Note 5 - Loans Receivable, Credit Quality for Loans and the Allowance for Loan Losses

The loan portfolio comprises the major component of Riverview’s earning assets and is the highest yielding asset category. Loans receivable are summarized as follows for the periods presented:


(Dollars in thousands)	June 30, 2016			December 31, 2015
Commercial	$	46,330		$	46,076
Commercial real estate		206,721			205,500
Commercial land and land development		9,166			18,599
Residential real estate		112,514			117,669
Home equity lines of credit		18,909			17,437
Consumer installment		4,853			4,564

Total loans		398,493			409,845
Allowance for loan losses		(3,609	)		(4,365	)

Total loans, net	$	394,884		$	405,480

The Bank takes a balanced approach to its lending activities, managing risk associated with its loan portfolio by maintaining diversification within the portfolio, consistently applying prudent underwriting standards, engaging in ongoing monitoring efforts with attention to portfolio dynamics and mix, and using procedures that are consistently applied and updated on an annual basis. The Bank contracts with an independent third party each year to conduct a credit review of the loan portfolio to provide an independent assessment of asset quality through, among other things, an evaluation of how the Bank’s established underwriting criteria is applied in originating credits. Separately, every loan booked and every loan application turned down undergoes an internal review for conformity with established policies and compliance with lending laws. The Bank has maintained its loan underwriting criteria, and management believes its standards are conservative. All of the Bank’s loans are to domestic borrowers.

The Bank’s management monitors the loan portfolio on a regular basis, performing a detailed analysis of loans by portfolio segment. Portfolio segments represent pools of loans with similar risk characteristics. There are eight portfolio segments - commercial loans; non-owner occupied commercial real estate loans; owner occupied commercial real estate loans; one-to-four family investment property loans; commercial land/land development/construction loans; residential real estate loans; home equity lines of credit; and consumer loans. For the purpose of estimating the allowance for loan losses, purchased loan participations in the segments for commercial loans, non-owner occupied commercial real estate loans, owner occupied commercial real estate loans, one-to-four family investment property loans, and commercial land/land development/construction loans are also separately evaluated. In addition, the Company separately evaluates the acquired Union Bank and Citizens portfolios.

Internal policy requires that the Chief Credit Officer make a quarterly report to the Board of Directors to discuss the status of the loan portfolio and any related credit quality issues. These reports include, but are not limited to, information on past due and nonaccrual loans, impaired loans, the allowance for loan losses, changes in the allowance for loan losses, credit quality indicators and foreclosed assets.

Past Due Loans and Nonaccrual Loans

Loans are considered to be past due when they are not paid in accordance with contractual terms. Past due loans are monitored by portfolio segment and by severity of delinquency: 30-59 days past due; 60-89 days past due; and 90 days and greater past due. The accrual of interest is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. A loan may remain on accrual status if it can be documented that it is well secured and in the process of collection. When a loan is placed on nonaccrual status, all unpaid interest credited to income in the current calendar year is reversed and all unpaid interest accrued in prior calendar years is charged against the allowance for loan losses. Interest payments received on nonaccrual loans are either applied against principal or reported as interest income according to management’s judgment as to the collectability of principal. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with contractual terms for a reasonable period of time and the ultimate collectability of the total contractual principal and interest is no longer in doubt.

The following table presents an aging of loans receivable by loan portfolio segments as of June 30, 2016 and December 31, 2015, and includes nonaccrual loans and loans past due 90 days or more and still accruing:


(In thousands)	30-59 Days Past Due		60-89 Days Past Due		90 Days and Greater		Total Past Due		Current		Total		Recorded Investment Greater Than 90 Days & Accruing
June 30, 2016:
Commercial	$	741	$	1	$	215	$	957	$	45,373	$	46,330	$	—
Commercial real estate:
Non-owner occupied		2,232		—		—		2,232		102,398		104,630		—
Owner occupied		381		—		285		666		76,196		76,862		—
1-4 family investment		130		576		30		736		24,493		25,229		30
Commercial land and land development		218		—		—		218		8,948		9,166		—
Residential real estate		640		194		568		1,402		111,112		112,514		319
Home equity lines of credit		112		30		—		142		18,767		18,909		—
Consumer		1		—		—		1		4,852		4,853		—

Total	$	4,455	$	801	$	1,098	$	6,354	$	392,139	$	398,493	$	349

	30-59 Days Past Due		60-89 Days Past Due		90 Days and Greater		Total Past Due		Current		Total		Recorded Investment Greater Than 90 Days & Accruing
December 31, 2015
Commercial	$	34	$	—	$	1,007	$	1,041	$	45,035	$	46,076	$	—
Commercial real estate:
Non-owner occupied		—		—		24		24		110,431		110,455		—
Owner occupied		172		447		270		889		68,758		69,647		—
1-4 family investment		131		—		265		396		25,002		25,398		—
Commercial land and land development		—		250		—		250		18,349		18,599		—
Residential real estate		1,163		1,025		595		2,783		114,886		117,669		89
Home equity lines of credit		46		412		36		494		16,943		17,437		—
Consumer		10		—		1		11		4,553		4,564		—

Total	$	1,556	$	2,134	$	2,198	$	5,888	$	403,957	$	409,845	$	89

Loan balances above include net deferred loan fees of $873,000 and $764,000 at June 30, 2016 and December 31, 2015, respectively.

Included within the loan portfolio are loans in which the Bank discontinued the accrual of interest due to the deterioration in the financial condition of the borrower. Such loans approximated $1,575,000 and $3,182,000 at June 30, 2016 and December 31, 2015, respectively. If the nonaccrual loans had performed in accordance with their original terms, interest income would have increased by $28,000 for the three months ended June 30, 2016 and $56,000 for the six months ended June 30, 2016. These amounts compare to an increase in interest income of $45,000 for the three months ended June 30, 2015 and $88,000 for the six months ended June 30, 2015.

The following table presents loans by loan portfolio segments that were on a nonaccrual status as of June 30, 2016 and December 31, 2015:


(In thousands)	June 30, 2016		December 31, 2015
Commercial	$	355	$	1,143
Commercial real estate:
Non-owner occupied		—		24
Owner occupied		493		766
1-4 family investment		120		328
Residential real estate		607		885
Home equity lines of credit		—		36

Total	$	1,575	$	3,182

Impaired Loans

A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. The Bank further identifies all loans in nonaccrual status and troubled debt restructured loans as impaired loans, except for large groups of smaller balance homogeneous loans that are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures, unless the loans are the subject of a restructuring agreement. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. When the measure of an impaired loan results in a realizable value that is less than the recorded investment in the loan, the difference is recorded as a specific valuation allowance against that loan, and the Bank then makes the appropriate adjustment to the allowance for loan losses.

The following presents impaired loans by loan portfolio segments for the periods presented:


	June 30, 2016						Three Months Ended June 30, 2016				Six Months Ended June 30, 2016
(In thousands)	Recorded Investment in Impaired Loans		Unpaid Principal Balance of Impaired Loans		Related Allowance		Average Recorded Investment in Impaired Loans		Interest Income Recognized		Average Recorded Investment in Impaired Loans		Interest Income Recognized
Loans with no related allowance recorded:
Commercial	$	848	$	848	$	—	$	850	$	7	$	852	$	14
Commercial real estate:
Non-owner occupied		2,150		2,150		—		2,156		20		2,160		39
Owner occupied		972		972		—		976		18		981		37
1-4 family investment		854		854		—		861		7		868		14
Residential real estate		2,365		2,502		—		2,522		30		2,555		61
Home equity lines of credit		361		361		—		403		4		404		7

	$	7,550	$	7,687	$	—	$	7,768	$	86	$	7,820	$	172

Loans with an allowance recorded:
Commercial	$	131	$	131	$	1	$	132	$	—	$	134	$	—
Commercial real estate:
Owner Occupied		207		207		2		209		—		212		—
Residential real estate		119		119		33		120		1		120		2

	$	457	$	457	$	36	$	461	$	1	$	466	$	2

Total
Commercial	$	979	$	979	$	1	$	982	$	7	$	986	$	14
Commercial real estate:
Non-owner occupied		2,150		2,150		—		2,156		20		2,160		39
Owner occupied		1,179		1,179		2		1,185		18		1,193		37
1-4 family investment		854		854		0		861		7		868		14
Residential real estate		2,484		2,621		33		2,642		31		2,675		63
Home equity lines of credit		361		361		—		403		4		404		7

	$	8,007	$	8,144	$	36	$	8,229	$	87	$	8,286	$	174


	December 31, 2015						Three Months Ended June 30, 2015				Six Months Ended June 30, 2015
(In thousands)	Recorded Investment in Impaired Loans		Unpaid Principal Balance of Impaired Loans		Related Allowance		Average Recorded Investment in Impaired Loans		Interest Income Recognized		Average Recorded Investment in Impaired Loans		Interest Income Recognized
Loans with no related allowance recorded:
Commercial	$	994	$	994	$	—	$	511	$	20	$	512	$	27
Commercial real estate:
Non-owner occupied		2,163		2,163		—		2,182		20		2,184		39
Owner occupied		1,462		1,462		—		1,198		31		1,007		46
1-4 family investment		879		879		—		814		6		817		11
Commercial land and land development		—		—		—		219		—		218		—
Residential real estate		2,526		2,644		—		2,431		41		2,530		86
Home equity lines of credit		400		400		—		445		16		448		16

	$	8,424	$	8,562	$	—	$	7,800	$	134	$	7,716	$	225

Loans with an allowance recorded:
Commercial	$	793	$	1,193	$	700	$	1,062	$	—	$	866	$	15
Commercial real estate:
Non-owner occupied		24		155		1		—		—		—		—
1-4 family investment		186		193		7		193		—		192		—
Residential real estate		121		121		7		123		1		123		2

	$	1,124	$	1,662	$	715	$	1,378	$	1	$	1,181	$	17

Total
Commercial	$	1,787	$	2,187	$	700	$	1,573	$	20	$	1,378	$	42
Commercial real estate:
Non-owner occupied		2,187		2,318		1		2,182		20		2,184		39
Owner occupied		1,462		1,462		—		1,198		31		1,007		46
1-4 family investment		1,065		1,072		7		1,007		6		1,009		11
Commercial land and land development		—		—		—		219		—		218		—
Residential real estate		2,647		2,785		7		2,554		42		2,653		88
Home equity lines of credit		400		400		—		445		16		448		16

	$	9,548	$	10,224	$	715	$	9,178	$	135	$	8,897	$	242

The recorded investment in impaired loans decreased by $1,541,000 at June 30, 2016 as compared to December 31, 2015. This decrease resulted primarily from the charge-off of one large commercial loan in the amount of $723,000, and the transfer of two commercial real estate loans in the amount of $457,000 to other real estate owned, offset by payments and payoffs received on impaired loans.

Impaired loans also include all loans modified and identified as troubled debt restructurings (“TDRs”). A loan is deemed to be a TDR when the Bank agrees to a modification to the terms of a loan resulting in a concession made by the Bank in an effort to mitigate potential loss arising from a borrower’s financial difficulty. As of June 30, 2016, there were twenty nine restructured loans, totaling $6,853,000, involving twenty two separate and unrelated borrowers who were experiencing financial difficulty. The modifications to these loans included reductions in interest rates, extension of maturity dates, lengthening of amortization schedules and provisions for interest only payments. There are no commitments to extend additional funds to any of these borrowers. At December 31, 2015, there were thirty-two restructured loans, totaling $7,083,000, involving twenty six separate and unrelated borrowers who were experiencing financial difficulty.

The following table presents the number of loans and recorded investment in loans restructured and identified as TDRs for the three and six months ended June 30, 2015. There were no defaults or TDRs occurring within 12 months of modification during the three and six month periods ended June 30, 2016 and 2015. Defaulted loans are those for which payment is 30 days or more past due under the modified terms. There were no troubled debt restructurings during the three and six months ended June 30, 2016.


	Three Months Ended June 30, 2015						Six Months Ended June 30, 2015
(In thousands, except contracts data)	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled Debt Restructurings:
Commercial real estate:
Owner occupied		—	$	—	$	—		1	$	149	$	149
Residential real estate		—		—		—		3		473		473

Allowance for Loan Losses

The allowance for loan losses is composed of individual valuation allowances deemed necessary to absorb probable and quantifiable losses based upon current knowledge of the loan portfolio, and loan pool valuation allowances, allocated and unallocated, deemed necessary to absorb losses which are not specifically identified but are inherent in the portfolio. Management evaluates the adequacy of the allowance on a quarterly basis. If the allowance for loan losses is not sufficient to cover actual loan losses, provisions for loan losses may be recorded and, as a result, the Bank’s earnings may be reduced.

Individual valuation allowances are established in connection with specific loan reviews and the asset classification process, including the procedures for impairment testing. Such a valuation, which includes a review of loans for which full collectability in accordance with contractual terms is not reasonably assured, considers the estimated fair value of the underlying collateral less the costs to sell, or the present value of expected future cash flows, or the loan’s observable market value. Any shortfall that exists from this analysis results in a specific allowance for the loan. Pursuant to policy, loan losses must be recognized in the period the loans, or portions thereof, are deemed uncollectible. Assumptions and judgments by management in conjunction with outside sources are used to determine whether full collectability of a loan is reasonably assured or not. These assumptions and judgments are also used to determine the estimates of the fair value of the underlying collateral or the present value of expected future cash flows or the loan’s observable market value. Individual valuation allowances could differ materially as a result of changes in these assumptions and judgments.

Individual loan analyses are performed quarterly on specific loans considered to be impaired. The results of the individual valuation allowances are aggregated and included in the overall allowance for loan losses.

Loan pool valuation allowances represent loss allowances that have been established to recognize the inherent risks associated with the Bank’s lending activity, but which, unlike individual allowances, have been allocated to unimpaired loans within the following eight portfolio segments: commercial loans; non-owner occupied commercial real estate loans; owner occupied commercial real estate loans; one-to-four family investment property loans; commercial land/land development/construction loans; residential real estate loans; home equity lines of credit; and consumer loans. Loan participations purchased in each of the segments for commercial loans, non-owner occupied commercial real estate loans, owner occupied commercial real estate loans, one-to-four family investment property loans, and commercial land/land development/ construction loans are also separately evaluated. In addition, separate evaluations are made for the acquired Union Bank and Citizens loan portfolios.

The Bank measures estimated credit losses in each of these groups of loans based, in part, on the historical loss rate of each group. The historical loss rate is calculated based on the average annualized net charge-offs over the most recent eight calendar quarters.

Loss factors are ascribed to loan segments based on the relative risk in each segment as indicated by historical loss ratios, the level of criticized/classified assets, and the nature of each segment in terms of collateral and inherent risk of the loan type. Management believes that historical losses or even recent trends in losses do not, by themselves, form a sufficient basis to determine the appropriate level for the allowance. Management therefore also considers the following qualitative factors that are likely to cause estimated credit losses associated with each of the portfolio segments to differ from historical loss experience:

•

Changes in lending policies and procedures, including changes in underwriting standards;

•

Changes in national, regional and local economic and business conditions and developments that affect the collectability of the portfolio;

•

Changes in the nature and volume of the portfolio and in the terms of loans;

•

Changes in the experience, ability and depth of lending management and other relevant staff;

•

Changes in the volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified loans;

•

Changes in the quality of the Bank’s loan review system;

•

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

•

The effect of other external factors, such as competition and legal and regulatory requirements.

Each portfolio segment is examined quarterly with regard to the impact of each of these factors on the quality and risk profile of the pool, and adjustments ranging from zero to fifty basis points per factor are calculated. The sum of these qualitative factor adjustments are added to the historical loss ratio for each segment, and the resulting percentage is applied to the loan balance of the segment to arrive at the required loan pool valuation allowance. An unallocated valuation allowance estimate is also made. Management determines the unallocated portion, which represents the difference between the reported allowance for loan losses and the calculated allowance for loan losses, based generally on the following criteria:

•

risk of imprecision in the specific and general reserve allocations;

•

other potential exposure in the loan portfolio, including the risks associated with the growing book of loans in the Berks, Schuylkill and Somerset County regions;

•

other potential exposure in the acquired Union Bank and Citizens loan portfolios;

•

variances in management’s assessment of national and local economic conditions; and

•

other internal or external factors that management believes appropriate at the time.

The loan pool valuation allowance for each segment, along with the unallocated valuation allowance, is totaled and added to the individual valuation allowance for impaired loans to arrive at the total allowance for loan losses. These evaluations are inherently subjective because, even though they are based on objective data, it is management’s interpretation of the data that determines the amount of the appropriate allowance. If the evaluations prove to be incorrect, the allowance for loan losses may not be sufficient to cover losses inherent in the loan portfolio, resulting in additions to the allowance for loan losses and a reduction in the Bank’s earnings.

Loan Charge Offs

Charge offs of commercial and industrial loans and commercial real estate and construction loans are recorded promptly upon determination that all or a portion of any loan balance is uncollectible. A loan is considered uncollectible when the borrower is 90 days or more delinquent in principal or interest repayment and the following conditions exist:

•

It is unlikely that the borrower will have the ability to pay the debt in a timely manner;

•

Collateral value is insufficient to cover the outstanding indebtedness; and

•

Guarantors do not provide adequate support.

All unsecured consumer loans are charged-off when they become 120 days delinquent or when it is determined that the debt is uncollectible. Overdrafts are charged off when it is determined that recovery is not likely, or the overdraft becomes 45 days old, whichever comes first.

All secured consumer loans, except those secured by a primary or secondary residence, are charged off when they become 120 days delinquent, or when it is determined that the debt is uncollectible.

Uncollateralized portions of residential real estate loans and consumer loans secured by real estate are charged off no later than when they are 180 days past due. Current appraisals are obtained to determine the appropriate carrying balance with any exposed portion of the loan principal balance being charged off.

The allowance for loan losses is presented by loan portfolio segments with the outstanding balances of loans for the periods presented:


				Commercial Real Estate
(In thousands)	Commercial			Non-Owner Occupied			Owner Occupied			1-4 Family Investment		Commercial – Land and Land Development		Residential Real Estate			Home Equity Lines of Credit		Consumer		Unallocated			Total
Allowance for Loan Losses for the Three Months Ended June 30, 2016:
Beginning balance	$	566		$	1,320		$	621		$	270	$	93	$	650		$	104	$	30	$	63		$	3,717
Charge-offs		—			—			—			41		249		8			—		5		—			303
Recoveries		36			—			—			—		—		2			—		1		—			39
Provision		(44	)		(135	)		11			54		326		(9	)		6		10		(63	)		156

Ending balance	$	558		$	1,185		$	632		$	283	$	170	$	635		$	110	$	36	$	0		$	3,609

Ending balance: individually evaluated for impairment	$	1		$	—		$	2		$	—	$	—	$	33		$	—	$	—	$	—		$	36

Ending balance: collectively evaluated for impairment	$	557		$	1,185		$	630		$	283	$	170	$	602		$	110	$	36	$	—		$	3,573

Allowance for Loan Losses for the Three Months Ended June 30, 2015:
Beginning balance	$	363		$	1,297		$	731		$	395	$	113	$	672		$	107	$	19	$	38		$	3,735
Charge-offs		—			—			—			11		—		12			10		16		—			49
Recoveries		8			—			—			—		—		—			—		1		—			9
Provision		269			(6	)		(12	)		14		3		20			19		18		125			450

Ending balance	$	640		$	1,291		$	719		$	398	$	116	$	680		$	116	$	22	$	163		$	4,145

Ending balance: individually evaluated for impairment	$	272		$	—		$	—		$	14	$	—	$	6		$	—	$	—	$	—		$	292

Ending balance: collectively evaluated for impairment	$	368		$	1,291		$	719		$	384	$	116	$	674		$	116	$	22	$	163		$	3,853


				Commercial Real Estate
(In thousands)	Commercial			Non-Owner Occupied			Owner Occupied		1-4 Family Investment		Commercial – Land and Land Development		Residential Real Estate		Home Equity Lines of Credit		Consumer		Unallocated		Total
Allowance for Loan Losses for the Six Months Ended June 30, 2016:
Beginning balance	$	1,298		$	1,372		$	552	$	303	$	202	$	520	$	93	$	25	$	—	$	4,365
Charge-offs		723			24			—		41		249		8		—		16		—		1,061
Recoveries		46			—			—		—		—		2		—		2		—		50
Provision		(63	)		(163	)		80		21		217		121		17		25		—		255

Ending balance	$	558		$	1,185		$	632	$	283	$	170	$	635	$	110	$	36	$	—	$	3,609

Ending balance: individually evaluated for impairment	$	1		$	—		$	2	$	—	$	—	$	33	$	—	$	—	$	—	$	36

Ending balance: collectively evaluated for impairment	$	557		$	1,185		$	630	$	283	$	170	$	602	$	110	$	36	$	—	$	3,573

Allowance for Loan Losses for the Six Months Ended June 30, 2015:
Beginning balance	$	330		$	1,380		$	713	$	369	$	115	$	701	$	104	$	15	$	65	$	3,792
Charge-offs		—			—			39		11		—		27		10		22		—		109
Recoveries		8			—			—		—		—		—		—		4		—		12
Provision		302			(89	)		45		40		1		6		22		25		98		450

Ending balance	$	640		$	1,291		$	719	$	398	$	116	$	680	$	116	$	22	$	163	$	4,145

Ending balance: individually evaluated for impairment	$	272		$	—		$	—	$	14	$	—	$	6	$	—	$	—	$	—	$	292

Ending balance: collectively evaluated for impairment	$	368		$	1,291		$	719	$	384	$	116	$	674	$	116	$	22	$	163	$	3,853


			Commercial Real Estate
(In thousands)	Commercial		Non-Owner Occupied		Owner Occupied		1-4 Family Investment		Commercial – Land and Land Development		Residential Real Estate		Home Equity Lines of Credit		Consumer		Unallocated	Total
Loans as of June 30, 2016:
Ending balance	$	46,330	$	104,630	$	76,862	$	25,229	$	9,166	$	112,514	$	18,909	$	4,853		$	398,493

Ending balance: individually evaluated for impairment	$	979	$	2,150	$	1,179	$	854	$	—	$	2,484	$	361	$	—		$	8,007

Ending balance: collectively evaluated for impairment	$	45,351	$	102,480	$	75,683	$	24,375	$	9,166	$	110,030	$	18,548	$	4,853		$	390,486

Loans as of December 31, 2015:
Ending balance	$	46,076	$	110,455	$	69,647	$	25,398	$	18,599	$	117,669	$	17,437	$	4,564		$	409,845

Ending balance: individually evaluated for impairment	$	1,787	$	2,187	$	1,462	$	1,065	$	—	$	2,647	$	400	$	—		$	9,548

Ending balance: collectively evaluated for impairment	$	44,289	$	108,268	$	68,185	$	24,333	$	18,599	$	115,022	$	17,037	$	4,564		$	400,297

Credit Quality Indicators

The Bank has established a credit risk rating system to quantify the risk in the Bank’s loan portfolio. This system is a critical tool for managing the Bank’s lending activities and for evaluating appropriate loan loss reserves. This rating system is dynamic, and risk ratings are subject to change at any time when circumstances warrant. The system rates the strength of the borrower and is designed to be a tool for management to manage the Bank’s credit risk and provide an early warning system for negative migration of credits. The system also provides for recognition of improvement in credits. Risk ratings move dynamically, both negatively and positively.

Each new, renewed or modified credit facility is given a risk rating that takes into consideration factors that affect credit quality. The primary determinants of the risk rating assigned are based upon the reliability of the primary source of repayment and the past, present, and projected financial condition of the borrower. The rating also reflects current economic and industry conditions. Major factors used in determining the rating include the following variables:

•

Capitalization;

•

Liquidity;

•

Cash flow;

•

Revenue and earnings trends;

•

Management strength or weakness;

•

Quality of financial information;

•

Reputation and credit history;

•

Industry, including economic climate.

In addition, the following factors may affect the risk rating derived from the above factors:

Collateral: The rating may be affected by the type and quality of collateral, the level of coverage, the economic life of the collateral, liquidation value, and the Bank’s ability to dispose of the collateral.

Guarantors: Guarantees can differ substantially in enhancing the risk rating assigned to a loan or lending commitment. In order to provide enough support to impact the assigned rating by one or more levels, the guarantee must be unconditional and must be from an individual or entity with substantial financial strength and a vested interest in the success of the borrower.

The Bank assigns risk ratings based on a scale from 1 to 8 with 1 being the highest quality rating and 8 being the lowest quality grade.

•

Levels 1-4 are “Pass” grades;

•

Level 5 is “Special Mention” (criticized loan);

•

Level 6 is “Substandard” (classified loan);

•

Level 7 is “Doubtful” (classified loan);

•

Level 8 is “Loss” (classified loan).

Risk Rating Definitions

1 - Excellent

This category is reserved for loans that contain a virtual absence of any credit risk. The loan is secured by properly margined cash collateral (in accordance with loan policy). Loans that are fully guaranteed by the U.S. government, or any agency thereof, would also fit this category.

2 - Good

Loans in this category would be characterized by nominal risk and strong repayment certainty. This category includes loans to companies or individuals that are paying as agreed and that are either unsecured or secured where reliance is placed on non-liquid or less than good quality liquid collateral.

3 - Satisfactory

Loans in this category are considered to exhibit an average level of credit risk. However, these loans have certain risk characteristics, whether due to management, industry, economic or financial concerns. Credits with satisfactory liquidity and leverage, with losses considered to be of a temporary nature for which there is only minor concern, are included in this category. Loans for start-up businesses or loans to firms exhibiting high leverage may receive this rating. Loans in this category also include borrowers whose underlying financial strength may be relatively weak. However, risk of loss of loans in this category is considered minimal due to adequate, well-margined and controlled collateral.

4 - Watch

Loans in this category typically are experiencing some negative trends due to financial, operational, economic, or regulatory reasons. A deteriorating collateral position or guarantor, in isolation, may also justify this rating. Such loans must have elevated monitoring as a result of negative trends which, if not addressed, could result in an unacceptable increase in credit risk.

5 - Special Mention

A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in a deterioration of the repayment prospects for the loan or in the Bank’s credit position at some future date. Special mention loans are not adversely classified and do not expose the Bank to sufficient risk to warrant an adverse classification. Loans for which economic or market conditions are beginning to adversely affect the borrower may be so rated. An adverse trend in the borrower’s operations or an imbalanced position in the balance sheet which has not reached a point where the liquidation is jeopardized may be best handled by this rating. Loans in which actual weaknesses are evident and significant are considered for more serious criticism. In cases where the credit is weak but trends are improving, and/or collateral support is within normal advance margins, consideration is given for the next higher rating.

6 - Substandard

A substandard loan is inadequately protected by the current sound worth and paying capacity of the borrower or by the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. These loans, even if apparently protected by collateral value, have well-defined weaknesses related to adverse financial, managerial, economic, market, or political conditions which have clearly jeopardized repayment of principal and interest as originally intended.

These loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans rated below this category are placed on nonaccrual status.

7 - Doubtful

A doubtful loan has all of the weaknesses inherent in a loan classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of current facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending events that may work to strengthen the asset, its classification as a loss is deferred until its most exact status may be determined. Generally, pending events should be resolved within a relatively short period and the rating will be adjusted based on the new information. Because of high probability of loss, loans rated doubtful are placed in non-accrual status.

8 - Loss

Loans classified loss are considered uncollectible and of such little value that their continuance as a bankable asset is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though a partial recovery may be effected in the future. When access to collateral, rather than the value of the collateral, is a problem, a less severe classification may be appropriate. However, the Bank will not maintain an asset on the balance sheet if realizing its value would require long-term litigation or other lengthy recovery efforts. Losses are recorded in the period the asset becomes uncollectible.

The following table presents the credit quality indicators and total credit exposure for each segment in the loan portfolio by internally assigned grades as of June 30, 2016 and December 31, 2015:


			Commercial Real Estate
(In thousands)	Commercial		Non- Owner Occupied		Owner Occupied		1-4 Family Investment		Commercial – Land and Land Development		Residential Real Estate		Home Equity Lines of Credit		Consumer		Total
June 30, 2016
1 – Excellent	$	241	$	—	$	—	$	—	$	—	$	—	$	—	$	106	$	347
2 – Good		2,607		34		1,134		28		179		—		—		—		3,982
3 – Satisfactory		40,563		94,055		69,844		18,123		8,738		108,872		18,185		4,747		363,127
4 – Watch		1,046		5,377		2,895		5,168		249		398		335		—		15,468
5 – Special Mention		475		2,252		1,466		1,254		—		161		28		—		5,636
6 – Substandard		1,398		2,912		1,523		656		—		3,083		361		—		9,933
7 – Doubtful		—		—		—		—		—		—		—		—		—
8 – Loss		—		—		—		—		—		—		—		—		—

Total	$	46,330	$	104,630	$	76,862	$	25,229	$	9,166	$	112,514	$	18,909	$	4,853	$	398,493


			Commercial Real Estate
(In thousands)	Commercial		Non- Owner Occupied		Owner Occupied		1-4 Family Investment		Commercial – Land and Land Development		Residential Real Estate		Home Equity Lines of Credit		Consumer		Total
December 31, 2015:
1 – Excellent	$	249	$	—	$	—	$	—	$	—	$	—	$	—	$	114	$	363
2 – Good		2,729		111		1,190		35		168		—		—		—		4,233
3 – Satisfactory		39,193		99,010		60,806		17,990		18,070		113,681		16,671		4,450		369,871
4 – Watch		1,206		5,730		4,290		5,238		111		403		338		—		17,316
5 – Special Mention		443		2,270		1,530		1,269		—		164		28		—		5,704
6 – Substandard		2,256		3,334		1,831		866		250		3,421		400		—		12,358
7 – Doubtful		—		—		—		—		—		—		—		—		—
8 – Loss		—		—		—		—		—		—		—		—		—

Total	$	46,076	$	110,455	$	69,647	$	25,398	$	18,599	$	117,669	$	17,437	$	4,564	$	409,845

The adequacy of the allowance is analyzed quarterly, and adjusted to the level deemed appropriate by management, based upon its risk assessment of the entire portfolio. Based upon credit administration’s review of the classified loans and the overall allowance levels as they relate to the entire loan portfolio at June 30, 2016, management believes the allowance for loan losses has been established at a level sufficient to cover the probable incurred losses in the loan portfolio.

Purchased Loans

Purchased loans are initially recorded at their acquisition date fair values. The carryover of the allowance for loan losses is prohibited as any credit losses in the loans are included in the determination of the fair value of the loans at the acquisition date. Fair values for purchased loans are based on a cash flow methodology that involves assumptions and judgments as to credit risk, default rates, loss severity, collateral values, discount rates, payment speeds, and prepayment risk.

As part of its acquisition due diligence process, the Bank reviews the acquired institution’s loan grading system and the associated risk rating for loans. In performing this review, the Bank considers cash flows, debt service coverage, delinquency status, accrual status, and collateral for the loan. This process allows the Bank to clearly identify the population of acquired loans that had evidence of deterioration in credit quality since origination and for which it was probable, at acquisition, that the Bank would be unable to collect all contractually required payments. All such loans identified by the Bank are considered to be within the scope of ASC 310-30, Loan and Debt Securities Acquired with Deteriorated Credit Quality and are identified as “Purchased Credit Impaired Loans”.

As a result of the merger with Citizens, effective December 31, 2015, the Bank identified ten purchased credit impaired (“PCI”) loans. As part of the consolidation with Union, effective November 1, 2013, the Bank identified fourteen purchased credit impaired (“PCI”) loans. For all PCI loans, the excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount and is recognized into interest income over the remaining life of the loan. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non-accretable discount. The non-accretable discount represents estimated future credit losses expected to be incurred over the life of the loan. Subsequent decreases to the expected cash flows require the Bank to evaluate the need for an allowance for loan losses on these loans. Subsequent improvements in expected cash flows result in the reversal of a corresponding amount of the non-accretable discount which the Bank then reclassifies as an accretable discount that is recognized into interest income over the remaining life of the loan. The Bank’s evaluation of the amount of future cash flows that it expects to collect is based on a cash flow methodology that involves assumptions and judgments as to credit risk, collateral values, discount rates, payment speeds, and prepayment risk. Charge-offs of the principal amount on purchased impaired loans are first applied to the non-accretable discount.

As a result of this accounting methodology, certain credit-related ratios of the Bank, including, for example, the growth rate in non-performing assets, may not necessarily be directly comparable with periods prior to the acquisition of the PCI loans.

For purchased loans that are not deemed impaired at acquisition, credit discounts representing principal losses expected over the life of the loans are a component of the initial fair value, and the discount is accreted to interest income over the life of the asset. Subsequent to the purchase date, the method used to evaluate the sufficiency of the credit discount is similar to originated loans, and if necessary, additional reserves are recognized in the allowance for loan losses.

The following is a summary of the loans acquired in the Union transaction as of November 1, 2013, the date of the consolidation:

Purchased
Credit
Impaired
Loans

Purchased
Non-
Impaired
Loans

Total
Purchased
Loans

Union

(In thousands)

Contractually required principal and interest at acquisition

10,290

92,704

102,994

Contractual cash flows not expected to be collected

(5,487

)

(9,492

)

(14,979

)

Expected cash flows at acquisition

4,803

83,212

88,015

Interest component of expected cash flows

(386

)

(12,278

)

(12,664

)

Basis in acquired loans at acquisition – estimated fair value

4,417

70,934

75,351

The unpaid principal balances and the related carrying amount of Union acquired loans as of June 30, 2016 and December 31, 2015 were as follows:


	June 30, 2016		December 31, 2015
	(In thousands)
Credit impaired purchased loans evaluated individually for incurred credit losses
Outstanding balance	$	1,303	$	1,478
Carrying Amount		580		668
Other purchased loans evaluated collectively for incurred credit losses
Outstanding balance		43,647		49,762
Carrying Amount		42,719		47,723
Total Purchased Loans
Outstanding balance		44,950		51,240
Carrying Amount		43,299		48,391

As of the indicated dates, the changes in the accretable discount related to the purchased credit impaired loans were as follows:


	Three Months Ended						Six Months Ended
	June 30, 2016			June 30, 2015			June 30, 2016			June 30, 2015
(In thousands)
Balance – beginning of period	$	259		$	300		$	307		$	310
Accretion recognized during the period		(21	)		(30	)		(115	)		(56	)
Net reclassification from non-accretable to accretable		13			56			59			72

Balance – end of period	$	251		$	326		$	251		$	326

The following is a summary of the loans acquired in the Citizens’ merger as of December 31, 2015, the effective date of the merger:

Purchased
Credit
Impaired
Loans

Purchased
Non-
Impaired
Loans

Total
Purchased
Loans

Citizens

(In thousands)

Contractually required principal and interest at acquisition

894

81,780

82,674

Contractual cash flows not expected to be collected

(237

)

(13,517

)

(13,754

)

Expected cash flows at acquisition

657

68,263

68,920

Interest component of expected cash flows

(217

)

(10,841

)

(11,058

)

Basis in acquired loans at acquisition – estimated fair value

440

57,422

57,862

The unpaid principal balances and the related carrying amount of Citizens acquired loans as of June 30, 2016 and December 31, 2015 were as follows:


	June 30, 2016		December 31, 2015
	(In thousands)
Credit impaired purchased loans evaluated individually for incurred credit losses
Outstanding balance	$	610	$	608
Carrying Amount		431		440
Other purchased loans evaluated collectively for incurred credit losses
Outstanding balance		51,933		57,581
Carrying Amount		51,677		57,422
Total Purchased Loans
Outstanding balance		52,543		58,189
Carrying Amount		52,108		57,862

As of the indicated dates, the changes in the accretable discount related to the purchased credit impaired loans were as follows:


	Three Months Ended					Six Months Ended
	June 30, 2016			June 30, 2015		June 30, 2016			June 30, 2015
(In thousands)
Balance – beginning of period	$	213		$	—	$	217		$	—
Accretion recognized during the period		(8	)		—		(14	)		—
Net reclassification from non-accretable to accretable		1			—		3			—

Balance – end of period	$	206		$	—	$	206		$	—