10-K 1 arow-12312015x10k.htm 10-K 10-K


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of
The Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 2015
Commission File Number: 0-12507
ARROW FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)
New York
 
22-2448962
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
250 GLEN STREET, GLENS FALLS, NEW YORK 12801
(Address of principal executive offices)   (Zip Code)
Registrant’s telephone number, including area code:   (518) 745-1000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Common Stock, Par Value $1.00
(Title of Class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes      x  No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes      x   No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes          No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes          No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer     
Accelerated filer   x 
Non-accelerated filer     
Smaller reporting company     
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes      x   No
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter:    $348,534,481
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.
Class
 
Outstanding as of February 29, 2016
Common Stock, par value $1.00 per share
 
12,952,227
DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement for the Annual Meeting of Stockholders to be held May 4, 2016 (Part III)




ARROW FINANCIAL CORPORATION
FORM 10-K
TABLE OF CONTENTS
 
Page

Note on Terminology
3

The Company and Its Subsidiaries
3

Forward-Looking Statements
3

Use of Non-GAAP Financial Measures
4

PART I
 






PART II
 








PART III
 





PART IV
 





*These items are incorporated by reference to the Corporations Proxy Statement for the Annual Meeting of Stockholders to be held May 4, 2016.


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NOTE ON TERMINOLOGY
In this Annual Report on Form 10-K, the terms Arrow, the registrant, the company, we, us, and our generally refer to Arrow Financial Corporation and subsidiaries as a group, except where the context indicates otherwise.  At certain points in this Report, our performance is compared with that of our peer group of financial institutions.  Unless otherwise specifically stated, this peer group is comprised of the group of 329 domestic (U.S. based) bank holding companies with $1 to $3 billion in total consolidated assets as identified in the Federal Reserve Boards most recent Bank Holding Company Performance Report (which is the Performance Report for the most recently available period ending December 31, 2015), and peer group data has been derived from such Report.  This peer group is not, however, identical to either of the peer groups comprising the two bank indices included in the stock performance graphs on pages 18 and 19 of this Report.


THE COMPANY AND ITS SUBSIDIARIES
Arrow is a two-bank holding company headquartered in Glens Falls, New York.  Our banking subsidiaries are Glens Falls National Bank and Trust Company (Glens Falls National) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (Saratoga National) whose main office is located in Saratoga Springs, New York.  Active subsidiaries of Glens Falls National include Capital Financial Group, Inc. (an insurance agency specializing in selling and servicing group health care policies and life insurance), Upstate Agency, LLC (a property and casualty insurance agency), Glens Falls National Insurance Agencies, LLC (a property and casualty insurance agency - currently doing business under the name of McPhillips Insurance Agency), North Country Investment Advisers, Inc. (a registered investment adviser that provides investment advice to our proprietary mutual funds) and Arrow Properties, Inc. (a real estate investment trust, or REIT). Our holding company also owns directly two subsidiary business trusts, organized in 2003 and 2004 to issue trust preferred securities (TRUPs), which are still outstanding.


FORWARD-LOOKING STATEMENTS
The information contained in this Annual Report on Form 10-K contains statements that are not historical in nature but rather are based on our beliefs, assumptions, expectations, estimates and projections about the future.  These statements are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk.  Words such as expects, believes, anticipates, estimates and variations of such words and similar expressions often identify such forward-looking statements.  Some of these statements, such as those included in the interest rate sensitivity analysis in Item 7A of this Report, entitled Quantitative and Qualitative Disclosures About Market Risk, are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulation models.  Other forward-looking statements are based on our general perceptions of market conditions and trends in activity, both locally and nationally, as well as current management strategies for future operations and development.

Forward-looking statements in this Report include the following:
Topic
Section
Page
Location
Dividend Capacity
Part I, Item 1.C.
8
1st paragraph under "Dividend Restrictions; Other Regulatory Sanctions"
 
Part II, Item 7.E.
48
1st paragraph under "Dividends"
Impact of Legislative Developments
Part I, Item 1.D.
9
Last paragraph in Section D
 
Part II, Item 7.A.
27
Paragraph in "Health Care Reform"
Visa Stock
Part II, Item 7.A.
27
Paragraph under "Visa Class B Common Stock"
Impact of Changing Interest Rates on Earnings
Part II, Item 7.C.II.a.
40
Last paragraph under “Automobile Loans”
 
Part II, Item 7.C.II.a.
41
Last two paragraphs
 
Part II, Item 7A.
51
Last 4 paragraphs
Adequacy of the Allowance for Loan
   Losses
Part II, Item 7.B.II.
32
1st paragraph under II. Provision For Loan Losses and Allowance For Loan Losses
Noninterest Income
Part II, Item 7.C.IV
34
Paragraphs four and five under "2015 Compared to 2014"
Expected Level of Real Estate Loans
Part II,   Item 7.C.II.a.
39
Paragraphs under Residential Real Estate
Loans
Liquidity
Part II, Item 7.D.
46
Last 2 paragraphs under "Liquidity"
Commitments to Extend Credit
Part II, Item 8
78
Last 2 paragraphs in Note 8
Pension plan return on assets
Part II, Item 8
94
2nd to last paragraph in Note 13
Realization of recognized net
   deferred tax assets
Part II, Item 8
95
2nd to last paragraph in Note 15

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These forward-looking statements may not be exhaustive, are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify.  You should not place undue reliance on any such forward-looking statements. In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast.  Factors that could cause or contribute to such differences include, but are not limited to:  
a.
rapid and dramatic changes in economic and market conditions, such as the U.S. economy experienced during the financial crisis of 2008-2010;
b.sharp fluctuations in interest rates, economic activity, and consumer spending patterns;
c.sudden changes in the market for products we provide, such as real estate loans;
d.
significant new banking or other laws and regulations, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or Dodd-Frank) and the rules and regulations issued or to be issued thereunder;
e.
significant changes in U.S. monetary or fiscal policy, including new or revised monetary programs or targets adopted or announced by the Federal Reserve ("monetary tightening or easing") or significant new federal legislation materially affecting the federal budget ("fiscal tightening or expansion");
f.
enhanced competition from unforeseen sources; and
g.
similar uncertainties inherent in banking operations or business generally, including technological developments and changes.

We are under no duty to update any of the forward-looking statements after the date of this Annual Report on Form 10-K to conform such statements to actual results. All forward-looking statements, express or implied, included in this report and the documents we incorporate by reference and that are attributable to the Company are expressly qualified in their entirety by this cautionary statement. This cautionary statement should also be considered in connection with any subsequent written or oral forward-looking statements that the Company or any persons acting on our behalf may issue.



USE OF NON-GAAP FINANCIAL MEASURES
The Securities and Exchange Commission (SEC) has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain non-GAAP financial measures.  GAAP is generally accepted accounting principles in the United States of America.  Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the Companys reasons for utilizing the non-GAAP financial measure as part of its financial disclosures.  The SEC has exempted from the definition of non-GAAP financial measures certain commonly used financial measures that are not based on GAAP.  When these exempted measures are included in public disclosures, supplemental information is not required.  The following measures used in this Report, which are commonly utilized by financial institutions, have not been specifically exempted by the SEC and may constitute "non-GAAP financial measures" within the meaning of the SEC's new rules, although we are unable to state with certainty that the SEC would so regard them.

Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, as well as disclosures based on that tabular presentation, is commonly presented on a tax-equivalent basis.  That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual before-tax net interest income total.  This adjustment is considered helpful in comparing one financial institution's net interest income to that of another institution or in analyzing any institutions net interest income trend line over time, to correct any analytical distortion that might otherwise arise from the fact that financial institutions vary widely in the proportions of their portfolios that are invested in tax-exempt securities, and from the fact that even a single institution may significantly alter over time the proportion of its own portfolio that is invested in tax-exempt obligations.  Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets.  For purposes of this measure as well, tax-equivalent net interest income is generally used by financial institutions, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institutions performance over time. We follow these practices.

The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control.  The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and noninterest income.  Net interest income as utilized in calculating the efficiency ratio is typically the same as the net interest income presented in Selected Financial Information table discussed in the preceding paragraph, i.e., it is expressed on a tax-equivalent basis.  Moreover, many financial institutions, in calculating the efficiency ratio, also adjust both noninterest expense and noninterest income to exclude from these items (as calculated under GAAP) certain recurring component elements of income and expense, such as intangible asset amortization (which is included in noninterest expense under GAAP but may not be included therein for purposes of calculating the efficiency ratio) and securities gains or losses (which are reflected in the calculation of noninterest income under GAAP but may be ignored for purposes of calculating the efficiency ratio).  We make these adjustments.

Tangible Book Value per Share:  Tangible equity is total stockholders equity less intangible assets.  Tangible book value per share is tangible equity divided by total shares issued and outstanding.  Tangible book value per share is often regarded as a more meaningful comparative ratio than book value per share as calculated under GAAP, that is, total stockholders equity including intangible assets divided by total shares issued and outstanding.  Intangible assets includes many items, but in our case, essentially represents goodwill.


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Adjustments for Certain Items of Income or Expense:  In addition to our regular utilization in our public filings and disclosures of the various non-GAAP measures commonly utilized by financial institutions discussed above, we also may elect from time to time, in connection with our presentation of various financial measures prepared in accordance with GAAP, such as net income, earnings per share (i.e. EPS), return on average assets (i.e. ROA), and return on average equity (i.e. ROE), to provide as well certain comparative disclosures that adjust these GAAP financial measures, typically by removing therefrom the impact of certain transactions or other material items of income or expense that are unusual or unlikely to be repeated.  We do so only if we believe that inclusion of the resulting non-GAAP financial measures may improve the average investor's understanding of our results of operations by separating out items that have a disproportional positive or negative impact on the particular period in question or by otherwise permitting a better comparison from period-to-period in our results of operations with respect to our fundamental lines of business, including the commercial banking business.
We believe that the non-GAAP financial measures disclosed by us from time-to-time are useful in evaluating our performance and that such information should be considered as supplemental in nature and not as a substitute for or superior to the related financial information prepared in accordance with GAAP.  Our non-GAAP financial measures may differ from similar measures presented by other companies.

PART I
Item 1. Business

A. GENERAL
Our holding company, Arrow Financial Corporation, a New York corporation, was incorporated on March 21, 1983 and is registered as a bank holding company within the meaning of the Bank Holding Company Act of 1956.  Arrow owns two nationally chartered banks in New York (Glens Falls National and Saratoga National), and through such banks indirectly owns various non-bank subsidiaries, including three insurance agencies, a registered investment adviser and a REIT. See "The Company and Its Subsidiaries," above.
Subsidiary Banks (dollars in thousands)
 
 
 
 
Glens Falls National
 
Saratoga National
Total Assets at Year-End
$
2,057,938

 
$
390,998

Trust Assets Under Administration and
   Investment Management at Year-End
   (Not Included in Total Assets)
$
1,154,897

 
$
77,993

Date Organized
1851

 
1988

Employees (full-time equivalent)
462

 
49

Offices
30

 
9

Counties of Operation
Warren, Washington,
Saratoga, Essex &
Clinton
 
 Saratoga, Albany &
Rensselaer
Main Office
250 Glen Street
Glens Falls, NY
 
171 So. Broadway
Saratoga Springs, NY

The holding companys business consists primarily of the ownership, supervision and control of our two banks, including the banks' subsidiaries.  The holding company provides various advisory and administrative services and coordinates the general policies and operation of the banks. There were 511 full-time equivalent employees, including 66 employees within our insurance agency affiliates, at December 31, 2015.
We offer a full range of commercial and consumer banking and financial products.  Our deposit base consists of deposits derived principally from the communities we serve.  We target our lending activities to consumers and small and mid-sized companies in our immediate geographic areas.  Through our banks' trust operations, we provide retirement planning, trust and estate administration services for individuals, and pension, profit-sharing and employee benefit plan administration for corporations.


B. LENDING ACTIVITIES
Arrow engages in a wide range of lending activities, including commercial and industrial lending primarily to small and mid-sized companies; mortgage lending for residential and commercial properties; and consumer installment and home equity financing.  We also maintain an active indirect lending program through our sponsorship of automobile dealer programs under which we purchase dealer paper, primarily from dealers that meet pre-established specifications.  From time to time we sell a portion of our residential real estate loan originations into the secondary market, primarily to the Federal Home Loan Mortgage Corporation ("Freddie Mac") as well as a limited number of other financial institutions and governmental agencies. Normally, we retain the servicing rights on mortgage loans originated and sold by us into the secondary markets, subject to our periodic determinations on the continuing profitability of such activity.  
Generally, we continue to implement lending strategies and policies that are intended to protect the quality of the loan portfolio, including strong underwriting and collateral control procedures and credit review systems. Loans are placed on nonaccrual status either due to the delinquency status of principal and/or interest or a judgment by management that the full repayment of principal and interest is unlikely. Home equity lines of credit, secured by real property, are systematically placed on nonaccrual status when 120 days past due, and residential real estate loans when 150 days past due. Commercial and commercial real estate loans are evaluated on a loan-by-loan basis and are placed on nonaccrual status when 90 days past due if the full collection of principal and interest is uncertain. (See Part II, Item 7.C.II.c. "Risk Elements.") Subsequent cash payments on loans classified as nonaccrual may be applied all to principal, although income in some cases may be recognized on a cash basis.

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We lend almost exclusively to borrowers within our normal retail service area in northeastern New York State, with the exception of our indirect consumer lending line of business, where we acquire retail paper from an extensive network of automobile dealers that operate in a slightly larger area of upstate New York and in central and southern Vermont. The loan portfolio does not include any foreign loans or any other significant risk concentrations.  We do not generally participate in loan syndications, either as originator or as a participant.  However, from time to time, we buy participations in individual loans, typically commercial loans, originated by other financial institutions in New York and adjacent states. In recent periods the total dollar amount of such participations has fluctuated, but generally represents less than 20% of commercial loans outstanding. Most of the portfolio is fully collateralized, and many commercial loans are further supported by personal guarantees.
We do not engage in subprime mortgage lending as a business line and we do not extend or purchase so-called "Alt A," "negative amortization," "option ARM's" or "negative equity" mortgage loans.  
 

C. SUPERVISION AND REGULATION
The following generally describes the laws and regulations to which we are subject.  Bank holding companies, banks and their affiliates are extensively regulated under both federal and state law.  To the extent that the following information summarizes statutory or regulatory law, it is qualified in its entirety by reference to the particular provisions of the various statutes and regulations.  Any change in applicable law may have a material effect on our business operations, customers, prospects and investors.

Bank Regulatory Authorities with Jurisdiction over Arrow and its Subsidiary Banks

Arrow is a registered bank holding company within the meaning of the Bank Holding Company Act of 1956 ("BHC Act") and as such is subject to regulation by the Board of Governors of the Federal Reserve System ("FRB").  Arrow is not, at present, a so-called "financial holding company" under federal banking law.  As a "bank holding company" under New York State law, Arrow is also subject to regulation by the New York State Department of Financial Services.  Our two subsidiary banks are both national banks and are subject to supervision and examination by the Office of the Comptroller of the Currency ("OCC"). The banks are members of the Federal Reserve System and the deposits of each bank are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC").  The BHC Act generally prohibits Arrow from engaging, directly or indirectly, in activities other than banking, activities closely related to banking, and certain other financial activities.  Under the BHC Act, a bank holding company generally must obtain FRB approval before acquiring, directly or indirectly, voting shares of another bank or bank holding company, if after the acquisition the acquiror would own 5 percent or more of a class of the voting shares of that other bank or bank holding company.  Bank holding companies are able to acquire banks or other bank holding companies located in all 50 states, subject to certain limitations.  The Gramm-Leach-Bliley Act ("GLBA"), enacted in 1999, authorized bank holding companies designated as "financial holding companies" to affiliate with a much broader array of other financial institutions than was previously permitted, including insurance companies, investment banks and merchant banks. Arrow has not attempted to become, and has not been designated as, a financial holding company.  See Item 1.D., "Recent Legislative Developments."

The FRB and the OCC have broad regulatory, examination and enforcement authority. The FRB and the OCC conduct regular examinations of the entities they regulate. In addition, banking organizations are subject to periodic reporting requirements to the regulatory authorities.  The FRB and OCC have the authority to implement various remedies if they determine that the financial condition, capital, asset quality, management, earnings, liquidity or other aspects of a banking organization's operations are unsatisfactory or if they determine the banking organization is violating or has violated any law or regulation. The authority of the FRB and the OCC over banking organizations includes, but is not limited to, prohibiting unsafe or unsound practices; requiring affirmative action to correct a violation or unsafe or unsound practice; issuing administrative orders; requiring the organization to increase capital; requiring the organization to sell subsidiaries or other assets; restricting dividends and distributions; restricting the growth of the organization; assessing civil money penalties; removing officers and directors; and terminating deposit insurance. The FDIC may terminate a depository institution's deposit insurance upon a finding that the institution's financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the depository institution's bank regulators.

Regulatory Supervision of Other Arrow Subsidiaries

The insurance agency subsidiaries of Glens Falls National are subject to the licensing and other provisions of New York State Insurance Law and are regulated by the New York State Department of Financial Services. Arrow's investment adviser subsidiary is subject to the licensing and other provisions of the federal Investment Advisers Act of 1940 and is regulated by the SEC.
  
Regulation of Transactions between Banks and their Affiliates

Transactions between banks and their "affiliates" are regulated by Sections 23A and 23B of the Federal Reserve Act (the "FRA"). Each of our organization's non-bank subsidiaries (other than the business trusts we formed to issue our TRUPs) is a subsidiary of one of our banks, and also is an "operating subsidiary" under Sections 23A and 23B. This means the non-bank subsidiary is considered to be part of the bank that owns it and thus is not an affiliate of the bank. However, each of our two banks is an affiliate of the other bank, and our holding company (Arrow) is also an affiliate of each bank. Extensions of credit that a bank may make to affiliates, or to third parties secured by securities or obligations of the affiliates, are substantially limited by the FRA and the Federal Deposit Insurance Act (the "FDIA"). Such acts further restrict the range of permissible transactions between a bank and any affiliate, including a bank affiliate. Furthermore, under the FRA, a bank may engage in certain transactions, including

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loans and purchases of assets, with a non-bank affiliate, only if certain special conditions, including collateral requirements for loans, are met and if the other terms and conditions of the transaction, including interest rates and credit standards, are substantially the same as, or at least as favorable to the bank as, those prevailing at the time for comparable transactions by it with non-affiliated companies or, in the absence of comparable transactions, on terms and conditions that would be offered by it to non-affiliated companies.
 
Regulatory Capital Standards

An important area of banking regulation is the federal banking system's promulgation and enforcement of minimum capitalization standards for banks and bank holding companies.  
Bank Capital Rules. The Dodd-Frank Act, among other things, directed U.S. bank regulators to promulgate new capital standards for U.S. banking organizations, which needed be at least as strict (i.e., must establish minimum capital levels that are at least as high) as the regulatory capital standards that were in effect for U.S. insured depository financial institutions at the time Dodd-Frank was enacted in 2010.
In July 2013, federal bank regulators, including the FRB and the OCC, approved their final new bank capital rules aimed at implementing these Dodd-Frank capital requirements. These rules were also intended to coordinate U.S. bank capital standards with the current drafts of the Basel III proposed bank capital standards for all of the developed world's banking organizations. The federal regulators' new capital rules (the "Capital Rules"), which impose significantly higher minimum capital ratios on U.S. financial institutions than the rules they replaced, became effective for our holding company and banks on January 1, 2015, and will be fully phased in by 2019.
The new Capital Rules, like the rules they replaced, consist of two basic types of capital measures, a leverage ratio and set of risk-based capital measures. Within these two broad types of rules, however, significant changes were made in the new Capital Rules, as discussed below.
Leverage Rule. The new Capital Rules did not fundamentally alter the structure of the leverage rule that previously applied to banks and bank holding companies, except to increase the minimum required leverage ratio from 3.0% to 4.0%. The leverage ratio continues to be defined as the ratio of the institution's "Tier 1" capital (as defined under the new leverage rule) to total tangible assets (again, as defined under the new leverage rule).
Risk-Based Capital Measures. The principal changes under the new Capital Rules involve the other basic type of regulatory capital measures, the so-called risk-based capital measures. As a general matter, risk-based capital measures assign various risk weightings to all of the institution's assets, by asset type, and to certain off-balance sheet items, and then establish minimum levels of capital to the aggregate dollar amount of such risk-weighted assets. The general effect of the new risk-based Capital Rules was to increase most of the pre-existing risk-based minimum capital ratios and to introduce several new minimum capital ratios and capital definitions. The basic result was to increase required capital for banks and their holding companies.
Under the new risk-based Capital Rules, there are 8 major risk-weighted categories of assets (although there are several additional super-weighted categories for high-risk assets that are generally not held by community banking organizations like ours). The new rules also are more restrictive in their definitions of what qualify as capital components. Most importantly, the new rules, as required under Dodd-Frank, added several new risk-based capital measures that also must be met. One such measure is the "common equity tier 1 capital ratio" (CET1). For this ratio, only common equity (basically, common stock plus surplus plus retained earnings) qualifies as capital (i.e., CET1). Preferred stock and trust preferred securities, which qualified as Tier 1 capital under the old Tier 1 risk-based capital measure (and continue to qualify as capital under the new Tier 1 risk-based capital measure), are not included in CET1 capital. Technically, under the new rules, CET1 capital also includes most elements of accumulated other comprehensive income (AOCI), including unrealized securities gains and losses, as part of both total regulatory capital (numerator) and total assets (denominator). However, smaller banking organizations like ours were given the opportunity to make a one-time irrevocable election to include or not to include certain elements of AOCI, most notably unrealized securities gains or losses. We made such an election, i.e., not to include unrealized securities gains and losses in calculating our CET1 ratio under the new Capital Rules. The minimum CET1 ratio under the new rules, effective January 1, 2015, is 4.50%, which will remain constant throughout the phase-in period.
Consistent with the general theme of higher capital levels, the new Capital Rules also increased the minimum ratio for Tier 1 risk-based capital, which was 4.0%, to 6.0%, effective January 1, 2015. The minimum level for total risk-based capital under the new Capital Rules remained at 8.0%, the same level as under the old rules.
The new Capital Rules incorporate a capital concept, the so-called "capital conservation buffer" (set at 2.5%, after full phase-in), which must be added to each of the minimum required risk-based capital ratios (i.e., the minimum CET1 ratio, the minimum Tier 1 risk-based capital ratio and the minimum total risk-based capital ratio). The capital conservation buffer is being phased-in over four years beginning January 1, 2016 (see the table below). When, during economic downturns, an institution's capital begins to erode, the first deductions from a regulatory perspective would be taken against the conservation buffer. To the extent that such deductions should erode the buffer below the required level (2.5% of total risk-based assets), the institution will not necessarily be required to replace the buffer deficit immediately, but will face restrictions on paying dividends and other negative consequences until the buffer is fully replenished.
Also under the new Capital Rules, and as required under Dodd-Frank, TRUPs issued by small- to medium-sized banking organizations (such as ours) that were outstanding on the Dodd-Frank grandfathering date for TRUPS (May 19, 2010) will continue to qualify as tier 1 capital, up to a limit of 25% of tier 1 capital, until the TRUPs mature or are redeemed. See the discussion of grandfathered TRUPs in section D of this item under "The Dodd-Frank Act."

The following is a summary of the new definitions of capital under the various new risk-based measures in the new Capital Rules:

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Common Equity Tier 1 Capital: Equals the sum of common stock instruments and related surplus (net of treasury stock), retained earnings, accumulated other comprehensive income (AOCI), and qualifying minority interests, minus applicable regulatory adjustments and deductions. Such deductions will include AOCI, if the organization exercises its irrevocable option not to include AOCI in capital (we made such an election). Mortgage-servicing assets, deferred tax assets, and investments in financial institutions are limited to 15 percent of CET1 in the aggregate and 10 percent of CET1 for each such item individually.
Additional Tier 1 Capital: Equals the sum of noncumulative perpetual preferred stock, tier 1 minority interests, grandfathered TRUPs, and Troubled Asset Relief Program instruments, minus applicable regulatory adjustments and deductions.
Tier 2 Capital: Equals the sum of subordinated debt and preferred stock, total capital minority interests not included in Tier 1, and allowance for loan and lease losses (not exceeding 1.25 percent of risk-weighted assets) minus applicable regulatory adjustments and deductions.

The following table presents the transition schedule applicable to our holding company and banks under the new Capital Rules:
Year, as of January 1
2015
2016
2017
2018
2019
Minimum CET1 Ratio
4.500
%
4.500
%
4.500
%
4.500
%
4.500
%
Capital Conservation Buffer ("Buffer")
N/A

0.625
%
1.250
%
1.875
%
2.500
%
Minimum CET1 Ratio Plus Buffer
4.500
%
5.125
%
5.750
%
6.375
%
7.000
%
[ Phase-in of Deductions from CET1 (e.g., AOCI)]
40.000
%
60.000
%
80.000
%
100.000
%
100.000
%
Minimum Tier 1 Risk-Based Capital Ratio
6.000
%
6.000
%
6.000
%
6.000
%
6.000
%
Minimum Tier 1 Risk-Based Capital Ratio Plus Buffer
N/A

6.625
%
7.250
%
7.875
%
8.500
%
Minimum Total Risk-Based Capital Ratio
8.000
%
8.000
%
8.000
%
8.000
%
8.000
%
Minimum Total Risk-Based Capital Ratio Plus Buffer
N/A

8.625
%
9.250
%
9.875
%
10.500
%
Minimum Leverage Ratio
4.000
%
4.000
%
4.000
%
4.000
%
4.000
%
 
These minimum capital ratios, especially the CET1 ratio (4.5%) and the Tier 1 risk-based capital ratio (6.0%), which began to apply to our organization on January 1, 2015, represent a heightened and more restrictive capital regime than institutions like ours previously had to meet, and the four year phase-in of the new regulatory capital buffer, which began this past January 1, 2016, will add to the stress on banks' profitability.

At December 31, 2015, our holding company and both of our banks exceeded by a substantial amount each of the minimum capital ratios established under the new Capital Rules, including the new minimum CET1 Ratio, the new minimum Tier 1 Risk-Based Capital Ratio, the new minimum Total Risk-Based Capital Ratio, and the new minimum Leverage Ratio. See Note 19 to our audited financial statements, beginning on page 99, for a presentation of our period-end ratios for 2015 and 2014.
    
Regulatory Capital Classifications. Under applicable banking law, federal banking regulators are required to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements.  The regulators have established five capital classifications for banking institutions, ranging from the highest category of "well-capitalized" to the lowest category of "critically under-capitalized". As a result of the regulators' adoption of the new Capital Rules, the definitions for determining which of the five capital classifications a particular banking organization will fall into were changed, effective as of January 1, 2015. Under the revised capital classifications, a banking institution is considered "well-capitalized" if it meets the following capitalization standards on the date of measurement: a CET1 risk-based capital ratio of 6.50% or greater, a Tier 1 risk-based capital ratio of 8.00% or greater, and a total risk-based capital ratio of 10.00% or greater, provided the institution is not subject to any regulatory order or written directive regarding capital maintenance.
As of December 31, 2015, our holding company and both of our banks qualified as "well-capitalized" under the new capital classification scheme.

Dividend Restrictions; Other Regulatory Sanctions

A holding company's ability to pay dividends or repurchase its outstanding stock, as well as its ability to expand its business through acquisitions of additional banking organizations or permitted non-bank companies, may be restricted if its capital falls below minimum regulatory capital ratios or fails to meet other informal capital guidelines that the regulators may apply from time to time to specific banking organizations.  In addition to these potential regulatory limitations on payment of dividends, our holding company's ability to pay dividends to our shareholders, and our subsidiary banks' ability to pay dividends to our holding company are also subject to various restrictions under applicable corporate laws, including banking laws (which affect our subsidiary banks) and the New York Business Corporation Law (which affects our holding company). The ability of our holding company and banks to pay dividends in the future is, and is expected to continue to be, influenced by regulatory policies, the phase-in of the new, more stringent bank capital guidelines and applicable law.
In cases where banking regulators have significant concerns regarding the financial condition, assets or operations of a bank or bank holding company, the regulators may take enforcement action or impose enforcement orders, formal or informal, against

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the organization.  If the ratio of tangible equity to total assets of a bank falls to 2% or below, the bank will likely be closed and placed in receivership, with the FDIC as receiver.
Anti-Money Laundering and OFAC
Under federal law, financial institutions must maintain anti-money laundering programs that include established internal policies, procedures, and controls. Financial institutions are also prohibited from entering into specified financial transactions and account relationships and must meet enhanced standards for due diligence and customer identification. Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships to guard against money laundering and to report any suspicious transactions. Law enforcement authorities have been granted increased access to financial information maintained by financial institutions. Bank regulators routinely examine institutions for compliance with these obligations and they must consider an institution's compliance in connection with the regulatory review of applications, including applications for banking mergers and acquisitions. The U.S. Department of the Treasury's Office of Foreign Assets Control, or "OFAC," is responsible for helping to insure that U.S. entities do not engage in transactions with certain prohibited parties, as defined by various Executive Orders and Acts of Congress. OFAC publishes lists of persons, organizations, and countries suspected of aiding, harboring or engaging in terrorist acts, known as Specially Designated Nationals and Blocked Persons. If Arrow finds a name on any transaction, account or wire transfer that is on an OFAC list, Arrow must freeze or block such account or transaction, file a suspicious activity report and notify the appropriate authorities.
Reserve Requirements
Pursuant to regulations of the FRB, all banking organizations are required to maintain average daily reserves at mandated ratios against their transaction accounts and certain other types of deposit accounts. These reserves must be maintained in the form of vault cash or in an account at a Federal Reserve Bank.
Community Reinvestment Act
Each of Arrow's subsidiary banks is subject to the Community Reinvestment Act ("CRA") and implementing regulations. CRA regulations establish the framework and criteria by which the bank regulatory agencies assess an institution's record of helping to meet the credit needs of its community, including low and moderate-income neighborhoods. CRA ratings are taken into account by regulators in reviewing certain applications made by Arrow and its bank subsidiaries.
Privacy and Confidentiality Laws
Arrow and its subsidiaries are subject to a variety of laws that regulate customer privacy and confidentiality. The Gramm-Leach-Bliley Act requires financial institutions to adopt privacy policies, to restrict the sharing of nonpublic customer information with nonaffiliated parties upon the request of the customer, and to implement data security measures to protect customer information. The Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act of 2003, regulates use of credit reports, providing of information to credit reporting agencies and sharing of customer information with affiliates, and sets identity theft prevention standards.


D. RECENT LEGISLATIVE DEVELOPMENTS

The principal federal law enacted after the 2008-2009 financial crisis that attempted to deal with the causes of that crisis was the Dodd-Frank Act of 2010. Dodd-Frank has significantly affected all financial institutions, including Arrow and our banks. There are other earlier-enacted banking laws that continue to significantly impact our operations. The Dodd-Frank Act and these other statutes are discussed briefly below.

The Dodd-Frank Act

As a result of the 2008-2009 financial crisis, the U.S. Congress passed and the President signed the Dodd-Frank Act on July 21, 2010. While some of the Act's provisions have not had, and likely will not have, any direct impact on Arrow, other provisions have impacted or likely will impact our business operations and financial results in a significant way. These include the establishment of a new regulatory body known as the Consumer Financial Protection Bureau ("the CFPB"), which operates as an independent entity within the Federal Reserve System and is authorized to issue rules for consumer protection, some of which have increased, and likely will continue to increase banks' compliance expenses, thereby reducing or restraining profitability. For depository institutions with $10 billion or less in assets (such as Arrow's banks), the banks' traditional regulatory agencies (for our banks, the OCC), and not the CFPB, will have primary examination and enforcement authority over the banks' compliance with new CFPB rules as well as all other consumer protection rules and regulations.  However, the  CFPB has the right to include its examiners on a "sampling" basis in examinations conducted by the traditional regulators and is authorized to give those agencies input and recommendations with respect to consumer protection laws and to require reports and other examination documents. The CFPB has broad authority to curb practices it finds to be unfair, deceptive and abusive. What constitutes "abusive" behavior has been broadly defined and is very likely to create an environment conducive to increased litigation.  This is likely to be exacerbated by the

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fact that, in addition to the federal authorities charged with enforcing the CFPB's rules, state attorneys general are also authorized to enforce certain of the Federal consumer laws transferred to the CFPB and the rules issued by the CFPB thereunder.
Dodd-Frank also directed the federal banking authorities to issue new capital requirements for banks and holding companies. See the discussion under “Regulatory Capital Standards” on page 7 of this Report. Dodd-Frank also provided that any new issuances of trust preferred securities (TRUPs) by bank holding companies having between $500 million and $15 billion in assets (such as Arrow) will no longer be able to qualify as Tier 1 capital, although previously issued TRUPs of such bank holding companies that were outstanding on the Dodd-Frank grandfathering date (May 19, 2010), including the $20 million of TRUPs issued by Arrow before that date, will continue to qualify as Tier 1 capital until maturity or earlier redemption, subject to certain limitations. The new bank Capital Rules, in their final form, preserve this "grandfathered" status of TRUPs previously issued by small- to mid-sized financial institutions like Arrow before the grandfathering date. Generally, however, TRUPs, which were an important financing tool for community banks such as ours, can no longer be counted on as a viable source of new capital for banks, unless the U.S. Congress passes legislation that specifically accords regulatory capital status to newly-issued TRUPs.
Bank regulators have not finished promulgating all the rules required to be issued by them under Dodd-Frank and many of the new rules will have phase-in periods even after final promulgation. (Many of the rules already issued also will become effective only on a deferred, phased-in basis, including the recently issued new rules under the Home Mortgage Disclosure Act. The following is a summary of some additional Dodd-Frank provisions likely to have a material impact, positive or negative, as the case may be, on us and our customers:

1. Increase of FDIC deposit insurance to $250,000 per customer made permanent by statute.
2. Changes in the methodology for assessing FDIC deposit insurance premiums on banks. Such assessment as a result of Dodd-Frank is now asset-based, not deposit-based, as was previously the case. This change has had the effect of actually reduces insurance costs for most small- to mid-sized institutions, like Arrow. Under the new method, our premiums were reduced from $513 thousand of FDIC and FICO assessments for the first quarter of 2011 (the last quarter under the old deposit-based method of assessment), to $267 thousand of expense for the second quarter of 2011 (under the new asset-based method), a decline of 48%.
3. New limitations imposed by Dodd-Frank on debit card interchange fees, which technically apply only to the very large banks having more than $10 billion in assets. Despite the fact that we are not a large bank, this change has already had and likely will continue to have a negative impact on us, as on many smaller banks, due to competitive pressures. 
4. Requirements for mortgage originators to act in the best interests of a consumer and to seek to ensure that a consumer will have the ability to repay certain consumer loans. This change imposes fiduciary-like standards on banks, exposing them to an enhanced risk of liability to customers and regulators generally.
5. Requirements for comprehensive additional residential mortgage loan-related disclosures, which has increased our costs.
6. A comprehensive overhaul of the Home Mortgage Disclosure Act rules and information collection and data reporting requirements, which also has increased our costs.
7. Statutory implementation of “source of strength doctrine” for both bank and savings and loan holding companies, under which the Federal Reserve can compel a holding company to contribute additional capital to its subsidiary depository institutions.
8. Limitation of previously established Federal preemption standards for national banks (such as our banks). Dodd-Frank reduces the extent to which state law is preempted by Federal law with regard to certain operations of national banks, particularly the operations of their subsidiaries.  This greatly increases the potential for state authorities as well as bank customers, to challenge the way national banks do business on a state-by-state basis, substantially increasing such banks' exposure.
9. Repeal of the federal prohibitions on the payment of interest on demand deposits. This has enabled depository institutions to pay interest on business transaction and other accounts, and more importantly, has exposed them to competitive pressures to do so (i.e., pay interest on commercial deposits), thereby increasing overall costs of their deposit liabilities.

To date, implementation of the Dodd-Frank Act provisions has resulted in many new mandatory and discretionary rule-makings by regulatory authorities, a process that is still not completed, almost six years after Dodd-Frank's enactment. As a result, bank holding companies and their bank and non-bank operating subsidiaries have faced thousands of new pages of regulations and associated regulatory burdens still being formulated, several of which are highly controversial and the implementation of which will be costly and time consuming.

Other Federal Laws Affecting Banks

Federal laws enacted in 2008, before Dodd-Frank, also in response to the financial crisis, included The Emergency Economic Stabilization Act of 2008 (EESA) and the American Recovery and Reinvestment Act of 2008 (ARRA). These laws established emergency capital and liquidity support programs which enabled many major financial institutions to survive the crisis. Such programs served their purpose and have largely run their course or been superseded by subsequent statutory and regulatory measures, principally Dodd-Frank. We did not need to participate, nor did we request to participate or actually participate, in any of the emergency capital support programs.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "New Bankruptcy Act") became effective October 17, 2005. The New Bankruptcy Act addressed many areas of bankruptcy practice, including consumer bankruptcy, general and small business bankruptcy, treatment of tax claims in bankruptcy, ancillary and cross-border cases, financial contract protection amendments to Chapter 12 governing family farmer reorganization, and special protection for patients of a health care business filing for bankruptcy.  The New Bankruptcy Act did not have a significant impact on our earnings or on our efforts to recover collateral on secured loans.

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The Sarbanes-Oxley Act ("Sarbanes-Oxley"), signed into law on July 30, 2002, adopted a number of measures having a significant impact on all publicly-traded companies, including Arrow.  Generally, Sarbanes-Oxley sought to improve the quality of financial reporting of these companies by compelling them to adopt good corporate governance practices and by strengthening the independence of their auditors.  Sarbanes-Oxley placed substantial additional duties on directors, officers, auditors and attorneys of public companies.  Among other specific measures, Sarbanes-Oxley required that the chief executive officers and chief financial officers of such companies certify to the SEC, in the holding company's annual and quarterly reports filed with the SEC, regarding the accuracy of the company's financial statements contained therein and the integrity of its internal controls.  Sarbanes-Oxley also accelerated insiders' reporting requirements for transactions in company securities, restricted certain executive officer and director transactions, imposed obligations on corporate audit committees, and provided for enhanced review of company filings by the SEC.  As part of the general effort to improve public company auditing, Sarbanes-Oxley placed limits on non-audit services that may be performed by a company's independent auditors and required that the company's Audit Committee review and approve in advance any non-audit services performed by the independent auditor, as well as its audit services.  Sarbanes-Oxley created a federal public company accounting oversight board (the PCAOB) to set auditing standards, inspect registered public accounting firms, and exercise enforcement powers, subject to oversight by the SEC.  
In the wake of Sarbanes-Oxley, the nation's stock exchanges, including the exchange on which Arrow's stock is listed, the National Association of Securities Dealers, Inc. ("NASDAQ®"), promulgated a wide array of new corporate governance standards that must be followed by listed companies.  The NASDAQ® standards include a requirement that a majority of the Board of Directors of a listed company consist of Directors who are "independent" of management, as defined in exchange-adopted regulations, and that the audit, compensation and nomination committees of the Board consist exclusively of independent directors (with "independent," for purposes of serving on the audit and compensation committees, defined even more rigorously).  Over the years, we have implemented a variety of corporate governance measures and procedures to comply with Sarbanes-Oxley and the NASDAQ® listing requirements.
The USA Patriot Act initially adopted in 2001 and re-adopted by the U.S. Congress in 2006 with certain changes (the "Patriot Act"), imposes substantial record-keeping and due diligence obligations on banks and other financial institutions, with a particular focus on detecting and reporting money-laundering transactions involving domestic or international customers.  The U.S. Treasury Department has issued and will continue to issue regulations clarifying the Patriot Act's requirements.  The Patriot Act requires all financial institutions, including banks, to maintain certain anti-money laundering compliance and due diligence programs.  The provisions of the Patriot Act impose substantial costs on all financial institutions, including ours.

Deposit Insurance Laws and Regulations

The FDIC, which collects insurance premiums from banks on insured deposits, has made several modifications in recent years to its deposit insurance premium structure that have had a significant impact on bank earnings, the most important of which was the FDIC's decision to calibrate premiums based on the total assets (versus total deposits) of insured institutions. This has tended to benefit smaller regional banks such as ours, that typically maintain a higher ratio of deposits to total assets than the large, money-center banks. In 2007, after a several year period in which banks were charged no or very low premiums for deposit insurance, the FDIC resumed charging financial institutions an FDIC deposit insurance premium, under a new risk-based assessment system. Under this system, institutions in Risk Category I (the lowest of four risk categories) paid a rate (based on a formula) of 5 to 7 cents per $100 of assessable deposits.  
In February of 2011, the FDIC finalized a new assessment system that took effect in the second quarter of 2011.  The final rule changed the assessment base from domestic deposits to average assets minus average tangible equity, adopted a new large-bank pricing assessment scheme, and set a target size for the Deposit Insurance Fund (the successor to the Bank Insurance Fund).  The changes went into effect in the second quarter of 2011.  The rule (as mandated by Dodd-Frank) finalizes a target size for the Deposit Insurance Fund at 2% of insured deposits. It also implements a lower assessment rate schedule when the fund reaches 1.15% (so that the average rate over time should be about 8.5 basis points) and, in lieu of dividends, provides for a lower rate schedule when the reserve ratio reaches 2% and 2.5%.  Also as mandated by Dodd-Frank, the rule changes the assessment base from adjusted domestic deposits to a bank's average consolidated total assets minus average tangible equity.  
We are unable to predict whether or to what extent the FDIC may elect to impose additional special assessments on insured institutions in upcoming years, if bank failures should once again become a significant problem on a system-wide basis.


E. STATISTICAL DISCLOSURE (GUIDE 3)
Set forth below is an index identifying the location in this Report of various items of statistical information required to be included in this Report by the SECs industry guide for Bank Holding Companies.
Required Information
Location in Report
Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential
Part II, Item 7.B.I.
Investment Portfolio
Part II, Item 7.C.I.
Loan Portfolio
Part II, Item 7.C.II.
Summary of Loan Loss Experience
Part II, Item 7.C.III.
Deposits
Part II, Item 7.C.IV.
Return on Equity and Assets
Part II, Item 6.
Short-Term Borrowings
Part II, Item 7.C.V.

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F. COMPETITION
We face intense competition in all markets we serve.  Competitors include traditional local commercial banks, savings banks and credit unions, non-traditional internet-based lending alternatives, as well as local offices of major regional and money center banks.  Like all banks, we encounter strong competition in the mortgage lending space from a wide variety of other mortgage originators, all of whom are principally affected in this business by the rate and terms set, and the lending practices established from time-to-time by the very large government sponsored enterprises ("GSEs") engaged in residential mortgage lending, most importantly, “Fannie Mae” and “Freddie Mac.” These GSEs purchase and/or guarantee a very substantial dollar amount and number of mortgage loans, which in 2015 accounted for a large majority of the total amount of mortgage loans extended in the U.S. Additionally, non-banking financial organizations, such as consumer finance companies, insurance companies, securities firms, money market funds, mutual funds and credit card companies offer substantive equivalents of the various other types of loan and financial products and transactional accounts that we offer, even though these non-banking organizations are not subject to the same regulatory restrictions and capital requirements that apply to us.  Under federal banking laws, such non-banking financial organizations not only may offer products comparable to those offered by commercial banks, but also may establish or acquire their own commercial banks.
G. EXECUTIVE OFFICERS OF THE REGISTRANT
The names and ages of the executive officers of Arrow and positions held by each are presented in the following table.  Officers are elected annually by the Board of Directors.
Name
Age
Positions Held and Years from Which Held
Thomas J. Murphy, CPA
57
President and Chief Executive Officer of Arrow since January 1, 2013. He has been a director of Arrow since July 2012. Mr. Murphy served as a Vice President of Arrow from 2009 to 2012, and as Corporate Secretary from 2009 to 2012. Mr. Murphy also has been the President and Chief Executive Officer of GFNB since January 1, 2013. Prior to that date he served as Senior Executive Vice President of Arrow and President of GFNB commencing July 1, 2011. Prior to July 1, 2011, Mr. Murphy served as Senior Trust Officer of GFNB (since 2010) and Cashier of GFNB (since 2009). Mr. Murphy previously served as Assistant Corporate Secretary of Arrow (2008-2009), Senior Vice President of GFNB (2008-2011) and Manager of the Personal Trust Department of GFNB (2004-2011). Mr. Murphy started with the Company in 2004.
Terry R. Goodemote, CPA
52
Chief Financial Officer of Arrow since January 1, 2007. He also has been Executive Vice President of Arrow (since January 1, 2013); prior to that, he was Senior Vice President of Arrow (since 2008). Mr. Goodemote also serves as Chief Financial Officer of GFNB (since January 1, 2007) and as Senior Executive Vice President of GFNB (since July 1, 2011). Before that he was Executive Vice President of GFNB (since 2008). Prior to becoming Chief Financial Officer, Mr. Goodemote served as Senior Vice President and Head of the Accounting Division of GFNB. Mr. Goodemote started with the Company in 1992.
David S. DeMarco
54
Senior Vice President of Arrow since May 1, 2009. Mr. DeMarco has been the President and Chief Executive Officer of SNB since January 1, 2013. Prior to that date, Mr. DeMarco served as Executive Vice President and Head of the Branch, Corporate Development, Financial Services & Marketing Division of GFNB since January 1, 2003. Mr. DeMarco started with the Company in 1987.
David D. Kaiser
55
Senior Vice President and Chief Loan Officer of Arrow since February 1, 2015. Mr. Kaiser has also served as Executive Vice President of GFNB and SNB since 2012 and as Chief Loan Officer of GFNB and SNB since 2011. Previously, he served as the Corporate Banking Manager for GFNB from 2005 to 2011. Mr. Kaiser started with the Company in 2000.

H. AVAILABLE INFORMATION
Our Internet address is www.arrowfinancial.com.  We make available free of charge on or through our internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we file or furnish them with the SEC pursuant to the Exchange Act.  We also make available on the internet website various other documents related to corporate operations, including our Corporate Governance Guidelines, the charters of our principal board committees, and our codes of ethics.  We have adopted a financial code of ethics that applies to Arrows chief executive officer, chief financial officer and principal accounting officer and a business code of ethics that applies to all directors, officers and employees of our holding company and its subsidiaries.


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Item 1A. Risk Factors
Our financial results and the market price of our stock are subject to risks arising from many factors, including the risks listed below, as well as other risks and uncertainties. Any of these risks could materially and adversely affect our business, financial condition or results of operations. (Please note that the discussion below regarding potential impact on Arrow of certain of these factors that may develop in the future is not meant to provide predictions by Arrow's management that such factors will develop, but to acknowledge the possible negative consequences to our company and business if certain conditions develop.)
Difficult market conditions continue to adversely affect the U.S. commercial banking industry and its core business of making and servicing loans and could adversely affect our ability to originate loans. Many existing or potential loan customers of commercial banks, especially individuals and small businesses, continue to experience financial and budgetary pressures that both challenge their ability to service their existing indebtedness and sharply restrict their ability or willingness to incur additional indebtedness. The demand for loans has generally increased in recent years, and very low prevailing rates of interest for all types of credit still exist, which makes borrowing more affordable and attractive to customers of all types. However, while the U.S. economy and our regional economy have shown signs of improvement in recent years, consumers and small businesses are still struggling under heavy debt loads, which will continue to weigh against any surge in growth or profitability in the banking sector. This cautionary scenario confronts us as it confronts all commercial banks, large and small, and could adversely affect our ability to originate loans.
We face continuing and growing security risks to our information base including the information we maintain relating to our customers, and breaches in the security systems we have implemented to protect this information could have a negative effect on our business operations and financial condition. We have implemented and regularly review and update extensive systems of internal controls and procedures as well as corporate governance policies and procedures intended to protect our business operations, including the security and privacy of all confidential customer information. In addition, we rely on the services of a variety of vendors to meet our data processing and communication needs. No matter how well designed or implemented our controls are, we cannot provide an absolute guarantee to protect our business operations from every type of problem in every situation. A failure or circumvention of these controls could have a material adverse effect on our business operations and financial condition.
Also, the computer systems and network infrastructure that we use are always vulnerable to unforeseen disruptions, including theft of confidential customer information (“identity theft”) and interruption of service as a result of fire, natural disasters, explosion, general infrastructure failure or cyber attacks. These disruptions may arise in our internally developed systems, or the systems of our third-party service providers or may originate from the actions of our consumer and business customers who access our systems from their own networks or digital devices to process transactions. Information security and cyber security risks have increased significantly in recent years because of consumer demand to use the Internet and other electronic delivery channels to conduct financial transactions. Cyber security risk is a major concern to financial services regulators and all financial service providers, including our company. These risks are further exacerbated due to the increased sophistication and activities of organized crime, hackers, terrorists and other disreputable parties. We regularly assess and test our security systems and disaster preparedness, including back-up systems, but the risks are substantially escalating. As a result, cybersecurity and the continued enhancement of our controls and processes to protect our systems, data and networks from attacks or unauthorized access remain a priority. Accordingly, we may be required to expend additional resources to enhance our protective measures or to investigate and remediate any information security vulnerabilities or exposures. Any breach of our system security could result in disruption of our operations, unauthorized access to confidential customer information, significant regulatory costs, litigation exposure and other possible damages, loss or liability. Such costs or losses could exceed the amount of available insurance coverage, if any, and would adversely affect our earnings. Also, any failure to prevent a security breach or to quickly and effectively deal with such a breach could negatively impact customer confidence, damaging our reputation and undermining our ability to attract and keep customers.

U.S. bank loan portfolios, although generally improving in quality, continue to experience signs of weakness or stress, particularly in the consumer loan sector, which could deteriorate if the U.S. economy experiences even a modest downturn and which could have an adverse impact on our financial condition. Home prices in all regions of the U.S., including our market area in northeastern New York, have stabilized or even strengthened somewhat in recent periods. Delinquency and charge-off rates in bank loan portfolios have also improved. However, many banks continue to have substantial exposure in their loan portfolios to borrowers, particularly individual and small business borrowers, that if confronted by an economic downturn of any consequence, including one that results in their loss of their job or the failure of their business, may quickly fall in arrears on their borrowings. We, like most banks, believe that the quality of our loan portfolio is strong and our allowance is entirely adequate to cover all embedded risk, but any downturn of consequence in the economy, nationwide or in our region, would likely rekindle the stress in loan portfolios, potentially damaging our financial condition and results.
Persistent volatility in the U.S. equity markets, coupled with economic instability and uncertainty, has an adverse effect on the core business of the U.S. commercial banking sector which could adversely impact our financial results. The U.S. financial sector, particularly that portion that is focused on the equity markets (i.e., “Wall Street”), has largely recovered from the 2008-2009 financial crisis. However, increased market volatility during the latter half calendar year 2015 and early 2016, has had a negative effect on many investors, including those holding shares of financial institutions. At the same time, the wider U.S. economy, especially the business sector that underlies the day-to-day health of U.S. commercial banks (“Main Street”), continues to experience a much slower recovery. In some areas of the U.S. and some sectors of the U.S. economy companies, workers and

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municipalities have not returned to the levels of financial health they enjoyed before the 2008-2009 crisis. Commercial banks like ours are much more closely tied, in terms of growth and profits, to the Main Street sector than the Wall Street sector. Accordingly, our financial results and condition may continue to be pressured by the modest and uneven growth in the U.S. economy generally or in our region.
Any future economic or financial downturn, including any significant correction in the equity markets, may negatively affect the volume of income attributable to, and demand for, fee-based services of banks such as ours which could negatively impact our financial condition and results of operation. Revenues from our trust and wealth management business are dependent on the level of assets under management. Any significant downturn in the equity markets may lead our trust and wealth management customers to liquidate their investments, or may diminish account values for those customers who elect to leave their portfolios with us, in either case reducing our assets under management and thereby decreasing our revenues from this important sector of our business.
Rulemaking under Dodd-Frank continues to unfold; these and other regulations being promulgated may adversely affect our Company and certain players in the financial industry as a whole. Even before the recent financial crisis and the resulting new banking laws and regulations, including Dodd-Frank, we were subject to extensive Federal and state banking regulations and supervision. Banking laws and regulations are intended primarily to protect bank depositors’ funds (and indirectly the Federal deposit insurance funds) as well as bank retail customers, who may lack the sophistication to understand or appreciate bank products and services. These laws and regulations generally are not, however, aimed at protecting or enhancing the returns on investment enjoyed by bank shareholders.
Our depositor/customer awareness of the changing regulatory environment is particularly true of the recently adopted set of laws and regulations under the Dodd-Frank Act, which were passed in the aftermath of the 2008-2009 financial crisis and in large part were intended to better protect bank customers (and to some degree, banks) against the wide variety of lending products and aggressive lending practices that pre-dated the crisis and are seen as having contributed to its severity. Although not all banks offered such products or engaged in such practices, all banks are affected by the new laws and regulations to some degree.
Dodd-Frank restricts our lending practices, requires us to expend substantial additional resources to safeguard customers, significantly increases our regulatory burden, and subjects us to significantly higher minimum capital requirements which, in the long run, may serve as a drag on our earnings, growth and ultimately on our dividends and stock price (the new capital standards are separately addressed in the following risk factor).
While it is difficult to predict the full extent to which Dodd-Frank and the resulting new regulations and rules may adversely impact our business or financial results, we are certain Dodd-Frank will continue to increase our costs, and require us to modify certain strategies, business operations and capital and liquidity structures which, individually or collectively, may very well have a material adverse impact on our financial condition.
  
New capital and liquidity standards adopted by the U.S. banking regulators require banks and bank holding companies to maintain more and higher quality capital and greater liquidity than has historically been the case. New and evolving capital standards, particularly those adopted as a result of Dodd-Frank, will have a significant effect on banks and bank holding companies, including Arrow. These new standards, which now apply and will be fully phased-in over the next several years, force bank holding companies and their bank subsidiaries to maintain substantially higher levels of capital as a percentage of their assets, with a greater emphasis on common equity as opposed to other components of capital. The need to maintain more and higher quality capital, as well as greater liquidity, and generally increased regulatory scrutiny with respect to capital levels, may at some point limit our business activities, including lending, and our ability to expand. It could also result in our being required to take steps to increase our regulatory capital and may dilute shareholder value or limit our ability to pay dividends or otherwise return capital to our investors through stock repurchases.
If economic conditions should worsen and the U.S. experiences a recession or prolonged economic stagnation, our allowance for loan losses may not be adequate to cover actual losses. Like all financial institutions, we maintain an allowance for loan losses to provide for probable loan losses at the balance sheet date. Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the portfolio, current economic conditions and geographic concentrations within the portfolio and other factors. While we have continued to enjoy a very high level of quality in our loan portfolio generally and very low levels of loan charge-offs and non-performing loans, if the economy in our geographic market area, the northeastern region of New York State, or in the U.S. generally, should deteriorate to the point that recessionary conditions return, or if the regional or national economy experiences a protracted period of stagnation, the quality of our loan portfolio may weaken significantly. As a result, our allowance for loan losses may not be adequate to cover actual loan losses, and future increases in provisions for loan losses could materially and adversely affect financial results. Moreover, weak or worsening economic conditions often lead to difficulties in other areas of our business, including growth of our business generally, thereby compounding the negative effects on earnings.
The current interest rate environment is not particularly favorable for commercial banks or their core businesses, and any prospective changes in prevailing interest rates may actually have a negative impact on our prospects and performance. Prevailing market interest rates, and changes in those rates, have a direct and material impact on the financial performance and condition of commercial banks. A bank’s net interest income generally comprises the majority of its total income, and changes in prevailing rates for bank assets and bank liabilities significantly affect its net interest income.
Currently, market interest rates in the U.S., across all maturities and for all types of loans remain at, or close, to historic lows, despite the Federal Reserve's recent and long anticipated increase in the Federal funds rate. The continuing, long-lasting and

# 14



historic low rate environment has placed lending institutions such as commercial banks in a very challenging position.
In December 2015, the Fed, after allowing the Fed funds rate to remain at the unprecedented low level of 0 to 25 basis points for almost seven years, raised the Fed funds rate, and presumably short-term interest rates generally, by 25 basis points. The general understanding that the Fed encouraged, in connection with this rate rise, was that there would likely be additional rate increases during the remainder of 2016, perhaps modest in size, but marking the beginnings of an upward trend. In the event, the general perception of a weakening of various economic factors combined with a sudden drop in the equity markets that followed the Fed's rate hike in late 2015 and early 2016, have led many in the financial markets to predict that the Fed may reconsider its long-term intentions on successive, even moderate interest rate increases, at least in the foreseeable future. In the long run, even a general gradual increase in prevailing interest rates across all maturities, if that should occur, may be beneficial to the banking sector, including our banks. However, at least in the short run, even moderate increases in market rates might be expected to adversely impact the commercial banking sector in certain respects. Bank liabilities (deposits) typically reprice much more quickly than bank assets (investments and loans). If the Fed raises rates too quickly, it could slow economic growth and possibly result in a recession. It is this potential risk to the economy at large that has led the Fed and the world's other central banks to continue with their efforts to ensure a long-term, low-rate environment through financial repression, and that presents commercial banks with the conundrum of an unfavorable rate situation that might not improve, even if rates rise. Whatever the Fed and the other central banks in the developed world elect to do from the standpoint of monetary policy, their decisions will affect the activities, results of operations and profitability of banks and bank holding companies such as Arrow. We cannot predict the nature or timing of future changes in monetary and other policies or the effect that they may have on our operations or financial condition.
We operate in a highly competitive industry and market areas that could negatively affect our growth and profitability. Competition for commercial banking and other financial services is fierce in our market areas. In one or more aspects of its business, our subsidiaries compete with other commercial banks, savings and loan associations, credit unions, finance companies, Internet-based financial services companies, mutual funds, insurance companies, brokerage and investment banking companies, and other financial intermediaries. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can. Technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. In addition, many of our competitors are not subject to the same extensive Federal regulations that govern bank holding companies and Federally insured banks. Failure to offer competitive services in our market areas could significantly weaken our market position, adversely affecting our growth, which, in turn, could have a material adverse effect on our financial condition and results of operations.
The Company relies on the operations of our banking subsidiaries to provide liquidity which, if limited, could impact our ability to pay dividends to our shareholders or to repurchase our common stock. We are a bank holding company, a separate legal entity from our subsidiaries. Our bank holding company does not have significant operations of its own. The ability of our subsidiaries, including our bank and insurance subsidiaries, to pay dividends is limited by various statutes and regulations. It is possible, depending upon the financial condition of our subsidiaries and other factors, that our subsidiaries might be restricted at some point in their ability to pay dividends to the holding company, including by a bank regulator asserting that the payment of such dividends or other payments would constitute an unsafe or unsound practice. In addition, under Dodd-Frank, we are subjected to consolidated capital requirements at the holding company level. If our holding company or its bank subsidiaries are required to retain capital, we may not be able to pay dividends on our common stock or repurchase shares of our common stock.
If economic conditions worsen and the U.S. financial markets should suffer a downturn, we may experience limited access to credit markets. As discussed under Part I, Item 7.D. “Liquidity,” we maintain borrowing relationships with various third parties that enable us to obtain from them, on relatively short notice, overnight and longer-term funds sufficient to enable us to fulfill our obligations to customers, including deposit withdrawals. If and to the extent these third parties may themselves have difficulty in accessing their own credit markets, we may, in turn, experience a decrease in our capacity to borrow funds from them or other third parties traditionally relied upon by banks for liquidity.
We are subject to the local economies where we operate, and unfavorable economic conditions in these areas could have a material adverse effect on our financial condition and results of operations. Much of our success depends upon the growth in business activity, income levels and deposits in our geographic market area. Although our market area has experienced a stabilizing of economic conditions in recent years and even periods of modest growth, if unpredictable or unfavorable economic conditions unique to our market area should occur in upcoming periods, such will likely have an adverse effect on the quality of our loan portfolio and financial performance. As a community bank, we are less able than our larger regional competitors to spread the risk of unfavorable local economic conditions over a larger market area. Moreover, we cannot give any assurances that we, as a single enterprise, will benefit from any unique and favorable economic conditions in our market area, even if they do occur.
Changes in accounting standards may materially and negatively impact our financial statements. From time-to-time, the Financial Accounting Standards Board (“FASB”) changes the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we may be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial statements. Specifically, changes in the fair value of our financial assets could have a significant negative impact on our asset portfolios and indirectly on our capital levels.

# 15



Our business could suffer if we lose key personnel unexpectedly or if employee wages increase significantly. Our success depends, in large part, on our ability to retain our key personnel for the duration of their expected terms of service. On an ongoing basis, we prepare and review back-up plans, in the event key personnel are unexpectedly rendered incapable of performing or depart or resign from their positions. However, any sudden unexpected change at the senior management level may adversely affect our business. In addition, should our industry begin to experience a shortage of qualified employees, we like other financial institutions may have difficulty attracting and retaining entry level or higher bracket personnel and also may experience, as a result of such shortages or the enactment of higher minimum wage laws locally or nationwide, increased salary expense, which would likely negatively impact our results of operations.
We rely on other companies to provide key components of our business infrastructure. Third-party vendors provide key components of our business infrastructure such as Internet connections, network access and mutual fund distribution. The financial health and operational capabilities of these third parties are for the most part beyond our control, and any problems experienced by these third parties, such that they are not able to continue to provide services to us or to perform such services consistent with our expectations, could adversely affect our ability to deliver products and services to our customers and to conduct our business.
Problems encountered by other financial institutions could adversely affect us. Our ability to engage in routine funding transactions could be adversely affected by financial or commercial problems confronting other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships. We have exposure to many different counterparties in the normal course of business, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, other commercial banks, investment banks, mutual and hedge funds, and other financial institutions. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity problems and losses or defaults by us or by other financial institutions on whom we rely or with whom we interact. Some of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be liquidated or only may be liquidated at prices not sufficient to recover the full amount due us under the underlying financial instrument held by us. There is no assurance that any such losses would not materially and adversely affect our results of operations.
Our industry is faced with technological advances and changes on a continuing basis, and failure to adapt to these advances and changes could have a material adverse impact on our business. Technological advances and changes in the financial services industry are pervasive and constant factors. For our business to remain competitive, we must comprehend developments in new products, services and delivery systems utilizing new technology and adapt to those developments. Proper implementation of new technology can increase efficiency, decrease costs and help to meet customer demand. However, many of our competitors have greater resources to invest in technological advances and changes. We may not always be successful in utilizing the latest technological advances in offering our products and services or in otherwise conducting our business. Failure to identify, adapt to and implement technological advances and changes could have a material adverse effect on our business.
Item 1B.
Unresolved Staff Comments - None

Item 2. Properties

Our main office is at 250 Glen Street, Glens Falls, New York.  The building is owned by us and serves as the main office for Arrow and Glens Falls National, our principal subsidiary bank.  The main office of our other banking subsidiary, Saratoga National, is in Saratoga Springs, New York. We own twenty-nine branch banking offices, lease ten branch banking offices and lease two residential loan origination offices, all at market rates. We also own two offices specifically dedicated to our insurance agency operations and lease six others. Three of our insurance agency offices are located at our banking locations. We also lease office space in a building near our main office in Glens Falls.
In the opinion of management, the physical properties of our holding company and our various subsidiaries are suitable and adequate.  For more information on our properties, see Notes 2, 6 and 18 to the Consolidated Financial Statements contained in Part II, Item 8 of this Report.

Item 3. Legal Proceedings

We are not the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of our business.  On an ongoing basis, we typically are the subject of or a party to various legal claims, which arise in the normal course of our business.  The various legal claims currently pending against us will not, in the opinion of management based upon consultation with counsel, result in any material liability.

Item 4. Mine Safety Disclosures - None

# 16





PART II

Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The common stock of Arrow Financial Corporation is traded on the Global Select Market of the NASDAQ® Stock Market under the symbol AROW.
The high and low prices listed below represent actual sales transactions, as reported by NASDAQ®.  All stock prices and cash dividends per share have been restated to reflect subsequent stock dividends.  On September 28, 2015, we distributed a 2% stock dividend on our outstanding shares of common stock.

 
2015
 
2014
 
Market Price
 
Cash Dividends Declared
 
Market Price
 
Cash Dividends Declared
 
Low
 
High
 
 
Low
 
High
 
First Quarter
$
25.05

 
$
26.99

 
0.245

 
$23.55
 
$26.41
 
0.240

Second Quarter
24.78

 
27.45

 
0.245

 
23.84
 
25.94
 
0.240

Third Quarter
26.06

 
28.00

 
0.245

 
24.34
 
25.94
 
0.240

Fourth Quarter
25.82

 
29.24

 
0.250

 
24.61
 
27.38
 
0.245


The payment of cash dividends by Arrow is determined at the discretion of its Board of Directors and is dependent upon, among other things, our earnings, financial condition and other factors, including applicable legal and regulatory restrictions.  See "Capital Resources and Dividends" in Part II, Item 7.E. of this Report.
There were approximately 7,300 holders of record of Arrows common stock at December 31, 2015. Arrow has no other class of stock outstanding.

Equity Compensation Plan Information
The following table sets forth certain information regarding Arrow's equity compensation plans as of December 31, 2015.  These equity compensation plans were (i) our 2013 Long-Term Incentive Plan ("LTIP"), and its predecessors, our 2008 Long-Term Incentive Plan and our 1998 Long-Term Incentive Plan; (ii) our 2014 Employee Stock Purchase Plan ("ESPP"); and (iii) our 2013 Directors' Stock Plan ("DSP").  All of these plans have been approved by Arrow's shareholders.

Plan Category
(a)
Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights        
 
(b)
Weighted-Average
Exercise Price of Outstanding Options, Warrants and Rights     
 
(c)
Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a))        
Equity Compensation Plans Approved by Security Holders (1)(2)
409,482

 
$
22.59

 
564,358

Equity Compensation Plans Not Approved by Security Holders
 
 
 
 
 
Total
409,482

 
 
 
564,358


(1)
All 409,482 shares of common stock listed in column (a) are issuable pursuant to outstanding stock options granted under the LTIP or its predecessor plans. 
(2)
The total of 564,358 shares listed in column (c) includes (i) 401,000 shares of common stock available for future award grants under the LTIP, (ii) 130,276 shares of common stock available for future issuance under the ESPP, and (iii) 33,082 shares of common stock available for future issuance under the DSP.



# 17



STOCK PERFORMANCE GRAPHS

The following two graphs provide a comparison of the total cumulative return (assuming reinvestment of dividends) for the common stock of Arrow as compared to the Russell 2000 Index, the NASDAQ Banks Index and the Zacks $1B-$5B Bank Assets Index.

The first graph presents comparative stock performance for the five-year period from December 31, 2010 to December 31, 2015 and the second graph presents comparative stock performance for the ten-year period from December 31, 2005 to December 31, 2015.

The historical information in the graphs and accompanying tables may not be indicative of future performance of Arrow stock on the various stock indices.
 
 
TOTAL RETURN PERFORMANCE
Period Ending
Index
2010
 
2011
 
2012
 
2013
 
2014
 
2015
Arrow Financial Corporation
100.00

 
91.47

 
103.50

 
116.93

 
128.33

 
134.33

Russell 2000 Index
100.00

 
95.82

 
111.49

 
154.78

 
162.35

 
155.18

NASDAQ Banks Index
100.00

 
89.43

 
107.00

 
153.14

 
160.92

 
175.27

Zacks $1B - $5B Bank Assets Index
100.00

 
93.98

 
111.99

 
159.46

 
166.25

 
184.07


Source: Prepared by Zacks Investment Research, Inc. Used with permission. All rights reserved. Copyright 1980-2016.



# 18




 
TOTAL RETURN PERFORMANCE
Period Ending
Index
2005
 
2006
 
2007
 
2008
 
2009
 
2010
 
2011
 
2012
 
2013
 
2014
 
2015
Arrow Financial
  Corporation
100.00

 
101.28

 
94.59

 
115.50

 
123.08

 
145.18

 
132.80

 
150.27

 
169.77

 
186.31

 
195.02

Russell 2000 Index
100.00

 
118.37

 
116.51

 
77.15

 
98.11

 
124.46

 
119.26

 
138.76

 
192.63

 
202.06

 
193.14

NASDAQ Banks
   Index
100.00

 
112.29

 
88.87

 
64.79

 
53.91

 
64.11

 
57.34

 
68.60

 
98.18

 
103.17

 
112.37

Zacks $1B - $5B Bank
  Assets Index
100.00

 
115.68

 
89.15

 
87.23

 
62.63

 
72.79

 
68.40

 
81.52

 
116.07

 
121.01

 
133.99


Source: Prepared by Zacks Investment Research, Inc. Used with permission. All rights reserved. Copyright 1980-2016.

The preceding stock performance graphs and tables shall not be deemed incorporated by reference, by virtue of any general statement contained herein or in any other filing incorporated by reference herein, into any other SEC filing by the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent the company specifically incorporates this information by reference into such filing, and shall not otherwise be deemed filed as part of any such other filing.

Unregistered Sales of Equity Securities

None.


# 19



Issuer Purchases of Equity Securities
The following table presents information about repurchases by Arrow during the three months ended December 31, 2015 of our common stock (our only class of equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934):

Fourth Quarter 2015
Calendar Month
(a) Total Number of
Shares Purchased1
 
(b) Average Price Paid Per Share1
 
(c) Total Number of
Shares Purchased as
Part of Publicly
Announced
Plans or Programs2
 
(d) Maximum
Approximate Dollar
Value of Shares that
May Yet be
Purchased Under the
Plans or Programs2
October
9,075

 
$
28.07

 

 
$
4,294,710

November
3,820

 
27.62

 

 
4,294,710

December
18,100

 
27.54

 

 
4,294,710

Total
30,995

 
27.70

 

 
 

1The total number of shares purchased and the average price paid per share listed in columns (a) and (b) consist of (i) any shares purchased in such periods in open market or private transactions under the Arrow Financial Corporation Automatic Dividend Reinvestment Plan (the "DRIP") by the administrator of the DRIP, and (ii) shares surrendered or deemed surrendered to Arrow in such periods by holders of options to acquire Arrow common stock received by them under Arrow's compensatory stock plans in connection with their exercise of such options.  In the months indicated, the listed number of shares purchased included the following numbers of shares purchased through such methods:  October - DRIP purchases (1,667 shares), stock options (7,408 shares) ; November - DRIP purchases (2,263 shares), stock options (1,557 shares); December - DRIP purchases (18,100 shares).  
2Includes only those shares acquired by Arrow pursuant to its publicly-announced stock repurchase programs; does not include any shares purchased or subject to purchase under the DRIP, any shares surrendered or deemed surrendered to Arrow upon exercise of options granted under any compensatory stock plans, or any shares purchased by the Company for its ESOP.  Our only publicly-announced stock repurchase program in effect for the fourth quarter of 2015 was the program approved by the Board of Directors and announced in November 2014, under which the Board authorized management, in its discretion, to repurchase from time to time during 2015, in the open market or in privately negotiated transactions, up to $5 million of Arrow common stock subject to certain exceptions (the "2015 Program"). Arrow did not repurchase any of its shares in the fourth quarter of 2015 under the 2015 Program. In October 2015, the Board authorized a repurchase program for 2016 similar to its 2015 program, which also authorizes management to repurchase up to $5 million of stock in the ensuing year (2016).


# 20



Item 6. Selected Financial Data

FIVE YEAR SUMMARY OF SELECTED DATA
Arrow Financial Corporation and Subsidiaries
(Dollars In Thousands, Except Per Share Data)

Consolidated Statements of Income Data:
2015
 
2014
 
2013
 
2012
 
2011
Interest and Dividend Income
$
70,738

 
$
66,861

 
$
64,138

 
$
69,379

 
$
76,791

Interest Expense
4,813

 
5,767

 
7,922

 
11,957

 
18,679

Net Interest Income
65,925

 
61,094

 
56,216

 
57,422

 
58,112

Provision for Loan Losses
1,347

 
1,848

 
200

 
845

 
845

Net Interest Income After Provision
 for Loan Losses
64,578

 
59,246

 
56,016

 
56,577

 
57,267

Noninterest Income
27,995

 
28,206

 
27,521

 
26,234

 
23,133

Net Gains on Securities Transactions
129

 
110

 
540

 
865

 
2,795

Noninterest Expense
(57,430
)
 
(54,028
)
 
(53,203
)
 
(51,836
)
 
(51,548
)
Income Before Provision for Income Taxes
35,272

 
33,534

 
30,874

 
31,840

 
31,647

Provision for Income Taxes
10,610

 
10,174

 
9,079

 
9,661

 
9,714

Net Income
$
24,662

 
$
23,360

 
$
21,795

 
$
22,179

 
$
21,933

Per Common Share: 1
 
 
 
 
 
 
 
 
 
Basic Earnings
$
1.91

 
$
1.82

 
$
1.70

 
$
1.74

 
$
1.73

Diluted Earnings
1.91

 
1.81

 
1.70

 
1.74

 
1.72

Per Common Share: 1
 
 
 
 
 
 
 
 
 
Cash Dividends
$
0.99

 
$
0.97

 
$
0.95

 
$
0.93

 
$
0.90

Book Value
16.54

 
15.61

 
14.94

 
13.78

 
13.07

Tangible Book Value 2
14.61

 
13.62

 
12.91

 
11.70

 
10.97

Consolidated Year-End Balance Sheet Data:
 
 
 
 
 
 
 
 
 
Total Assets
$
2,446,188

 
$
2,217,420

 
$
2,163,698

 
$
2,022,796

 
$
1,962,684

Securities Available-for-Sale
402,309

 
366,139

 
457,606

 
478,698

 
556,538

Securities Held-to-Maturity
320,611

 
302,024

 
299,261

 
239,803

 
150,688

Loans
1,573,952

 
1,413,268

 
1,266,472

 
1,172,641

 
1,131,457

Nonperforming Assets 3
8,924

 
8,162

 
7,916

 
9,070

 
8,128

Deposits
2,030,423

 
1,902,948

 
1,842,330

 
1,731,155

 
1,644,046

Federal Home Loan Bank Advances
137,000

 
51,000

 
73,000

 
59,000

 
82,000

Other Borrowed Funds
43,173

 
39,421

 
31,777

 
32,678

 
46,293

Stockholders Equity
213,971

 
200,926

 
192,154

 
175,825

 
166,385

Selected Key Ratios:
 
 
 
 
 
 
 
 
 
Return on Average Assets
1.05
%
 
1.07
%
 
1.04
%
 
1.11
%
 
1.13
%
Return on Average Equity
11.86

 
11.79

 
12.11

 
12.88

 
13.45

Dividend Payout  4
51.83

 
53.59

 
55.88

 
53.45

 
52.33


1Share and per share amounts have been adjusted for subsequent stock splits and dividends, including the most recent
September 2015 2% stock dividend.
2Tangible book value excludes goodwill and other intangible assets from total equity.
3Nonperforming assets consist of nonaccrual loans, loans past due 90 or more days but still accruing interest, repossessed assets, restructured loans, other real estate owned and nonaccrual investments.
4Dividend Payout Ratio cash dividends per share to fully diluted earnings per share.

# 21




Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Selected Quarterly Information
Dollars in thousands, except per share amounts
Share and per share amounts have been restated for the September 2015 2% stock dividend


Quarter Ended
12/31/2015

 
9/30/2015

 
6/30/2015

 
3/31/2015

 
12/31/2014

Net Income
$
6,569

 
$
5,933

 
$
6,305

 
$
5,855

 
$
6,369

Transactions Recorded in Net Income (Net of Tax):
 
 
 
 
 
 
 
 
 
Net Gains (Losses) on Securities Transactions
14

 

 
10

 
54

 

Share and Per Share Data:
 
 
 
 
 
 
 
 
 
Period End Shares Outstanding
12,939

 
12,905

 
12,875

 
12,880

 
12,874

Basic Average Shares Outstanding
12,918

 
12,888

 
12,886

 
12,886

 
12,867

Diluted Average Shares Outstanding
12,979

 
12,929

 
12,922

 
12,924

 
12,908

Basic Earnings Per Share
$
0.51

 
$
0.46

 
$
0.49

 
$
0.45

 
$
0.49

Diluted Earnings Per Share
0.51

 
0.46

 
0.49

 
0.45

 
0.49

Cash Dividend Per Share
0.250

 
0.245

 
0.245

 
0.245

 
0.245

Selected Quarterly Average Balances:
 
 
 
 
 
 
 
 
 
Interest-Bearing Deposits at Banks
$
44,603

 
$
17,788

 
$
37,303

 
$
30,562

 
$
58,048

Investment Securities
716,947

 
711,830

 
701,329

 
673,753

 
664,334

Loans
1,556,234

 
1,502,620

 
1,456,534

 
1,422,005

 
1,401,601

Deposits
2,075,825

 
1,970,738

 
1,983,647

 
1,949,776

 
1,962,698

Other Borrowed Funds
127,471

 
148,887

 
99,994

 
69,034

 
56,185

Shareholders’ Equity
213,219

 
209,334

 
206,831

 
202,552

 
202,603

Total Assets
2,442,964

 
2,356,121

 
2,316,427

 
2,248,054

 
2,247,576

Return on Average Assets
1.07
%
 
1.00
%
 
1.09
%
 
1.06
%
 
1.12
%
Return on Average Equity
12.22
%
 
11.24
%
 
12.23
%
 
11.72
%
 
12.47
%
Return on Tangible Equity 1
13.86
%
 
12.79
%
 
13.94
%
 
13.42
%
 
14.28
%
Average Earning Assets
$
2,317,784

 
$
2,232,238

 
$
2,195,166

 
$
2,126,320

 
$
2,123,983

Average Interest-Bearing Liabilities
1,854,549

 
1,772,156

 
1,770,023

 
1,713,253

 
1,716,699

Interest Income, Tax-Equivalent
19,619

 
18,924

 
18,501

 
18,073

 
18,213

Interest Expense
1,231

 
1,253

 
1,243

 
1,086

 
1,219

Net Interest Income, Tax-Equivalent
18,388

 
17,671

 
17,258

 
16,987

 
16,994

Tax-Equivalent Adjustment
1,109

 
1,093

 
1,094

 
1,083

 
1,073

Net Interest Margin 1
3.15
%
 
3.14
%
 
3.15
%
 
3.24
%
 
3.17
%
Efficiency Ratio Calculation 1:
 
 
 
 
 
 
 
 
 
Noninterest Expense
$
14,242

 
$
14,850

 
$
14,383

 
$
13,955

 
$
13,299

Less: Intangible Asset Amortization
(78
)
 
(79
)
 
(80
)
 
(91
)
 
(94
)
Net Noninterest Expense
$
14,164

 
$
14,771

 
$
14,303

 
$
13,864

 
$
13,205

Net Interest Income, Tax-Equivalent 1
$
18,388

 
$
17,671

 
$
17,258

 
$
16,987

 
$
16,994

Noninterest Income
6,687

 
7,137

 
7,444

 
6,856

 
7,060

Less: Net Securities Gains
(23
)
 

 
(16
)
 
(90
)
 

Net Gross Income, Adjusted
$
25,052

 
$
24,808

 
$
24,686

 
$
23,753

 
$
24,054

Efficiency Ratio 1
56.54
%
 
59.54
%
 
57.94
%
 
58.37
%
 
54.90
%
Period-End Capital Information:
 
 
 
 
 
 
 
 
 
Total Stockholders’ Equity (i.e. Book Value)
$
213,971

 
$
211,142

 
$
206,947

 
$
204,965

 
$
200,926

Book Value per Share
16.54

 
16.36

 
16.07

 
15.91

 
15.61

Intangible Assets
24,980

 
25,266

 
25,372

 
25,492

 
25,628

Tangible Book Value per Share 1
14.61

 
14.40

 
14.10

 
13.93

 
13.62

Capital Ratios:
 
 
 
 
 
 
 
 
 
Tier 1 Leverage Ratio
9.25
%
 
9.40
%
 
9.41
%
 
9.57
%
 
9.44
%
Common Equity Tier 1 Capital Ratio
12.82
%
 
12.66
%
 
12.92
%
 
13.27
%
 
N/A

Tier 1 Risk-Based Capital Ratio
14.08
%
 
13.93
%
 
14.24
%
 
14.65
%
 
14.47
%
Total Risk-Based Capital Ratio
15.09
%
 
14.94
%
 
15.28
%
 
15.73
%
 
15.54
%
Assets Under Trust Administration
  and Investment Management
$
1,232,890

 
$
1,195,629

 
$
1,246,849

 
$
1,254,823

 
$
1,227,179

1 See "Use of Non-GAAP Financial Measures" on page 4.

# 22



Selected Twelve-Month Information
Dollars in thousands, except per share amounts
Share and per share amounts have been restated for the September 2015 2% stock dividend

 
2015
 
2014
 
2013
Net Income
$
24,662

 
$
23,360

 
$
21,795

Transactions Recorded in Net Income (Net of Tax):
 
 
 
 
 
Net Securities Gains
$
78

 
$
67

 
$
326

Period End Shares Outstanding
12,939

 
12,874

 
12,859

Basic Average Shares Outstanding
12,894

 
12,856

 
12,793

Diluted Average Shares Outstanding
12,942

 
12,886

 
12,825

Basic Earnings Per Share
$
1.91

 
$
1.82

 
$
1.70

Diluted Earnings Per Share
1.91

 
1.81

 
1.70

Cash Dividends Per Share
0.99

 
0.97

 
0.95

Average Assets
$
2,341,467

 
$
2,190,480

 
$
2,102,788

Average Equity
208,017

 
198,208

 
179,990

Return on Average Assets
1.05
%
 
1.07
%
 
1.04
%
Return on Average Equity
11.86

 
11.79

 
12.11

Average Earning Assets
$
2,218,440

 
$
2,068,611

 
$
1,988,884

Average Interest-Bearing Liabilities
1,777,867

 
1,675,285

 
1,633,605

Interest Income, Tax-Equivalent 1
75,117

 
71,323

 
68,713

Interest Expense
4,813

 
5,767

 
7,922

Net Interest Income, Tax-Equivalent 1
70,304

 
65,556

 
60,791

Tax-Equivalent Adjustment
4,379

 
4,462

 
4,575

Net Interest Margin 1
3.17
%
 
3.17
%
 
3.06
%
Efficiency Ratio Calculation 1
 
 
 
 
 
Noninterest Expense
$
57,430

 
$
54,028

 
$
53,203

Less: Intangible Asset Amortization
(327
)
 
(387
)
 
(388
)
Net Noninterest Expense
$
57,103

 
$
53,641

 
$
52,815

Net Interest Income, Tax-Equivalent 1
$
70,304

 
$
65,556

 
$
60,791

Noninterest Income
28,124

 
28,316

 
28,061

Less: Net Securities Gains
(129
)
 
(110
)
 
(540
)
Net Gross Income, Adjusted
$
98,299

 
$
93,762

 
$
88,312

Efficiency Ratio 1
58.09
%
 
57.21
%
 
59.81
%
Period-End Capital Information:
 
 
 
 
 
Tier 1 Leverage Ratio
9.25
%
 
9.44
%
 
9.24
%
Total Stockholders Equity (i.e. Book Value)
$
213,971

 
$
200,926

 
$
192,154

Book Value per Share
16.54

 
15.61

 
14.94

Intangible Assets
24,980

 
25,628

 
26,143

Tangible Book Value per Share 1
14.61

 
13.62

 
12.91

Asset Quality Information:
 
 
 
 
 
Net Loans Charged-off as a Percentage of Average Loans
0.06
%
 
0.05
%
 
0.09
%
Provision for Loan Losses as a Percentage of Average Loans
0.09
%
 
0.14
%
 
0.02
%
Allowance for Loan Losses as a Percentage of Period-End Loans
1.02
%
 
1.10
%
 
1.14
%
Allowance for Loan Losses as a Percentage of Nonperforming Loans
232.24
%
 
200.41
%
 
185.71
%
Nonperforming Loans as a Percentage of Period-End Loans
0.44
%
 
0.55
%
 
0.61
%
Nonperforming Assets as a Percentage of Total Assets
0.36
%
 
0.37
%
 
0.37
%
1 See "Use of Non-GAAP Financial Measures" on page 4.

# 23



Arrow Financial Corporation
Reconciliation of Non-GAAP Financial Information
(Dollars In Thousands, Except Per Share Amounts)

Footnotes:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1.
Share and Per Share Data have been restated for the September 28, 2015, 2% stock dividend.
 
 
2.
Tangible Book Value and Tangible Equity exclude goodwill and other intangible assets, net from total equity.  These are non-GAAP financial measures which we believe provide investors with information that is useful in understanding our financial performance.
 
 
12/31/2015
 
9/30/2015
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
Total Stockholders' Equity (GAAP)
$
213,971

 
$
211,142

 
$
206,947

 
$
204,965

 
$
200,926

 
Less: Goodwill and Other Intangible assets, net
24,980

 
25,266

 
25,372

 
25,492

 
25,628

 
Tangible Equity (Non-GAAP)
$
188,991

 
$
185,876

 
$
181,575

 
$
179,473

 
$
175,298

 
 
 
 
 
 
 
 
 
 
 
 
Period End Shares Outstanding
12,939

 
12,905

 
12,875

 
12,880

 
12,874

 
Tangible Book Value per Share (Non-GAAP)
$
14.61

 
$
14.40

 
$
14.10

 
$
13.93

 
$
13.62

 
 
 
 
 
 
 
 
 
 
 
3.
Net Interest Margin is the ratio of our annualized tax-equivalent net interest income to average earning assets. This is also a non-GAAP financial measure which we believe provides investors with information that is useful in understanding our financial performance.
 
For the Quarterly Periods:
12/31/2015
 
9/30/2015
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
Net Interest Income (GAAP)
$
17,279

 
$
16,578

 
$
16,164

 
$
15,904

 
$
15,921

 
Add: Tax-Equivalent adjustment (Non-GAAP)
1,109

 
1,093

 
1,094

 
1,083

 
1,073

 
Net Interest Income - Tax Equivalent (Non-GAAP)
$
18,388

 
$
17,671

 
$
17,258

 
$
16,987

 
$
16,994

 
Average Earning Assets
2,317,784

 
2,232,238

 
2,195,166

 
2,126,320

 
2,123,983

 
Net Interest Margin (Non-GAAP)*
3.15
%
 
3.14
%
 
3.15
%
 
3.24
%
 
3.17
%
 
 * Quarterly ratios have been annualized
 
 
 
 
 
 
 
 
 
 
For the Annual Periods:
12/31/2015
 
12/31/2014
 
12/31/2013
 
 
 
 
 
Net Interest Income (GAAP)
$
65,925

 
$
61,094

 
$
56,216

 
 
 
 
 
Add: Tax-Equivalent adjustment (Non-GAAP)
4,379

 
4,462

 
4,575

 
 
 
 
 
Net Interest Income - Tax Equivalent (Non-GAAP)
$
70,304

 
$
65,556

 
$
60,791

 
 
 
 
 
Average Earning Assets
2,218,440

 
2,068,611

 
1,988,884

 
 
 
 
 
Net Interest Margin (Non-GAAP)
3.17
%
 
3.17
%
 
3.06
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
4.
Financial Institutions often use the "efficiency ratio", a non-GAAP ratio, as a measure of expense control. We believe the efficiency ratio provides investors with information that is useful in understanding our financial performance. We define our efficiency ratio as the ratio of our noninterest expense to our net gross income (which equals our tax-equivalent net interest income plus noninterest income, as adjusted).
 
 
 
 
 
 
 
 
 
 
 
5.
Common Equity Tier 1 Capital Ratio (CET1) is a new regulatory capital measure applicable to financial institutions, effective January 1, 2015. For the current quarter, all of the regulatory capital ratios in the table above, as well as the Total Risk-Weighted Assets and Common Equity Tier 1 Capital amounts listed in the table below, are estimates based on, and calculated in accordance with, these new bank regulatory capital rules. All prior quarters reflect actual results. The December 31, 2015 CET1 ratio listed in the tables (i.e., 12.82%) exceeds the sum of the required minimum CET1 ratio plus the fully phased-in Capital Conservation Buffer (i.e., 7.00%).
 
 
12/31/2015
 
9/30/2015
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
Total Risk Weighted Assets
1,590,129

 
1,574,704

 
$
1,515,416

 
$
1,452,975

 
N/A

 
Common Equity Tier 1 Capital
213,970

 
199,377

 
$
195,800

 
$
192,865

 
N/A

 
Common Equity Tier 1 Ratio
12.82
%
 
12.66
%
 
12.92
%
 
13.27
%
 
N/A

    

# 24



CRITICAL ACCOUNTING ESTIMATES

Our significant accounting principles, as described in Note 2 - Summary of Significant Accounting Policies to the Consolidated Financial Statements are essential in understanding the MD&A. Many of our significant accounting policies require complex judgments to estimate the values of assets and liabilities. We have procedures and processes in place to facilitate making these judgments. The more judgmental estimates are summarized in the following discussion. In many cases, there are numerous alternative judgments that could be used in the process of determining the inputs to the models. Where alternatives exist, we have used the factors that we believe represent the most reasonable value in developing the inputs. Actual performance that differs from
our estimates of the key variables could impact our results of operations.

Allowance for loan losses: The allowance for loan losses represents management’s estimate of probable losses inherent in the Company’s loan portfolio. Our process for determining the allowance for loan losses is discussed in Note 2 - Summary of Significant Accounting Policies and Note 5 - Loans to the Consolidated Financial Statements. We evaluate our allowance at the portfolio segment level and our portfolio segments are commercial, commercial construction, commercial real estate, automobile, residential real estate and other consumer loans. Due to the variability in the drivers of the assumptions used in this process, estimates of the portfolio’s inherent risks and overall collectability change with changes in the economy, individual industries, and borrowers’ ability and willingness to repay their obligations. The degree to which any particular assumption affects the allowance for loan losses depends on the severity of the change and its relationship to the other assumptions. Key judgments used in determining the allowance for loan losses for individual commercial loans include credit quality indicators, collateral values and estimated cash flows for impaired loans. For pools of loans we consider our historical net loss experience, and as necessary, adjustments to address current events and conditions, considerations regarding economic uncertainty, and overall credit conditions. The historical loss factors incorporate a rolling twelve quarter look-back period for each loan segment in order to reduce the volatility associated with improperly weighting short-term fluctuations. The process of determining the level of the allowance for loan losses requires a high degree of judgment. Any downward trend in the economy, regional or national, may require us to increase the allowance for loan losses resulting in a negative impact on our results of operations and financial condition.

Pension and retirement plans: Management is required to make various assumptions in valuing its pension and postretirement plan assets, expenses and liabilities. The most significant assumptions include the expected rate of return on plan assets, the discount rate, and the rate of increase in future compensation levels. Changes to these assumptions could impact earnings in future periods. The Company utilizes an actuarial firm to assist in determining the various rates used to estimate pension obligations and expense, including the evaluation of market interest rates and discounted cash flows in setting the appropriate discount rate. In addition, the Company reviews expected inflationary and merit increases to compensation in determining the rate of increase in future compensation levels. Changes in these assumptions due to market conditions and governing laws and regulations may result in material changes to the Company’s pension and other postretirement plan assets, expenses and liabilities.

Other than temporary decline in the value of debt and equity securities: Management systematically evaluates individual securities classified as either available-for-sale or held-to-maturity to determine whether a decline in fair value below the amortized cost basis is other than temporary. Management considers historical values and current market conditions as a part of the assessment. The amount of the total other-than-temporary impairment related to the credit loss, if any, is recognized in earnings and the amount of the total other-than-temporary impairment related to other factors is generally recognized in other comprehensive income, net of applicable taxes unless the Company intends to sell the security prior to the recovery of the unrealized loss or it is more likely than not that the Company would be forced to sell the security, in which case the entire impairment is recognized in earnings. Any significant economic downturn might result, and historically have on occasion resulted, in an other-than-temporary impairment in securities held in our investment portfolio.

The following discussion and analysis focuses on and reviews our results of operations for each of the years in the three-year period ended December 31, 2015 and our financial condition as of December 31, 2015 and 2014.  The discussion below should be read in conjunction with the selected quarterly and annual information set forth above and the consolidated financial statements and other financial data presented elsewhere in this Report.  When necessary, prior-year financial information has been reclassified to conform to the current-year presentation.

A. OVERVIEW
Summary of 2015 Financial Results

We reported net income for 2015 of $24.7 million, an increase of $1.30 million or 5.6% over the 2014 total. Diluted earnings per share ("EPS") for 2015 was $1.91, an increase of 10 cents, or 5.4% from our 2014 EPS. Return on average equity ("ROE") for the 2015 year continued to be strong at 11.86%, up slightly from our ROE of 11.79% for the 2014 year. Return on average assets ("ROA") for 2015 also continued to be strong at 1.05%, although down slightly from a ROA of 1.07% for 2014. The decrease in ROA was due to the fact that the growth in average assets out-paced the growth in earnings, while the increase in ROE reflected the fact that net income grew faster than average equity.
The driving factor behind our increase in net income was a significant increase year-over-year in our net interest income. On a tax-equivalent basis, our net interest income for 2015 was $70.3 million, an increase of $4.7 million or 7.2% over the $65.6 million total for 2014. This increase in net interest income was primarily attributable to the significant amount of loan growth we experienced during the year. See our expanded analysis of changes in the loan portfolio beginning on page 39. Our noninterest income

# 25



decreased in 2015 by $192 thousand, or 0.7%, while our noninterest expense increased by $3.4 million, or 6.3%. Another key factor in 2015, was our continued strong asset quality which resulted in a $501 thousand decrease in the provision for loan losses.
Total assets were $2.446 billion at December 31, 2015, which represented an increase of $228.8 million, or 10.3%, above the $2.217 billion level at December 31, 2014. Virtually all asset growth was the result of internal expansion through our pre-existing branch network.
Stockholders' equity was $214.0 million at December 31, 2015, an increase of $13.0 million or 6.5%, from the year earlier level. The components of the change in stockholders' equity since year-end 2014 are presented in the Consolidated Statement of Changes in Stockholders' Equity on page 57, and are discussed in more detail in the last section of this Overview on page 27 entitled, “Increase in Stockholder Equity.”
 
Regulatory capital: As of December 31, 2015, we continued to exceed all regulatory minimum capital requirements at both the holding company and bank levels, by a substantial amount. As of January 1, 2015, we became subject to new bank regulatory capital standards adopted in 2013 by federal bank regulatory agencies pursuant to the Dodd-Frank Act. These new regulatory standards generally require financial institutions to meet higher minimum capital levels, measured in new ways. The standards are being phased in over a 5-year time period ending in 2019. See "Regulatory Capital Standards" on pages 7-9.
 
Economic trends and loan quality: During the past three years, economic activity in our market area reflected many positive trends as unemployment declined overall within New York State (NYS), as well as in the region where the Company operates. Unemployment rates in both the Glens Falls and Plattsburgh market areas have diminished almost to pre-recession lows in 2007, in the low 5% range. The housing market has remained stable for the past ten years with little change in the median sales price, although the number of sales has generally declined over the same period. Our nonperforming loans were $6.9 million at December 31, 2015, a decrease of $864 thousand, or 11.1%, from year-end 2014, even with substantial portfolio growth. The ratio of nonperforming loans to period-end loans at December 31, 2015 was .44%, a decrease from .55% at December 31, 2014. By way of comparison, this ratio for our peer group was .83% at December 31, 2015, which itself was a significant improvement for the peer group from its ratio of 3.60% at year-end 2010, and is now below the group's ratio of 1.09% at December 31, 2007 (i.e., before the financial crisis). Loans charged-off (net of recoveries) against our allowance for loan losses amounted to $879 thousand for 2015, up from $712 thousand for 2014. Our ratio of net charge-offs to average loans was a low .06% for 2015, compared to our peer group ratio of .09% for the period ended December 31, 2015. At December 31, 2015, our allowance for loan losses was $16.0 million, representing 1.02% of total loans, a decrease of 8 basis points from the December 31, 2014 ratio.
Since the onset of the financial crisis in 2008, we have not during any year experienced significant deterioration in any of our three major loan portfolio segments:
Commercial and Commercial Real Estate Loans: These loans comprise approximately 31% of our loan portfolio. Current unemployment rates in our region have continued to decline over the past few years. Commercial property values have not shown significant deterioration. We update the appraisals on our nonperforming and watched commercial properties as deemed necessary, usually when the loan is downgraded or when we perceive significant market deterioration since our last appraisal.
Residential Real Estate Loans: These loans, including home equity loans, make up approximately 40% of our portfolio. We have not experienced any significant increase in our delinquency and foreclosure rates, primarily due to the fact that we never have originated or participated in underwriting high-risk mortgage loans, such as so called "Alt A," "negative amortization," "option ARM's" or "negative equity" loans. We originate all of the residential real estate loans held in our portfolio and apply conservative underwriting standards to all of our originations.
Automobile Loans (Primarily Through Indirect Lending): These loans comprise approximately 29% of our loan portfolio. Throughout the past three years we did not experience any significant change in our level of charge-offs on these loans. Our delinquency rate for automobile loans at December 31, 2014, was up over 2013, primarily due to a modest shift in the portfolio to loans with lower credit scores, however the ratio at December 31, 2015 was essentially unchanged from 2014.
 
Recent Legislative Developments:

(i) Dodd-Frank Act: As a result of the 2008-2009 financial crisis, the U.S. Congress passed and the President signed the Dodd-Frank Act on July 21, 2010 ("Dodd-Frank"). While many of Dodd-Frank's provisions have not had and likely will not have any direct impact on Arrow, other provisions have impacted or likely will impact our business operations and financial results in a significant way. These include the establishment of a new regulatory body known as the Consumer Financial Protection Bureau (CFPB). (See the discussion on page 9 under "The Dodd-Frank Act" regarding the likely impact on Arrow of the CFPB.) Dodd-Frank also directed the federal banking authorities to issue new capital requirements for banks and holding companies that would be at least as strict as the pre-existing capital requirements. The banking authorities have done so and those capital requirements are now effective for our Company (as of January 1, 2015). See the discussion under "Regulatory Capital Standards" on pages 7-9 of this Report. Dodd-Frank also provided that any new issuances of trust preferred securities ("TRUPs") by bank holding companies having between $500 million and $15 billion in assets (such as Arrow) would no longer qualify as Tier 1 capital, but that outstanding TRUPs issued by such bank holding companies on or before the Dodd-Frank grandfathering date (May 19, 2010), would continue to qualify as Tier 1 capital until maturity or redemption, subject to certain limitations. Nevertheless, TRUPs, which prior to Dodd-Frank were an important financing tool for community banks such as ours, are no longer available to us as a source of new capital. See the discussion on page 9 under "The Dodd-Frank Act" regarding the various provisions of Dodd-Frank that have had, or are likely to have, particular significance to Arrow and its banks.

# 26




(ii) Health care reform: In March 2010, comprehensive federal healthcare reform legislation was passed under the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010 (collectively, the "Health Reform Act"). Included among the major provisions of the Health Reform Act is a change in tax treatment of the federal drug subsidy paid with respect to eligible retirees. The statute also contains provisions that may impact the Company's accounting for some of its benefit plans in future periods. The exact extent of the Health Reform Act's impact, if any, upon us cannot be determined until final regulations are promulgated and interpretations of the Health Reform Act become available.
 
Liquidity and access to credit markets: We did not experience any liquidity problems or special concerns during 2015, nor during the prior two years. The terms of our lines of credit with our correspondent banks, the FHLBNY and the Federal Reserve Bank have not changed (see our general liquidity discussion on page 46). In general, we principally rely on asset-based liquidity (i.e., funds in overnight investments and cash flow from maturing investments and loans) with liability-based liquidity as a secondary source (our main liability-based sources are overnight borrowing arrangements with our correspondent banks, an arrangement for overnight borrowing and term credit advances from the FHLBNY, and an additional arrangement for short-term advances at the Federal Reserve Bank discount window). We regularly perform a liquidity stress test and periodically test our contingent liquidity plan to ensure that we can generate an adequate amount of available funds to meet a wide variety of potential liquidity crises, including a severe crisis.
FDIC Shift From Deposit-Based to Asset-Based Insurance Premiums; Reduction in Premiums: The Dodd-Frank Act changed the basis on which insured banks would be assessed deposit insurance premiums, which has had a beneficial effect on the rates we pay and our overall premiums. Beginning with the second quarter of 2011, the calculation of regular FDIC insurance premiums for insured institutions changed so as to be based thereafter on total assets (with certain adjustments) rather than deposits. Because the banking industry generally maintains substantially higher levels of assets than deposits, the FDIC's overall prevailing rates for deposit insurance were significantly reduced in connection with the changeover. The net effect of the shift was to impose FDIC insurance fees not only on deposits but on other sources of funding that banks typically use to support their assets, including short-term borrowings and repurchase agreements. Our banks, like most community banks, have a much higher ratio of deposits to total assets than the large banks maintain. Thus, in our case, the new significantly lower rate, even applied to a somewhat larger base (assets versus deposits), still resulted in a significant decrease in our FDIC premiums.

Visa Class B Common Stock: In July 2012, Visa® and MasterCard® entered into a Memorandum of Understanding ("MOU") with a class of plaintiffs to settle certain additional antitrust claims against the two companies involving merchant discounts. In December 2013, a federal judge gave final approval to the class settlement agreement in the multi-district interchange litigation against Visa and Mastercard.  The total cash settlement payment was set at approximately $6.05 billion, of which Visa’s share represented approximately $4.4 billion. Visa has paid its portion of this settlement from the litigation escrow account pursuant to Visa’s Retrospective Responsibility Plan, which was developed as part of the restructuring process to address potential liability in certain Visa litigation, including this interchange class action. However, there continue to be restrictions remaining on Visa Class B shares held by us. We, like other former Visa member banks, bear some indirect contingent liability for Visa's future liability on such claims to the extent that Visa's liability might exceed the remaining escrow amount. In light of the current state of covered litigation at Visa, which is winding down, as well as the substantial remaining dollar amounts in Visa's escrow fund, we determined in the second quarter 2012 to reverse the entire amount of our 2008 VISA litigation-related accrual, which was $294 thousand pre-tax. This reversal reduced our other operating expenses for the year ending December 31, 2012. We believed then, and continue to believe, that the balance that Visa maintains in its escrow fund is substantially sufficient to satisfy Visa's remaining direct liability to such claims without further resort to the contingent liability of the former Visa member banks such as ours. At December 31, 2015, the Company held 45,686 shares of Visa Class B common stock. We continue not to recognize any economic value for these shares.
 
Increase in Stockholders' Equity: At December 31, 2015, our tangible book value per share, a non-GAAP financial measure calculated based on tangible book value (total stockholders' equity minus intangible assets including goodwill) amounted to $14.61, an increase of $0.99, or 7.3%, from December 31, 2014. Our total stockholders' equity at December 31, 2015 increased 6.5% over the year-earlier level, and our total book value per share increased by 6.0% over the year earlier level. This increase principally reflected the following factors: (i) $24.7 million net income for the period, plus (ii) $1.6 million of equity received from our various stock-based compensation plans, plus (iii) an $806 thousand increase in accumulated other comprehensive income, reduced by (iv) cash dividends of $12.7 million; and (v) repurchases of our own common stock of $1.5 million. As of December 31, 2015, our closing stock price was $27.17, resulting in a trading multiple of 1.86 to our tangible book value. The Board of Directors declared and the Company paid a cash dividend of $.245 per share for each of the first three quarters of 2015, as adjusted for a 2% stock dividend distributed September 28, 2015, a cash dividend of $.25 per share for the fourth quarter of 2015 and has declared a $.25 per share cash dividend for the first quarter of 2016.



# 27



B. RESULTS OF OPERATIONS

The following analysis of net interest income, the provision for loan losses, noninterest income, noninterest expense and income taxes, highlights the factors that had the greatest impact on our results of operations for 2015 and the prior two years.

I. NET INTEREST INCOME (Tax-equivalent Basis)
Net interest income represents the difference between interest, dividends and fees earned on loans, securities and other earning assets and interest paid on deposits and other sources of funds.  Changes in net interest income result from changes in the level and mix of earning assets and sources of funds (volume) and changes in the yields earned and interest rates paid (rate).  Net interest margin is the ratio of net interest income to average earning assets.  Net interest income may also be described as the product of average earning assets and the net interest margin.  As described in the section entitled Use of Non-GAAP Financial Measures on page 4 of this Report, for purposes of our presentation of Selected Financial Information in this Report, including in this Item 7, "Management's Discussion and Analysis of Financial Conditions and Results of Operations," we calculate net interest income on a tax-equivalent basis, producing a non-GAAP financial measure. For our 2015 adjustment, we used a marginal tax rate of 35%. See the discussion and calculation of our 2015 tax equivalent net interest income and net interest margin on page 24 of this Report.

CHANGE IN NET INTEREST INCOME
(Dollars In Thousands) (Tax-equivalent Basis)

 
Years Ended December 31,
 
Change From Prior Year
 
 
 
 
 
 
 
2014 to 2015
 
2013 to 2014
 
2015
 
2014
 
2013
 
Amount
 
%
 
Amount
 
%
Interest and Dividend Income
$
75,117

 
$
71,323

 
$
68,713

 
$
3,794

 
5.3
 %
 
$
2,610

 
3.8
 %
Interest Expense
4,813

 
5,767

 
7,922

 
(954
)
 
(16.5
)
 
(2,155
)
 
(27.2
)
Net Interest Income
$
70,304

 
$
65,556

 
$
60,791

 
$
4,748

 
7.2

 
$
4,765

 
7.8


On a tax-equivalent basis, net interest income was $70.3 million in 2015, an increase of $4.7 million, or 7.2%, from $65.6 million in 2014.  This compared to an increase of $4.8 million, or 7.8%, from 2013 to 2014.  Factors contributing to the year-to-year changes in net interest income over the three-year period are discussed in the following portions of this Section B.I.

In the following table, net interest income components are presented on a tax-equivalent basis.  Changes between periods are attributed to movement in either the average daily balances or average rates for both earning assets and interest-bearing liabilities.  Changes attributable to both volume and rate have been allocated proportionately between the categories.

 
2015 Compared to 2014 Change in Net Interest Income Due to:
 
2014 Compared to 2013 Change in Net Interest Income Due to:
Interest and Dividend Income:
Volume
 
Rate
 
Total
 
Volume
 
Rate
 
Total
Interest-Bearing Bank Balances
$
12

 
$
2

 
$
14

 
$
(11
)
 
$
2

 
$
(9
)
Investment Securities:
 
 
 
 
 
 
 
 
 
 
 
Fully Taxable
428

 
(338
)
 
90

 
(400
)
 
1,450

 
1,050

Exempt from Federal Taxes
(603
)
 
554

 
(49
)
 
(927
)
 
552

 
(375
)
Loans
5,455

 
(1,716
)
 
3,739

 
5,540

 
(3,596
)
 
1,944

Total Interest and Dividend Income
5,292

 
(1,498
)
 
3,794

 
4,202

 
(1,592
)
 
2,610

Interest Expense:
 
 
 
 
 
 
 
 
 
 
 
Deposits:
 
 
 
 
 
 
 
 
 
 
 
NOW Accounts
103

 
(549
)
 
(446
)
 
183

 
(922
)
 
(739
)
Savings Deposits
50

 
(148
)
 
(98
)
 
62

 
(247
)
 
(185
)
Time Deposits of $100,000 or More
(102
)
 
(312
)
 
(414
)
 
(200
)
 
(228
)
 
(428
)
Other Time Deposits
(170
)
 
(442
)
 
(612
)
 
(215
)
 
(393
)
 
(608
)
Total Deposits
(119
)
 
(1,451
)
 
(1,570
)
 
(170
)
 
(1,790
)
 
(1,960
)
Short-Term Borrowings
44

 
17

 
61

 
(10
)
 
(11
)
 
(21
)
Long-Term Debt
797

 
(242
)
 
555

 
(314
)
 
140

 
(174
)
Total Interest Expense
722

 
(1,676
)
 
(954
)
 
(494
)
 
(1,661
)
 
(2,155
)
Net Interest Income
$
4,570

 
$
178

 
$
4,748

 
$
4,696

 
$
69

 
$
4,765



# 28



The following table reflects the components of our net interest income, setting forth, for years ended December 31, 2015, 2014 and 2013 (i) average balances of assets, liabilities and stockholders' equity, (ii) interest and dividend income earned on earning assets and interest expense incurred on interest-bearing liabilities, (iii) average yields earned on earning assets and average rates paid on interest-bearing liabilities, (iv) the net interest spread (average yield less average cost) and (v) the net interest margin (yield) on earning assets.  Interest income, net interest income and interest rate information is presented on a tax-equivalent basis, using a marginal tax rate of 35% (see the discussion under "Use of Non-GAAP Financial Measures" on page 4 of this Report).  The yield on securities available-for-sale is based on the amortized cost of the securities.  Nonaccrual loans are included in average loans.  

Average Consolidated Balance Sheets and Net Interest Income Analysis
(Tax-equivalent basis using a marginal tax rate of 35%)
(Dollars in Thousands)
Years Ended:
2015
 
2014
 
2013
 
 
 
Interest
 
Rate
 
 
 
Interest
 
Rate
 
 
 
Interest
 
Rate
 
Average
 
Income/
 
Earned/
 
Average
 
Income/
 
Earned/
 
Average
 
Income/
 
Earned/
 
Balance
 
Expense
 
Paid
 
Balance
 
Expense
 
Paid
 
Balance
 
Expense
 
Paid
Interest-Bearing Deposits at
   Banks
$
32,562

 
$
94

 
0.29
%
 
$
28,266

 
$
80

 
0.28
%
 
$
32,148

 
$
89

 
0.28
%
Investment Securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fully Taxable
431,445

 
8,060

 
1.87
%
 
408,989

 
7,970

 
1.95
%
 
432,947

 
6,920

 
1.60
%
    Exempt from Federal
       Taxes
269,667

 
9,681

 
3.59
%
 
286,929

 
9,730

 
3.39
%
 
314,835

 
10,105

 
3.21
%
Loans
1,484,766

 
57,282

 
3.86
%
 
1,344,427

 
53,543

 
3.98
%
 
1,208,954

 
51,599

 
4.27
%
Total Earning Assets
2,218,440

 
75,117

 
3.39
%
 
2,068,611

 
71,323

 
3.45
%
 
1,988,884

 
68,713

 
3.45
%
Allowance for Loan Losses
(15,595
)
 
 
 
 
 
(14,801
)
 
 
 
 
 
(14,778
)
 
 
 
 
Cash and Due From Banks
31,007

 
 
 
 
 
30,383

 
 
 
 
 
30,985

 
 
 
 
Other Assets
107,615

 
 
 
 
 
106,287

 
 
 
 
 
97,697

 
 
 
 
Total Assets
$
2,341,467

 
 
 
 
 
$
2,190,480

 
 
 
 
 
$
2,102,788

 
 
 
 
Deposits:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
NOW Accounts
$
915,565

 
1,276

 
0.14
%
 
$
861,457

 
1,722

 
0.20
%
 
$
798,230

 
2,461

 
0.31
%
Savings Deposits
554,330

 
741

 
0.13
%
 
521,595

 
839

 
0.16
%
 
490,558

 
1,024

 
0.21
%
  Time Deposits of $100,000
    Or More
59,967

 
356

 
0.59
%
 
70,475

 
770

 
1.09
%
 
86,457

 
1,198

 
1.39
%
Other Time Deposits
136,396

 
742

 
0.54
%
 
158,592

 
1,354

 
0.85
%
 
179,997

 
1,962

 
1.09
%
    Total Interest-
      Bearing Deposits
1,666,258

 
3,115

 
0.19
%
 
1,612,119

 
4,685

 
0.29
%
 
1,555,242

 
6,645

 
0.43
%
Short-Term Borrowings
45,595

 
128

 
0.28
%
 
29,166

 
67

 
0.23
%
 
33,404

 
88

 
0.26
%
FHLBNY Term Advances and
   Other Long-Term Debt
66,014