NOTE 12 – FAIR VALUE

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1:

Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2:

Significant observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.

Level 3:

Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Bank used the following methods and significant assumptions to estimate fair value:

Investment Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2), using matrix pricing. Matrix pricing is a mathematical technique commonly used to price debt securities that are not actively traded and, values debt securities by relying on quoted prices for the specific securities and the securities’ relationship to other benchmark quoted securities (Level 2 inputs). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). See below for additional discussion of Level 3 valuation methodologies and significant inputs. The fair values of all securities are determined from third party pricing services without adjustment.

Derivatives-Interest Rate Swaps: The fair values of derivatives are based on valuation models using observable market data as of the measurement date (Level 2). The Bank’s derivatives are traded in an over-the-counter market where quoted market prices are not always available. Therefore, the fair values of derivatives are determined using quantitative models that utilize multiple market inputs. The inputs will vary based on the type of derivative, but could include interest rates, prices and indices to generate continuous yield or pricing curves, prepayment rates, and volatility factors to value the position. The majority of market inputs are actively quoted and can be validated through external sources, including brokers, market transactions and third-party pricing services. The fair values of all interest rate swaps are determined from third party pricing services without adjustment.

Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available for similar loans and collateral underlying such loans. Such adjustments result in a Level 3 classification of the inputs for determining fair value. Collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on at least a quarterly basis for additional impairment and adjusted in accordance with the loan policy.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which are updated no less frequently than annually. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach with data from comparable properties. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Appraisals may be adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and/or management’s expertise and knowledge of the collateral. Such adjustments result in a Level 3 classification of the inputs for determining fair value. Real estate owned properties are evaluated on a quarterly basis for additional impairment and adjusted accordingly. The Company had no other real estate owned at September 30, 2018 or December 31, 2017.

Loans Held For Sale: Loans held for sale are carried at the lower of cost or fair value, which is evaluated on a pool-level basis. The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2). There were no loans held for sale carried at fair value at September 30, 2018 or December 31, 2017.

Assets and liabilities measured at fair value on a recurring basis are summarized below (dollars in thousands):

	Fair value measurements at September 30, 2018
				Quoted prices
				in active		Significant
				markets for		other			Significant
				identical		observable			unobservable
	Carrying			assets		inputs			inputs
	Value			(Level 1)		(Level 2)			(Level 3)
Assets:
Securities available-for-sale:
U.S. government-sponsored agencies	$	10,465		$	—	$	10,465		$	—
Obligations of states and political subdivisions		44,245			—		44,245			—
Mortgage-backed securities-residential		105,202			—		105,202			—
Asset-backed securities		15,713			—		15,713			—
Other debt securities		11,844			—		11,844			—
Total securities available-for-sale	$	187,469		$	—	$	187,469		$	—
Derivatives:
Interest rate swaps - customer related	$	624		$	—	$	624		$	—
Liabilities:
Derivatives:
Interest rate swaps - customer related	$	(624	)	$	—	$	(624	)	$	—
Interest rate swaps - cash flow hedges		(462	)		—		(462	)		—
Total derivatives	$	(1,086	)	$	—	$	(1,086	)	$	—

	Fair value measurements at December 31, 2017
				Quoted prices
				in active		Significant
				markets for		other			Significant
				identical		observable			unobservable
	Carrying			assets		inputs			inputs
	Value			(Level 1)		(Level 2)			(Level 3)
Assets:
Securities available-for-sale:
U.S. government-sponsored agencies	$	11,277		$	—	$	11,277		$	—
Obligations of states and political subdivisions		52,998			—		52,998			—
Mortgage-backed securities-residential		106,562			—		106,562			—
Asset-backed securities		16,377			—		16,377			—
Other debt securities		5,407			—		5,407			—
Total securities available-for-sale	$	192,621		$	—	$	192,621		$	—
Derivatives:
Interest rate swaps - customer related	$	184		$	—	$	184		$	—
Liabilities:
Derivatives:
Interest rate swaps - customer related	$	(184	)	$	—	$	(184	)	$	—
Interest rate swaps - cash flow hedges		(1,375	)		—		(1,375	)		—
Total derivatives	$	(1,559	)	$	—	$	(1,559	)	$	—

Assets measured at fair value on a nonrecurring basis are summarized below (dollars in thousands):

Fair value measurements at September 30, 2018

Quoted prices

in active

Significant

markets for

other

Significant

identical

observable

unobservable

Carrying

assets

inputs

Value

(level 1)

(level 2)

(level 3)

Assets:

Impaired loans:

Commercial and industrial

2,719

—

2,719

Fair value measurements at December 31, 2017

Quoted prices

in active

Significant

markets for

other

Significant

identical

observable

unobservable

Carrying

assets

inputs

Value

(level 1)

(level 2)

(level 3)

Assets:

Impaired loans:

Commercial and industrial

1,388

—

1,388

The following table presents quantitative information about Level 3 fair value measurements for assets measured at fair value on a non-recurring basis at September 30, 2018 and December 31, 2017 (dollars in thousands):

					Range
	Fair		Valuation		(Weighted-
September 30, 2018	Value		Technique(s)	Unobservable Input(s)	Average)
Impaired loans:
Commercial and industrial	$	2,719	Discounted cash flow	Probability of default	5%-60%
				Loss severity	5%-50%

Range

Fair

Valuation

(Weighted-

December 31, 2017

Value

Technique(s)

Unobservable Input(s)

Average)

Impaired loans:

Commercial and industrial

1,388

Sales comparison approach

Appraisal discounts

Fair Value of Financial Instruments

The carrying value and estimated fair values of the Bank’s financial instruments at September 30, 2018 and December 31, 2017 were as follows (dollars in thousands):

	September 30, 2018				December 31, 2017
	Carrying				Carrying				Fair value
	amount		Fair value		amount		Fair value		level of input
Financial assets:
Cash and due from banks, interest-bearing deposits in financial institutions	$	49,842	$	49,842	$	78,078	$	78,078	Level 1
Federal funds sold		2,747		2,747		4,719		4,719	Level 1
Securities available-for-sale		187,469		187,469		192,621		192,621	Level 2
Securities held-to-maturity		3,740		3,766		3,759		3,848	Level 2
Loans held for sale		50,499		51,326		74,093		75,549	Level 2
Restricted equity securities		8,817	N/A			8,806	N/A		N/A
Loans, net		1,073,870		1,065,226		947,537		944,037	Level 3
Accrued interest receivable		4,430		4,430		4,084		4,084	Level 2
Other assets		23,519		23,519		22,663		22,663	Level 2
Financial liabilities:
Deposits		1,126,403		1,074,725		1,119,866		1,065,669	Level 3
Federal Home Loan Bank advances		125,000		124,983		70,000		69,980	Level 2
Other liabilities		2,447		2,447		3,672		3,672	Level 3

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

(a)	Cash and Due from Banks, Interest-Bearing Deposits in Financial Institutions

For these short‑term instruments, the carrying amount is a reasonable estimate of fair value.

(b)	Federal Funds Sold

Federal funds sold clear on a daily basis. For this reason, the carrying amount is a reasonable estimate of fair value.

(c)	Restricted Equity Securities

It is not practical to determine the fair value of restricted securities due to restrictions placed on their transferability.

(d)	Loans, net

During the first quarter of 2018, the Company adopted ASU 2016-01, “Recognition and Measurement of Financial Assets and Liabilities.” The amendments included within this standard, which are applied prospectively, require the Company to disclose fair value of financial instruments measured at amortized cost on the balance sheet to measure that fair value using an exit price notion. Prior to adopting the amendments included in the standard, the Company was allowed to measure fair value under an entry price notion. The entry price notion previously applied by the Company used a discounted cash flows technique to calculate the present value of expected future cash flows for a financial instrument. The exit price notion uses the same approach, but also incorporates other factors, such as enhanced credit risk, illiquidity risk and market factors that sometimes exist in exit prices in dislocated markets.

As of September 30, 2018, the technique used by the Company to estimate the exit price of the loan portfolio consists of similar procedures to those used as of December 31, 2017, but with added emphasis on both illiquidity risk and credit risk not captured by the previously applied entry price notion. The fair value of the Company’s loan portfolio has always included a credit risk assumption in the determination of the fair value of its loans. This credit risk assumption is intended to approximate the fair value that a market participant would realize in a hypothetical orderly transaction. The Company’s loan portfolio is initially fair valued using a segmented approach. The Company divides its loan portfolio into the following categories: variable rate loans, impaired loans and all other loans. The results are then adjusted to account for credit risk as described above. However, under the new guidance, the Company believes a further credit risk discount must be applied through the use of a discounted cash flow model to compensate for illiquidity risk, based on certain assumptions included within the discounted cash flow model, primarily the use of discount rates that better capture inherent credit risk over the lifetime of a loan. This consideration of enhanced credit risk provides an estimated exit price for the Company’s loan portfolio.

For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values approximate carrying values. Fair values for impaired loans are estimated using discounted cash flow models or based on the fair value of the underlying collateral.

As of December 31, 2017, the fair value of the Company’s loan portfolio includes a credit risk assumption in the determination of the fair value of its loans. This credit risk assumption is intended to approximate the fair value that a market participant would realize in a hypothetical orderly transaction. The Company’s loan portfolio is initially fair valued using a segmented approach. The Company divides its loan portfolio into the following categories: variable rate loans, impaired loans and all other loans. The results are then adjusted to account for credit risk. For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values approximate carrying values. Fair values for impaired loans are estimated using discounted cash flow models or based on the fair value of the underlying collateral. For other loans, fair values are estimated using discounted cash flow models, using current market interest rates offered for loans with similar terms to borrowers of similar credit quality. The values derived from the discounted cash flow approach for each of the above portfolios are then further discounted to incorporate credit risk. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price as of December 31, 2017.

(e)	Accrued Interest Receivable

The carrying amounts of accrued interest approximate fair value.

(f)	Other Assets

Included in other assets are bank owned life insurance, certain interest rate swap agreements and the cash flow hedge relationships. The fair values of interest rate swap agreements and the cash flow hedge relationships are based on independent pricing services that utilize pricing models with observable market inputs. For bank owned life insurance, the carrying amount is based on the cash surrender value and is a reasonable estimate of fair value.

(g)

Deposits

The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounted cash flow models, using current market interest rates offered on certificates with similar remaining maturities.

(h)	Federal Home Loan Bank Advances

The fair value of fixed rate Federal Home Loan Bank Advances is estimated using discounted cash flow models, using current market interest rates offered on certificates, advances and other borrowings with similar remaining maturities.

(i)	Other Liabilities

Included in other liabilities are accrued interest payable, certain interest rate swap agreements, the cash flow hedge relationships and contingent consideration. The fair values of interest rate swap agreements and the cash flow hedge relationships are based on independent pricing services that utilize pricing models with observable market inputs. The fair value of contingent consideration is estimated by a discounted cash flow model that utilizes various unobservable inputs. The carrying amounts of accrued interest approximate fair value.

(j)	Off-Balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.

(k)	Limitations

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Bank’s entire holdings of a particular instrument. Because no market exists for a significant portion of the Bank’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on estimating on and off‑balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, fixed assets are not considered financial instruments and their value has not been incorporated into the fair value estimates. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.