 to 1.9% in December 2023. These decreases in state-wide unemployment rates are consistent with those experienced by the counties in which the Company operates branches and other corporate offices. There continued to be notable job gains nationally in healthcare, leisure and hospitality, professional, scientific and technical services, and government during the fourth quarter of 2023.

At both December 31, 2023 and 2022, the 10-year Treasury bond yield was 3.88%; however, it ranged from 3.30% to 4.98% during 2023 due to uncertain economic conditions and inflationary pressures. In an attempt to combat the impact of inflation, the rising consumer price index, supply chain disruptions, and labor market and geopolitical tensions, the FOMC approved increases to the Fed Funds rate totaling 525 basis points since March 2022 through the date of this report. In December of 2023, the FOMC signaled its intention to reduce interest rates in 2024, contingent upon inflation settling at its 2.0% target.

The majority of the assets and liabilities of a financial institution are monetary in nature and, therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an impact on the Company, particularly with respect to the growth of total assets and noninterest expenses, which tend to rise during periods of general inflation. Risks also exist due to supply and demand imbalances, employment shortages, the interest rate environment, and geopolitical tensions. It is reasonably foreseeable that estimates made in the financial statements could be materially and adversely impacted in the near term as a result of these conditions, including expected credit losses on loans and the fair value of financial instruments that are carried at fair value.

As the Company’s balance sheet consists primarily of financial instruments, interest income and interest expense are greatly influenced by the level of interest rates and the slope of the yield curve, as well as the mix of assets and funding. The Company has been able to grow its net interest income by $5.3 million from 2022 to 2023 due to organic commercial loan growth and rising interest rates, despite the decrease of $5.9 million in SBA PPP interest income from the prior year. Competition for quality lending opportunities and deposits remains intense, which, together with an inverted yield curve, will continue to challenge the Company's ability to grow its net interest margin and to manage its overhead expenses.

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Beginning in March 2023, the banking industry experienced disruption from the failures of multiple regional U.S. banking institutions, each due to unique circumstances related to risk management of liquidity, interest, and capital and associated stress on deposits and unrealized losses on investment securities. These events led to a decline of confidence in the banking industry, which has since subsided, and overall economic uncertainty, which is expected to result in increased regulatory oversight and policymaking. The industry has experienced a significant increase in competition and pricing on deposits, which has driven funding costs higher. Although the Company was not materially impacted by these events during the year ended December 31, 2023, the Company has continued to assess its funding sources and analyze its liquidity position, interest rate sensitivity and capital adequacy, while also monitoring the ongoing events and volatility in the banking industry.

Results of Operations

Summary

Net income totaled $35.7 million, $22.0 million and $32.9 million for 2023, 2022 and 2021, respectively. Diluted earnings per share totaled $3.42, $2.06 and $2.96 for 2023, 2022 and 2021, respectively. Excluding merger-related expenses of $1.1 million, for the year ended December 31, 2023, net income totaled $36.6 million and diluted earnings per share totaled $3.51 compared to net income of $34.8 million and diluted earnings per share of $3.25 for the year ended December 31, 2022, excluding the legal settlement and restructuring expenses. See “Supplemental Reporting of Non-GAAP Measures.”

Net interest income totaled $104.9 million, $99.6 million and $87.0 million for 2023, 2022 and 2021, respectively. During 2023 and 2022, the increase in net interest income reflected the deployment of cash into higher yielding commercial loans and investment securities and the impact of the rising interest rates on interest-earning asset yields, partially offset by the impact of an increase in cost of funds and increases in interest-bearing liabilities. During 2021, net interest income benefited from the Company's expanded geographic footprint, organic growth in commercial loans from an increased sales force as the Company continued to take advantage of market opportunities, and SBA PPP interest income. For 2023, 2022 and 2021, interest income recognized on SBA PPP loans totaled $192 thousand, $6.1 million and $16.8 million, respectively.

The provision for credit losses on loans totaled $1.7 million, $4.2 million and $1.1 million in 2023, 2022 and 2021, respectively. During the first quarter of 2023, the Company adopted the new accounting standard for CECL, which resulted in the change from the incurred loss model based on historical loss experience to the expected loss model, which reflects the expected credit losses over the expected life of financial assets and commitments.

Noninterest income totaled $25.7 million, $27.0 million and $29.2 million for 2023, 2022 and 2021, respectively. The decrease of $1.3 million from 2022 to 2023 was primarily due to a decrease of $1.6 million in swap fee income, partially offset by an increase in mortgage banking activities of $184 thousand. The decrease in noninterest income of $2.2 million from 2021 to 2022 was primarily due to a decrease in mortgage banking activities of $5.5 million, which was partially offset by increases in swap fee income of $2.3 million and other income of $1.1 million. Other income in 2022 included realized gains on the Company's investment in a non-housing limited partnership of $1.1 million.

Noninterest expenses totaled $83.8 million, $95.8 million and $74.1 million for 2023, 2022 and 2021, respectively. The decrease of $12.0 million from 2022 to 2023 was primarily due to a legal settlement of $13.0 million and a restructuring charge of $3.2 million during 2022, partially offset by an increase of $3.0 million in salaries and employee benefits expense and merger-related expenses of $1.1 million during 2023. The increase of $21.7 million in non-interest expenses from 2021 to 2022 was due to the aforementioned legal settlement and restructuring charge and an increase of $4.0 million in salaries and employee benefits expenses.

Income tax expense totaled $9.4 million, $4.6 million and $8.0 million for 2023, 2022 and 2021, or an effective tax rate of 20.8%, 17.2% and 19.6% respectively. The Company’s effective tax rate is less than the 21% federal statutory rate due to tax-exempt income, including interest earned on tax-exempt loans and investment securities and income from life insurance policies and tax credits. The increase in the effective tax rate in 2023 was primarily due to an increase in taxable income compared to the prior year due to the legal settlement and restructuring charge in 2022. In addition, the effective tax rate increased in 2023 due to the portion of interest expense disallowed as a deduction against earnings under the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA") and an increase in state taxes as a result of a greater percentage of taxable income earned in a state with a state income tax. The difference in the effective tax rate in 2022 from 2021 was primarily due to a decrease in taxable income resulting from the legal settlement and restructuring charge, an increase in tax-exempt interest income on loans and investment securities due to the higher interest rate environment, and additional tax credits.

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Net Interest Income

Net interest income is the primary component of the Company's net income. Interest-earning assets include loans, investment securities and interest-bearing bank balances. Interest-bearing liabilities include primarily deposits and borrowed funds.

Net interest income is affected by changes in interest rates, the volume of interest-earning assets and interest-bearing liabilities, and the composition of those assets and liabilities. “Net interest spread” and “net interest margin” are two common statistics related to changes in net interest income. Net interest spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. Net interest margin is the ratio of net interest income to average earning asset balances.

The FRB influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Starting in March 2022, the FOMC increased the Fed Fund rate by 425 basis points during 2022 and 100 basis points during 2023 as an attempt to combat the impact of inflation, the rising consumer price index, supply chain disruptions, the state of the labor market and geopolitical tensions.

Core deposits are deposits that are stable, lower cost and generally reprice more slowly than other deposits when interest rates change. Core deposits, which exclude certificates of deposit, are typically funds of local clients who also have a borrowing or other relationship with the Bank. The Company is primarily funded by core deposits, with noninterest-bearing demand deposits historically being a source of funds. During 2022, the lower-cost funding base had a positive impact on the Bank's net interest income and net interest margin in the rising interest rate environment. However, as the Fed Fund rate continued to increase, the competition for deposits also increased in the latter part of 2022 and continued throughout 2023 with clients utilizing their funds at a higher frequency and additional liquidity was needed to meet the demands of our clients. In addition, decreases in demand deposits and savings deposits were primarily due to clients shifting to higher-yielding products within the Bank, including time deposits with promotional offerings of up to 18-month terms. The Bank is currently liability sensitive as interest bearing liabilities are expected to reprice faster than interest earning assets.

The following table presents net interest income, net interest spread and net interest margin on a taxable-equivalent basis for 2023, 2022 and 2021. Taxable-equivalent adjustments are the result of increasing income from tax-exempt loans and investment securities by an amount equal to the taxes that would be paid if the income were fully taxable based on a 21% federal corporate tax rate for 2023, 2022 and 2021, reflecting our statutory tax rates for those years.

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The following table presents changes in net interest income on a taxable-equivalent basis for 2023 and 2022 by rate and volume components.

2023 versus 2022

Net interest income increased by $5.3 million, or 5%, from $99.6 million in 2022 to $104.9 million in 2023. Similarly, net interest income on a taxable-equivalent basis for 2023 increased by $5.3 million, or 5%, compared with 2022. The Company’s net interest spread decreased by 31 basis points from 3.70% in 2022 to 3.39% in 2023 primarily due to the increase in the cost of funds.

Interest income on loans increased by $33.1 million, from $93.5 million in 2022 to $126.6 million in 2023, and interest income on investment securities increased by $7.1 million, from $14.4 million in 2022 to $21.5 million in 2023. Total interest expense increased by $36.0 million from $9.0 million in 2022 to $45.0 million in 2023. Interest expense on deposits increased by $31.2 million from $6.3 million in 2022 to $37.5 million in 2023, and interest expense on borrowed funds increased by $4.8 million to $2.6 million in 2022 to $7.4 million in 2023.

Taxable-equivalent net interest margin decreased by one basis point to 3.80% in 2023 from 3.81% in 2022. The taxable-equivalent yield on interest-earning assets increased by 125 basis points to 5.40% in 2023 from 4.15% in 2022, reflecting both the deployment of cash into higher yielding loans and investment securities and the impact of elevated interest rates on these interest-earning assets. The increase in yield was partially offset by an increase of 157 basis points in the cost of interest-bearing liabilities from 0.45% in 2022 to 2.02% in 2023 due to increased funding costs from higher market interest rates, competitive pressures and an increase in higher cost borrowings.

Average loans increased by $197.2 million from $2.0 billion during 2022 to $2.2 billion during 2023. Average investment securities increased by $10.9 million from $509.6 million in 2022 to $520.5 million during 2023 due to net investment purchases and a decrease in unrealized losses from 2022. Average interest-bearing liabilities increased by $241.3 million from $2.0 billion in 2022 to $2.2 billion during 2023. The competition for deposits increased in the latter part of 2022 and continued throughout 2023, which was coupled with clients utilizing their funds at a higher frequency. Therefore, additional liquidity was needed to meet demands of our clients, which resulted in an increase in higher cost borrowings.

The yield on loans increased by 109 basis points to 5.68% in 2023 from 4.59% in 2022. Taxable-equivalent interest income earned on loans increased by $33.3 million from $93.8 million in 2022 to $127.1 million in 2023 primarily due to an

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increase in the average balances of commercial, residential mortgage and home equity loans and from the impact of the rising rate environment. The increase in interest income from loan growth and higher rates was partially offset by a decrease in interest income from SBA PPP loans due to a lower amount of forgiveness activity during 2023 compared to 2022.

The average balance of commercial loans, excluding SBA PPP loans, increased by $211.9 million from $1.6 billion during 2022 to $1.8 billion during 2023. SBA PPP loans, net of deferred fees and costs, averaged $8.8 million during 2023, a decrease of $58.3 million from an average of $67.1 million in 2022. This decrease was due to forgiveness of SBA PPP loans since 2022. Average residential mortgage loans increased by $35.7 million from $211.0 million for 2022 to $246.7 million for 2023 due primarily to adjustable-rate and jumbo mortgage loans originated for the portfolio. Average home equity loans increased by $14.1 million from $175.5 million for 2022 to $189.6 million for 2023. Average installment and other consumer loans decreased by $6.3 million from $26.3 million for 2022 to $20.0 million for 2023.

For 2023, interest income on loans included $192 thousand of interest and net deferred fee income associated with the SBA PPP loans compared to $6.1 million for 2022. Accretion of purchase accounting adjustments included in interest income was $748 thousand during 2023 compared to $1.1 million in 2022. The decrease in accretion was due to a decline in accelerated accretion from acquired loan payoffs or significant payments from the prior year. During 2023, accelerated accretion was $269 thousand compared to $724 thousand in 2022. Prepayment income on commercial loans decreased from $1.0 million during 2022 to $826 thousand during 2023.

Interest income on investment securities on a tax-equivalent basis increased by $7.0 million to $22.4 million for 2023 from $15.4 million for 2022, with the taxable equivalent yield increasing by 128 basis points from 3.03% for 2022 to 4.31% for 2023. The increase reflects the impact from higher interest rates since March 2022 and the impact of investment security purchases at higher yields. The average balance of investment securities was impacted by purchases of $45.6 million and unrealized gains of $14.0 million, which were partially offset by investment security sales totaling $22.0 million during 2023.

The average balance of federal funds sold and interest-bearing bank balances decreased by $57.9 million from $98.8 million for 2022 to $40.9 million for 2023, due primarily to the deployment of cash into loans and investment securities. The related interest income increased by $1.0 million to $1.8 million for 2023 from $774 thousand for 2022. This increase was caused by 525 basis points of Fed Funds rate increases by the FOMC since March 2022.

Interest expense on deposits increased by $31.2 million from $6.3 million in 2022 to $37.5 million in 2023. The average balance of interest-bearing deposits increased by $141.4 million from $1.9 billion in 2022 to $2.1 billion 2023 and the cost of funds increased by 149 basis points from 0.33% in 2022 to 1.82% in 2023. Average time deposits increased $64.9 million in 2023, which the change in volume increased interest expense on time deposits by $401 thousand. The cost of time deposits increased by 233 basis points from 0.62% in 2022 to 2.95% in 2023 as clients sought higher-yielding products during the rising interest rate environment, including the Bank's promotional offerings for time deposits with terms up to 18-months. Average interest-bearing demand deposits increased by $111.0 million in 2023. Interest expense for interest-bearing demand deposits increased by $22.6 million, with the cost of funds increasing by 147 basis points from 0.30% in 2022 to 1.77% in 2023 as a result of deposit rate increases during 2023.

Interest expense on borrowings increased by $4.8 million to $7.4 million in 2023 from $2.6 million in 2022, as the cost of borrowings increased by 31 basis points from 4.01% in 2022 to 4.32% in 2023. Average borrowings increased by $108.0 million from $15.7 million in 2022 to $123.7 million in 2023, as the Bank opted to borrow funds to provide additional liquidity to meet the credit needs of its clients. On December 31, 2023, the Company's subordinated notes converted from a fixed rate at 6.0% to a floating rate of interest at 90-day average fallback SOFR rate plus 3.16%, or 8.78%.

2022 versus 2021

Net interest income increased by $12.6 million, or 15%, from $87.0 million in 2021 to $99.6 million in 2022. Net interest income for 2022 on a taxable-equivalent basis increased by $13.1 million, or 15%, compared with 2021. The Company’s net interest spread increased by 53 basis points from 3.17% in 2021 to 3.70% in 2022.

Interest income on loans increased by $9.3 million, from $84.2 million in 2021 to $93.5 million in 2022, and interest income on investment securities increased by $5.3 million, from $9.1 million in 2021 to $14.4 million in 2022. Total interest expense increased by $2.3 million from $6.7 million in 2021 to $9.0 million in 2022.

Taxable-equivalent net interest margin increased by 56 basis points to 3.81% in 2022 from 3.25% in 2021.The taxable-equivalent yield on interest-earning assets increased by 65 basis points to 4.15% in 2022 from 3.50% in 2021, which reflects the deployment of cash into higher yielding loans and investment securities, as well as the rising interest rates on the loans and investment securities portfolios, which were partially offset by the increase of 12 basis points in the cost of interest-bearing liabilities from 2021 to 2022. The cost of interest-bearing liabilities increased from 0.33% in 2021 to 0.45% in 2022 reflecting

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an increase to deposit rates due to the rising rate environment, partially offset by the runoff in higher cost time deposit balances. In 2021, the Company repaid its overnight borrowings, resulting in a decrease in interest expense.

Average loans increased by $57.1 million, and remained at $2.0 billion during 2022 and 2021, due to commercial and home equity loan growth, but was partially offset by the impact of SBA PPP loan forgiveness. Average investment securities increased by $47.6 million from $462.0 million in 2021 to $509.6 million during 2022 due to investment purchases. Average interest-bearing liabilities decreased by $61.0 million from $2.1 billion in 2021 to $2.0 billion during 2022 due primarily to a decrease in average balances in time deposits and overnight borrowings.

The yield on loans increased by 34 basis points to 4.59% in 2022 from 4.25% in 2021. Taxable-equivalent interest income earned on loans increased by $9.3 million, or 11%, year-over-year, primarily due to an increase in the average balances of commercial and home equity loans, excluding SBA PPP loans, and the impact of the rising rate environment. The increase in interest income from loan growth and higher rates was partially offset by a decrease in interest income from SBA PPP loans due to reduced fee income as a lower amount of SBA PPP loans were forgiven during 2022 compared to 2021.

The average balance of commercial loans, excluding SBA PPP loans, increased by $352.1 million from $1.2 billion during 2021 to $1.6 billion during 2022. SBA PPP loans, net of deferred fees and costs, averaged $67.1 million during 2022, a decrease of $299.7 million from an average of $366.8 million in 2021. This decrease was due to the forgiveness of SBA PPP loans since 2021. Average home equity loans increased by $19.1 million from $156.4 million for 2021 to $175.5 million for 2022. Average installment and other consumer loans decreased by $12.9 million from $39.2 million for 2021 to $26.3 million for 2022.

For 2022, interest income on loans included $6.1 million of interest and net deferred fee income associated with the SBA PPP loans compared to $16.8 million for 2021. Accretion of purchase accounting adjustments included in interest income was $1.1 million during 2022 compared to $1.7 million in 2021. The decrease in accretion was partially due to a decline from the prior year in accelerated accretion from acquired loan payoffs or significant payments. During 2022, accelerated accretion was $724 thousand compared to $1.1 million in 2021. Prepayment income on commercial loans increased slightly by $109 thousand to $1.0 million during 2022 from $926 thousand in 2021.

Interest income on investment securities on a tax-equivalent basis increased by $5.6 million to $15.4 million for 2022 from $9.8 million for 2021, with the taxable equivalent yield increasing by 91 basis points from 2.12% for 2021 to 3.03% for 2022. The increase reflects the impact from higher interest rates in 2022 and investment security purchases at higher yields. The purchases of $181.5 million were partially offset by investment security sales totaling $31.3 million and unrealized losses of $55.2 million during 2022.

The average balance of federal funds sold and interest-bearing bank balances decreased by $160.0 million from $258.8 million for 2021 to $98.8 million for 2022, due primarily to the deployment of cash into loans and investment securities. The related interest income increased by $421 thousand to $774 thousand for 2022 from $353 thousand for 2021. This increase was caused by the increase in the interest rate at the FRB as a result of multiple Fed Funds rate increases by the FOMC during 2022.

Interest expense on interest-bearing liabilities increased by $2.3 million year-over-year due to the increase in the cost of interest-bearing liabilities by 12 basis points from 0.33% for 2021 to 0.45% for 2022. This increase is due to deposit rate increases made in 2022, partially offset by the impact of a decrease in the average balance of interest-bearing deposits of $61.0 million that resulted from continued runoff of certificates of deposit and the zero balance in overnight borrowings for the majority of 2022 following repayment of overnight borrowings in the third quarter of 2021.

The average balance of interest-bearing deposits decreased by $35.5 million from $2.0 billion in 2021 to $1.9 billion 2022; however, the cost of funds increased by 12 basis points from 0.21% in 2021 to 0.33% in 2022. Average time deposits decreased $87.0 million, or 24%, in 2022, which decrease in volume reduced interest expense on time deposits by $654 thousand. The cost of time deposits declined by 13 basis points from 0.75% in 2021 to 0.62% in 2022 as higher yielding time deposits matured. Average interest-bearing demand deposits increased by $21.2 million in 2022. Interest expense for interest-bearing demand deposits increased by $3.0 million, with the cost of funds increasing from 0.09% in 2021 to 0.30% in 2022 as a result of deposit rate increases during 2022.

Interest expense on borrowings increased by $164 thousand in 2022 from 2021, despite the decrease of $24.9 million in the average balance of FHLB advances from $40.6 million in 2021 to $15.7 million in 2022. This was due primarily to the increase in interest rates on overnight borrowings during the fourth quarter of 2022.

Provision for Credit Losses

The Company recorded a provision for credit losses of $1.7 million, $4.2 million and $1.1 million in 2023, 2022 and 2021, respectively. On January 1, 2023, the Company adopted the new accounting standard, referred to as CECL, which

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transitioned from the incurred loss model based on historical loss experience and economic and market conditions to the expected loss model. The CECL standard reflects expected credit losses over the expected life of the financial assets and commitments, primarily based on the DCF methodology for the majority of the loan segments, which applies the probability of default and loss given default factors to future cash flows, and adjusts to the net present value to derive the required reserve. Macroeconomic conditions are incorporated into the model for unemployment and gross domestic product, in addition to model assumptions for discount rate and prepayment and curtailment speeds.

In 2023, 2022 and 2021, the provision for credit losses was driven primarily by increases in commercial loans, excluding SBA PPP loan forgiveness activity, of $118.3 million, $299.9 million and $268.4 million, respectively, in addition to the overall increase in expected loss rates under CECL. The ACL to total loan ratio increased from 1.17% at December 31, 2022 to 1.25% at December 31, 2023, which is primarily due to the cumulative effect adjustment of $2.4 million recorded in connection with the adoption of CECL. During 2023, the Delinquency and Classified Loan Trends qualitative factor was increased for the commercial & industrial and owner-occupied commercial real estate loan classes, which was based on a trend of increases in loans downgraded to the special mention or classified risk rating. All other qualitative factors were unchanged from levels at adoption of CECL. During 2022, qualitative factors were unchanged, except for a reduction in the National and Local Economic Conditions factor, that reduced the provision by $726 thousand. The provision for loan losses during 2021 included a reversal of the COVID-19 qualitative reserve of $2.7 million, which was created in 2020 due to the potential impact from the COVID-19 pandemic. This reserve was fully reversed in 2021 based on the sustained performance of the impacted borrowers resulting in a decline in the provision for loan losses in 2021 compared to 2020.

Net charge-offs totaled $581 thousand in 2023, compared to net charge-offs of $162 thousand in 2022. The increase in net charge-offs was due primarily to three commercial and industrial relationships with partial charge-offs totaling $740 thousand during 2023, partially offset by the impact of recoveries. Nonaccrual loans were 1.11% of gross loans at December 31, 2023, compared with 0.96% of gross loans at December 31, 2022. Nonaccrual loans increased by $4.9 million from $20.6 million at December 31, 2022 to $25.5 million at December 31, 2023 due primarily to additions of $8.5 million and transfers to non-accrual of $931 thousand due to the treatment of PCD loans at the individual asset level under CECL, partially offset by payments of $3.6 million, charge-offs of $909 thousand and loans returned to accrual status of $401 thousand.

See further discussion in the “Asset Quality” and “Credit Risk Management” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Noninterest Income

The following table compares noninterest income for 2023, 2022 and 2021.

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2023 versus 2022

Noninterest income decreased by $1.3 million from 2022 to 2023. The following were significant factors in the net decrease:

•Other service charges, commissions and fees increased by $129 thousand, or 16%, due primarily to increases of $58 thousand in credit card fee income and $51 thousand in loan fees charged to clients for loan workout and forbearance agreements.

•Swap fee income decreased by $1.6 million, or 61%, as swap fee income will fluctuate based on market conditions and client demand.

•Mortgage banking income increased by $184 thousand, or 45%, from 2022 to 2023 due to a decline in the fair value losses on the Bank's held-for-sale loans caused by a significant increase in mortgage interest rates during 2022 compared to the fluctuation during the current year. The fair value mark declined $323 thousand in 2023 compared to a decrease of $1.3 million in 2022. However, market conditions and elevated interest rates continued to hinder mortgage production during 2023. Most mortgage production remains in adjustable-rate products, which are held in portfolio, and thus have resulted in a reduction in the residential mortgage loan pipeline and secondary market sales. Mortgage loans sold totaled $23.8 million during 2023 compared to $76.2 million during 2022.

•Other income decreased by $306 thousand, or 17%, from 2022 to 2023 primarily due to distribution of $964 thousand from investments in non-housing limited partnerships, gains on the sales of two SBA loans totaling $306 thousand and tax credits of $102 thousand recognized from the Bank's investment in solar energy renewable energy partnerships during 2022, partially offset by a gain of $1.1 million from the sale of the Bank's Path Valley branch during 2023.

•Investment securities losses declined by $113 thousand due primarily to a loss of $171 thousand during 2022 recorded on one non-agency CMO security, which was called at a price below par. During 2023, the Company sold three U.S. Treasury securities with a principal balance of $19.9 million for a nominal gain and six securities issued by state and political subdivisions with a principal balance of $2.2 million for a net loss of $44 thousand. During the year ended December 31, 2022, the Company sold 19 securities with a principal balance of $31.3 million for a net gain of $32 thousand.

2022 versus 2021

Noninterest income decreased by $2.2 million from 2021 to 2022. The following were significant factors in the net decrease:

•Service charges on deposit accounts increased by $779 thousand, or 26%, due to higher customer transaction activity as the economy continued to recover from the COVID-19 pandemic during 2022 and changes to the deposit fee structure that took effect in April 2022.

•Other service charges, commissions and fees increased by $142 thousand, or 22%, due primarily to increases of $49 thousand in letters of credit fees, ATM fees of $41 thousand and credit card fee income of $38 thousand.

•Swap fee income increased by $2.3 million, or 798%, which fluctuates based on market conditions and client demand.

•Mortgage banking income decreased by $5.5 million, or 93%, from 2021 to 2022 due to a significant decline in the gains on sale and fair value of the held-for-sale mortgages caused by market conditions, which included rapidly rising interest rates and lower housing inventory during 2022. In addition, the difficult mortgage market caused a slowdown in residential mortgage loan production, thereby causing corresponding reductions in the residential mortgage loan pipeline and secondary market sales year-over-year. The fair value on the held-for-sale mortgages, principally construction-to-permanent loans, decreased by $1.3 million from a gain of $181 thousand in 2021 to a loss of $1.2 million in 2022. Mortgage loans sold totaled $76.2 million in 2022 compared to $200.8 million in 2021. In addition, the Company recorded an MSR valuation reserve reversal of $79 thousand during 2022 compared to a reversal of $987 thousand in 2021, which were due to increases in market rates.

•Other income increased by $1.1 million, or 142%, from 2021 to 2022 primarily due to distributions of $964 thousand from investments in non-housing limited partnerships and an increase in gains on sale of SBA loans of $283 thousand, partially offset by a decrease of $128 thousand in tax credits recognized from the Bank's investment in solar energy renewable energy partnerships.

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•Investment securities losses totaled $160 thousand in 2022 compared to investment securities gains of $638 thousand in 2021. During 2022, the Company recorded a loss of $171 thousand on one non-agency CMO security which was called at a price below par. This realized loss was partially offset by the sale of $31.3 million of municipal securities, which resulted in a gain of $32 thousand. During 2021, the Company sold $148.4 million of commercial mortgage-backed securities and asset-backed securities for a net gain of $609 thousand.

Noninterest Expenses

The following table compares noninterest expenses for 2023, 2022 and 2021.

2023 versus 2022

Noninterest expenses decreased by $12.0 million from 2022 to 2023. The following were significant factors in the net decrease:

•Salaries and employee benefits expense increased by $3.0 million, or 6%, due primarily to staff additions that filled vacancies, merit-based and incentive compensation increases, higher employee benefit costs from increased claims volume and employee severance costs.

•Occupancy expense decreased by $387 thousand, or 8%, due primarily to operating efficiencies from branch closures in 2022.

•Data processing expense increased by $353 thousand, or 8%, due primarily to an increase in core system costs and investments in new technology as the Company focused on the evolving needs of its clients.

•FDIC insurance expense increased by $877 thousand, or 81%, due to increases in the assessment rate caused by an annualized two-basis point increase assessed by the FDIC to increase its deposit insurance fund and increases commercial loans and total assets.

•Professional services decreased by $349 thousand, or 11%, due primarily to a reduction in legal expenses following the settlement of outstanding litigation.

•Taxes other than income decreased by $341 thousand, or 25%, due to a decrease in the Pennsylvania Bank Shares Tax expense, which was driven by a decrease in the Bank's total equity balance from the increase in unrealized losses on investment securities and charges in the third quarter of 2022 for a legal settlement and restructuring expenses.

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•Intangible asset amortization decreased by $152 thousand, or 14%, due to amortization of the core deposit intangible assets on an accelerated basis.

•During the fourth quarter of 2023, the Company announced it entered into an agreement to merge with Codorus Valley. Merger-related expenses totaled $1.1 million, which included due diligence costs, legal expenses and a fairness opinion.

•The Company agreed to settle a litigation matter, which resulted in a provision for legal settlement of $13.0 million recorded in the third quarter of 2022.

•During the third quarter of 2022, the Company announced that five branch locations would be closing and staffing model adjustments would be made to drive long-term growth and improve operating efficiencies in 2023 and forward. As a result of these initiatives, the Company recorded a restructuring charge of $3.2 million.

2022 versus 2021

Noninterest expenses increased by $21.7 million from 2021 to 2022. The following were significant factors within the net increase:

•Salaries and employee benefit expense increased by $4.0 million, or 9%, due primarily to merit-based and incentive compensation increases, the filling of several vacancies in key positions and higher healthcare costs.

•Data processing expense increased by $499 thousand, or 12%, due primarily to an increase in core system costs and investments in new technology as the Company focuses on the evolving needs of its clients.

•FDIC insurance expense increased by $267 thousand, or 33%, due primarily to an increase in the assessment rate driven by commercial loan growth and a lower deduction from SBA PPP loans due to loan forgiveness.

•Professional services increased by $699 thousand, or 27%, due primarily to an increase in compliance and technology consulting services resulting from vacancies in compliance and technology staff and higher legal expenses partially associated with outstanding litigation.

•Intangible asset amortization decreased by $170 thousand, or 13%, due to amortization of the core deposit intangible assets on an accelerated basis.

•During 2022, the Company agreed to settle a litigation matter, which resulted in a provision for legal settlement of $13.0 million. There were no similar charges in 2021.

•During 2022, the Company announced that five branch locations would be closing and staffing model adjustments would be made to drive long-term growth and improve operating efficiencies in 2023 and forward. As a result of these initiatives, the Company recorded a pre-tax restructuring charge of $3.2 million. There were no similar charges in 2021.

Income Taxes

Income tax expense totaled $9.4 million, $4.6 million and $8.0 million for 2023, 2022 and 2021, respectively. The effective tax rate for 2023 was 20.8% compared with 17.2% for 2022 and 19.6% for 2021. Generally, the Company’s effective tax rate is less than the 21% federal statutory rate due to tax-exempt income, including interest earned on tax-exempt loans and investment securities, income from life insurance policies and tax credits, partially offset by disallowed interest expense and state income taxes. The difference in the effective tax rate in 2023 from prior years was primarily due to an increase in taxable income resulting from the legal settlement and restructuring charge in 2022. In addition, the effective tax rate was increased by the portion of interest expense disallowed as a deduction against earnings under the TEFRA and an increase in state taxes as a result of a greater percentage of taxable income earned in a state with a state income tax.

Note 8, Income Taxes, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data," includes a reconciliation of our federal statutory tax rate to the Company's effective tax rate, which is a meaningful comparison between years and measures income tax expense as a percentage of pretax income.

Financial Condition

Management devotes substantial time to overseeing the investment in and costs to fund loans and investment securities through deposits and borrowings as well as the formulation and adherence to policies directed toward enhancing profitability and managing the risks associated with these investments.

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Investment Securities

The Company utilizes AFS securities to manage interest rate risk, to enhance income through interest and dividend income, and to collateralize certain deposits and borrowings. The AFS securities may also serve as a liquidity source as needed.

The Company has established investment policies and an asset management policy to assist in administering its investment portfolio. Decisions to purchase or sell these securities are based on economic conditions and management’s strategy to respond to changes in interest rates, liquidity, pledges to secure deposits and repurchase agreements and other factors while trying to maximize return on the investments. The Company may segregate its investment portfolio into three categories: “securities held-to-maturity,” “trading securities” and “securities available-for-sale.” At December 31, 2023 and 2022, management has classified the entire investment securities portfolio as AFS, which is accounted for at current market value with non-credit losses and gains reported in OCI, net of income taxes. On January 1, 2023, the Company adopted the new CECL standard in accordance with ASU 2016-13, which changed the accounting framework by replacing the OTTI assessment with the recognition of an ACL.

The Company's investment securities portfolio includes debt investments that are subject to varying degrees of credit and market risks, which arise from general market conditions, and factors impacting specific industries, as well as news that may impact specific issues. Management monitors its debt securities, using various indicators in determining whether unrealized losses on debit securities are credit-related and require an ACL. These indicators include the amount of time the security has been in an unrealized loss position, the cause and extent of the unrealized loss and the credit quality of the issuer and underlying assets. In addition, management assesses whether it is likely the Company will have to sell the security prior to recovery, or it expects to be able to hold the security until the price recovers. The Company determined that the declines in market value were due to increases in interest rates and market movements, and not due to credit factors. The Company does not intend to sell these securities with unrealized losses and it is more likely than not that the Company will not be required to sell them before recovery of their amortized cost basis, which may be maturity. Therefore, the Company has concluded that the unrealized losses on the AFS securities do not require an ACL at December 31, 2023. Under the prior OTTI framework, the Company did not record any cumulative OTTI expense at December 31, 2022 and 2021.

The following table summarizes the fair value of AFS securities at December 31, 2023, 2022 and 2021.

At December 31, 2023, AFS securities totaled $513.5 million, a decrease of $209 thousand, from $513.7 million at December 31, 2022. During 2023, the Company purchased investment securities totaling $45.6 million, which included $19.8 million of U.S. Treasury securities, $15.3 million of agency MBS and CMO securities, $8.9 million of non-agency CMO securities and $972 thousand in asset-backed securities. During 2023, the Company sold three U.S. Treasury securities with a total principal balance of $19.9 million for a nominal gain and six securities issued by state and political subdivisions with a total principal balance of $2.2 million for a net loss of $44 thousand. The sale of the securities issued by state and political subdivisions in net unrealized loss position was to redeploy funds from the lower yielding investment securities to higher yielding assets. The balance of investment securities included net unrealized losses of $35.6 million at December 31, 2023 compared to net unrealized losses of $49.6 million at December 31, 2022 for a reduction in unrealized losses of $14.0 million. The decrease in net unrealized losses was primarily due to lower treasury rates and contracting credit spreads during 2023 compared to 2022. The Company has sufficient access to liquidity such that management does not believe it would be necessary to sell any of its investment securities at a loss to offset any unexpected deposit outflows. Management believes the structure of the Company's investment securities portfolio is appropriately aligned with the remainder of the balance sheet to protect against volatile interest rate environments and to generate steady earnings.

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At December 31, 2022, AFS securities totaled $513.7 million, an increase of $41.3 million, from $472.4 million at December 31, 2021. During 2022, the Company purchased investment securities totaling $181.5 million, which included $73.7 million of municipal securities, $47.5 million of agency MBS and CMO securities, $27.9 million of non-agency CMO securities, $27.6 million of asset-backed securities and $4.9 million of a U.S. government agency security. During 2022, the Company sold 19 municipal securities with a principal balance of $31.3 million for a net gain of $32 thousand and replaced with the aforementioned higher yielding investment securities. The Company recorded a loss of $171 thousand on a call of a non-agency CMO for the year ended December 31, 2022. The balance of investment securities included net unrealized losses of $49.6 million compared to net unrealized gains of $5.6 million at December 31, 2021. This change was due to significant increases in market interest rates and wider credit spreads.

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The following table shows the maturities of investment securities at book value at December 31, 2023, and weighted average yields of such investment securities. Yields are shown on a tax equivalent basis, assuming a 21% federal income tax rate.

The average maturity is based on the contractual terms of the debt or mortgage-backed securities, and does not factor in required repayments or anticipated prepayments. At December 31, 2023, the weighted average estimated life is 33 years for mortgage-backed and CMO securities, and 21 years for asset-backed securities, based on current interest rates and anticipated prepayment speeds. The overall duration of the Company's investment security portfolio is 4.3 years at December 31, 2023.

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The following table summarizes the credit ratings and collateral associated with the Company's AFS investment securities portfolio, excluding equity securities, at December 31, 2023:

Loan Portfolio

The Company offers a variety of products to meet the credit needs of its borrowers, principally commercial real estate loans, commercial and industrial loans, retail loans secured by residential properties, and to a lesser extent, installment loans. No loans are extended to non-domestic borrowers or governments.

Generally, the Bank is permitted under applicable law to make loans to single borrowers (including certain related persons and entities) in aggregate amounts of up to 15% of the sum of total capital and excess ACL not included in Tier 2 capital. The Company's policy has established an internal lending limit of $25.0 million to one borrower, except for commercial real estate loans, which the Company reduced the internal lending limit to $15.0 million on a per project basis beginning in 2023. Credit exposure may be aggregated if loans are under common control or ownership or with common guarantors, for which the internal lending limit is $40.0 million, but not permitted to exceed the regulatory lending limit. These amounts are below the Bank's regulatory lending limit of $47.5 million at December 31, 2023. No borrower had an outstanding exposure exceeding the Bank's legal lending limit at year-end.

The risks associated with lending activities differ among loan segments and classes and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans and general economic conditions. Any of these factors may adversely impact a borrower’s ability to repay loans, and also impact the associated collateral. A further discussion on the Company's loan segments and classes and related risks and the Company's implementation of the new account standard for expected credit losses, referred to as CECL, and FDM are included in Note 1, Summary of Significant Accounting Policies, and Note 4, Loans and Allowance for Credit Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."

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The following table presents the loan portfolio, excluding residential LHFS, by segments and classes at December 31 of each of the years set forth below.

(1) Includes $5.7 million, $13.8 million, $189.9 million, $403.3 million and zero of SBA PPP loans, net of deferred fees and costs, as of December 31, 2023, 2022, 2021, 2020 and 2019, respectively.

Total loans increased by $147.1 million to $2.3 billion at December 31, 2023 from $2.2 billion at December 31, 2022. The increase was due to growth in the commercial real estate loan segment of $146.9 million, residential mortgages of $39.2 million and commercial and industrial loans of $9.3 million, partially offset by a decrease in the acquisition and development loan segment of $43.6 million. The decrease in the acquisition and development loan segment includes construction-to-permanent loans for which construction has been completed or there is a certificate of occupancy, which allows for the transfer of the loan classification to a permanent loan class secured by real estate. Overall loan growth, excluding SBA PPP forgiveness activity of $8.1 million, was $155.2 million or 7% for the year ended December 31, 2023 compared to 2022.

The loan portfolio at December 31, 2022 increased by $171.2 million to $2.2 billion from $2.0 billion at December 31, 2021 due primarily to commercial loan and residential mortgage production, which was offset by SBA PPP loan forgiveness activity of $176.1 million and reductions in installment and other loans in 2022. Overall loan growth, excluding SBA PPP loan forgiveness activity, was $349.0 million or 20% for the year ended December 31, 2022 compared to 2021.

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In addition to monitoring the loan portfolio by loan class as noted above, the Company also monitors concentrations by segment. The Bank’s lending policy reports segment concentrations that exceed 20% of the Bank’s total risk-based capital ("RBC"). The following segments met this criterion at December 31, 2023:

Management regularly analyzes the commercial real estate portfolio, which includes the review of occupancy, cash flows, expenses and expiring leases, as well as the location of the real estate. At December 31, 2023, the Company had $226.5 million in loans related to office space, which had a weighted average loan-to-value ratio of 56% and a weighted average debt coverage ratio of 1.77x. Management believes that the office space portfolio is well-diversified and includes only limited exposure to properties located in major metropolitan markets (approximately 2% of the total commercial real estate loan balance as of December 31, 2023).

The following table presents expected maturities of loan classes by fixed rate or adjustable-rate categories at December 31, 2023.

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The final maturity is used in the determination of maturity of acquisition and development loans that convert from construction to permanent status. Variable rate loans shown above include semi-fixed loans that contractually will adjust with prime or another variable rate index after the interest lock period, which may be up to 10 years. At December 31, 2023, these semi-fixed loans totaled $542.7 million.

Asset Quality

Risk Elements

The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is managed through the Company's underwriting standards, on-going credit reviews, and monitoring of asset quality measures. Additionally, loan portfolio diversification, which limits exposure to a single industry or borrower, and collateral requirements also mitigate the Company's risk of credit loss.

The loan portfolio consists principally of loans to borrowers in south central Pennsylvania and the greater Baltimore, Maryland region. As the majority of loans are concentrated in these geographic regions, a substantial portion of the borrowers' ability to honor their obligations may be affected by the level of economic activity in the market areas.

Nonperforming assets include nonaccrual loans and foreclosed real estate. In addition, loan modifications to borrowers experiencing financial difficulty and loans past due 90 days or more and still accruing are also deemed to be risk assets. For all loan classes, the accrual of interest income on loans, including individually evaluated loans, ceases when principal or interest is past due 90 days or more and collateral is inadequate to cover principal and interest or immediately if, in the opinion of management, full collection is unlikely. Interest will continue to accrue on loans past due 90 days or more if the collateral is adequate to cover principal and interest, and the loan is in the process of collection. Interest accrued, but not collected, as of the date of placement on nonaccrual status, is generally reversed and charged against interest income, unless fully collateralized. Subsequent payments received are either applied to the outstanding principal balance or recorded as interest income, depending on management’s assessment of the ultimate collectability of principal. Loans are returned to accrual status, for all loan classes, when all the principal and interest amounts contractually due are brought current, the loans have performed in accordance with the contractual terms of the note for a reasonable period of time, generally six months, and the ultimate collectability of the total contractual principal and interest is reasonably assured. Past due status is based on contract terms of the loan.

Prior to the adoption of ASU No. 2022-02, Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures ("ASU 2022-02"), loans, the terms of which are modified, were classified as TDRs if a concession was granted for legal or economic reasons related to a borrower’s financial difficulties. Concessions granted under a TDR typically involved a temporary deferral of scheduled loan payments, an extension of a loan’s stated maturity date, temporary reduction in interest rates, or below market rates. If a modification occurred while the loan is on accruing status, it would continue to accrue interest under the modified terms. Nonaccrual TDRs were restored to accrual status if scheduled principal and interest payments, under the modified terms, were current for six months after modification, and the borrower continues to demonstrate its ability to meet the modified terms. TDRs were evaluated individually for impairment if they have been restructured during the most recent calendar year, or if they are not performing according to their modified terms.

ASU 2022-02 eliminated the TDR accounting model, and requires that the Company evaluate, based on the accounting for loan modifications, whether the borrower is experiencing financial difficulty, if the modification results in a more-than-insignificant direct change in the contractual cash flows and if the modified terms represent a new loan or a continuation of an existing loan, which the Company refers to these loans as "financial difficulty modifications" or "FDMs."

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The following table presents the Company’s risk elements and relevant asset quality ratios at December 31 of each of the years set forth below.

(1) During 2023, the Company modified terms for two loans totaling $1.4 million, including one existing nonaccrual loan of $1.4 million, which met the FDM criteria in accordance with ASU 2022-02.

(2) Includes zero, $307 thousand, $214 thousand, $456 thousand and $2.0 million, respectively, of PCI loans at December 31, 2023, 2022, 2021, 2020 and 2019 in accordance with ASU 310-30. Upon adoption of the CECL standard, PCD loans were evaluated on an individual loan level and reported on an individual loan basis under ASU 310-20, Nonrefundable Fees and Other Assets. As of December 31, 2021, there was one loan for $891 thousand, which was in the process of collection and guaranteed by the SBA, and was subsequently collected during the first quarter of 2022.

Nonperforming assets include nonaccrual loans and foreclosed real estate. Risk assets, which include nonperforming assets, FDMs still accruing and loans past due 90 days or more and still accruing, totaled $25.6 million at December 31, 2023, an increase of $3.9 million from $21.7 million at December 31, 2022. Nonaccrual loans increased by $4.9 million from $20.6 million at December 31, 2022 to $25.5 million at December 31, 2023 due primarily to additions of $8.5 million, due primarily to two commercial real estate clients with loans totaling $4.3 million and one commercial and industrial client totaling $1.0 million, and transfers to non-accrual of $931 thousand due to the treatment of PCD loans at the individual asset level under CECL, partially offset by payments of $3.6 million, charge-offs of $909 thousand and loans returned to accrual status of $401 thousand.

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The following table presents the amortized cost basis of nonaccrual loans, according to loan class, with and without reserves on individually evaluated loans at December 31, 2023, as compared to nonaccrual loans at December 31, 2022. At December 31, 2023, there was a specific reserve of $49 thousand on nonaccrual loans compared to no specific reserve on nonaccrual loans at December 31, 2022.

During the second quarter of 2023, the underlying project for a construction-to-permanent loan on nonaccrual status received its certificate of occupancy, which resulted in the recharacterization of the loan from commercial and land development to owner-occupied commercial real estate. The construction-to-permanent loan had a current outstanding balance of $13.4 million and $15.4 million at December 31, 2023 and 2022, respectively.

The information presented above in the nonaccrual loan table and the collateral-dependent table are not required for periods prior to the adoption of CECL. The following table, which excludes accruing PCI loans, presents the most comparable required information at December 31, 2022, which summarizes impaired loans by segment and class, segregated by those for which a specific allowance was required and those for which a specific allowance was not required at December 31, 2022. The recorded investment in loans excludes accrued interest receivable. Related allowances established generally pertain to those loans in which loan forbearance agreements were in the process of being negotiated or updated appraisals were pending, and any partial charge-off will be recorded when final information is received.

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The following table presents our exposure to relationships that are individually evaluated for impairment and the partial charge-offs taken to date and specific reserves established on those relationships at December 31, 2023 and 2022. Accruing PCI loans are excluded from loans individually analyzed for impairment at December 31, 2022. Prior to the adoption of CECL, acquired loans that met the criteria for impairment or nonaccrual of interest prior to the acquisition could be considered performing upon acquisition, regardless of whether the client is contractually delinquent, if the Company expected to fully collect the new carrying value (i.e., fair value) of the loans. As such, the Company may have no longer considered the loan to be nonperforming in accordance with guidance in ASC 310-30. Upon adoption of CECL, the Company elected to account for its PCD loans under ASC 310-20, which required that acquired loans be evaluated on an individual asset level. The election resulted in PCD loans totaling $931 thousand transferred to nonaccrual and included with loans individually evaluated under the CECL methodology.

The Company takes partial charge-offs on collateral-dependent loans when carrying value exceeds estimated fair value, as determined by the most recent appraisal adjusted for current (within the quarter) conditions, less costs to dispose. Specific reserves remain in place if updated appraisals are pending, and represent management’s estimate of potential loss.

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Internal loan reviews are completed annually on all commercial relationships secured by commercial real estate with a committed loan balance in excess of $1.0 million, which review includes confirmation of risk rating by an independent credit officer. In addition, all commercial relationships greater than $500 thousand rated Substandard, Doubtful or Loss are reviewed and corresponding risk ratings are reaffirmed by the Bank's Problem Loan Committee, with subsequent reporting to the Management ERM Committee.

In its individual evaluated loan analysis, the Company determines the extent of any full or partial charge-offs that may be required, or any reserves that may be needed. The determination of the Company’s charge-offs or impairment reserve include an evaluation of the outstanding loan balance and the related collateral securing the credit. Through a combination of collateral securing the loans and partial charge-offs taken to date, the Company believes that it has adequately provided for the potential losses that it may incur on these relationships at December 31, 2023. However, over time, additional information may result in increased reserve allocations or, alternatively, it may be deemed that the reserve allocations exceed those that are needed.

Credit Risk Management

Allowance for Credit Losses

The Company maintains the ACL at a level deemed adequate by management for expected credit losses. As disclosed in Note 1, Summary of Significant Accounting Policies, and Note 4, Loans and Allowance for Credit Losses, on January 1, 2023 the Company implemented CECL and increased the ACL, previously the ALL, with a cumulative-effect adjustment to the ACL of $2.4 million. In addition, the Company recorded a cumulative-effect adjustment to the ACL for off-balance sheet exposures of $100 thousand. The Company’s ACL is calculated quarterly, with any adjustment recorded to the provision for credit losses in the consolidated statement of income. A comprehensive analysis of the ACL is performed by the Company on a quarterly basis. Management evaluates the adequacy of the ACL utilizing a defined methodology to determine if it properly addresses the current and expected risks in the loan portfolio, which considers the performance of borrowers and specific evaluation of individually evaluated loans, including historical loss experiences, trends in delinquencies, nonperforming loans and other risk assets, and the qualitative factors. Risk factors are continuously reviewed and adjusted, as needed, by management when conditions support a change. Management believes its approach properly addresses relevant accounting and bank regulatory guidance for loans both collectively and individually evaluated. The results of the comprehensive analysis, including recommended changes, are governed by the Company's Reserve Adequacy Committee, whose members were also a part of the Company's CECL Committee, and are subsequently presented to the Enterprise Risk Management Committee of the Board of Directors.

The ACL is evaluated based on a review of the collectability of loans in light of historical experience; the nature and volume of the loan portfolio; adverse situations that may affect a borrower’s ability to repay; estimated value of any underlying collateral; and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. A description of the methodology for establishing the allowance and provision for credit losses and related procedures in establishing the appropriate level of reserve is included in Note 4, Loans and Allowance for Credit Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."

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Table of Contents

The following table presents the amortized cost basis of the loan portfolio, by year of origination, loan class, and credit quality, as of December 31, 2023. For residential and consumer loan classes, the Company also evaluates credit quality based on the aging status of the loan and payment activity. Residential mortgage and installment and other consumer loans are presented below based on payment performance: performing or nonperforming. During 2023, commercial and land development loans and 1-4 family residential construction loans totaling $109.3 million and $18.2 million, respectively, were recharacterized to a permanent amortizing loan secured by real estate class upon the completion of construction or receiving a certificate of occupancy.