10-K 1 amnb-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 0-12820
AMERICAN NATIONAL BANKSHARES INC.
(Exact name of registrant as specified in its charter)
Virginia
 
54-1284688
(State of incorporation)
 
(I.R.S. Employer Identification No.)
628 Main Street, Danville, VA
 
24541
(Address of principal executive offices)
 
(Zip Code)
434-792-5111
Registrant's telephone number, including area code
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class
 
Name of Exchange on Which Registered
Common Stock, $1 par value
 
NASDAQ Global Select Market
Securities registered pursuant to section 12(g) of the Act:  None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  ☐    No þ
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   ☐    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  þ 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 þ   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 definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act.  (Check one):
Large accelerated filer ☐  Accelerated filer  ☑  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  ☐  No ☑
The aggregate market value of the voting stock held by non-affiliates of the registrant at June 30, 2015, based on the closing price, was $190,436,023.
The number of shares of the registrant's common stock outstanding on March 7, 2016 was 8,610,721.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement of the Registrant for the Annual Meeting of Shareholders to be held on May 17, 2016, are incorporated by reference in Part III of this report.

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CROSS REFERENCE INDEX
 
 
 
PART I
 
PAGE
ITEM 1
ITEM 1A
ITEM 1B
Unresolved Staff Comments
None
ITEM 2
ITEM 3
ITEM 4
 
 
PART II
 
 
ITEM 5
ITEM 6
ITEM 7
ITEM 7A
ITEM 8
 
 
 
 
 
 
 
ITEM 9
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None
ITEM 9A
 
ITEM 9B
Other Information
None
 
 
PART III
 
 
ITEM 10
Directors, Executive Officers and Corporate Governance
*
ITEM 11
Executive Compensation
*
ITEM 12
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
*
ITEM 13
Certain Relationships and Related Transactions, and Director Independence
*
ITEM 14
Principal Accountant Fees and Services
*
 
 
PART IV
 
 
ITEM 15
_______________________________
*Certain information required by Item 10 is incorporated herein by reference to the information that appears under the headings "Election of Directors," "Election of Directors – Board Members Serving on Other Publicly Traded Company Boards of Directors," "Election of Directors – Board of Directors and Committees - The Audit Committee," "Section 16(a) Beneficial Ownership Reporting Compliance," "Report of the Audit Committee," and "Code of Conduct" in the Registrant's Proxy Statement for the 2016 Annual Meeting of Shareholders.  The information required by Item 401 of Regulation S-K on executive officers is disclosed herein.
The information required by Item 11 is incorporated herein by reference to the information that appears under the headings "Compensation Discussion and Analysis," "Compensation Committee Interlocks and Insider Participation," and "Compensation Committee Report" in the Registrant's Proxy Statement for the 2016 Annual Meeting of Shareholders.
The information required by Item 12 is incorporated herein by reference to the information that appears under the heading "Security Ownership" in the Registrant's Proxy Statement for the 2016 Annual Meeting of Shareholders.  The information required by Item 201(d) of Regulation S-K is disclosed herein.  See Item 5, "Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities."
The information required by Item 13 is incorporated herein by reference to the information that appears under the headings "Related Party Transactions" and "Election of Directors – Board Independence" in the Registrant's Proxy Statement for the 2016 Annual Meeting of Shareholders.
The information required by Item 14 is incorporated herein by reference to the information that appears under the heading "Independent Public Accountants" in the Registrant's Proxy Statement for the 2016 Annual Meeting of Shareholders.

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PART I
Forward-Looking Statements
This report contains forward-looking statements with respect to the financial condition, results of operations and business of American National Bankshares Inc. (the "Company") and its wholly owned subsidiary, American National Bank and Trust Company (the "Bank").  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on information available to management at the time these statements and disclosures were prepared.  Forward-looking statements are subject to numerous assumptions, estimates, risks, and uncertainties that could cause actual conditions, events, or results to differ materially from those stated or implied by such forward-looking statements.
A variety of factors, some of which are discussed in more detail in Item 1A – Risk Factors, may affect the operations, performance, business strategy, and results of the Company.  Those factors include but are not limited to the following:
Financial market volatility including the level of interest rates could affect the values of financial instruments and the amount of net interest income earned;
General economic or business conditions, either nationally or in the market areas in which the Company does business, may be less favorable than expected, resulting in deteriorating credit quality, reduced demand for credit, or a weakened ability to generate deposits;
Competition among financial institutions may increase and competitors may have greater financial resources and develop products and technology that enable those competitors to compete more successfully than the Company;
Businesses that the Company is engaged in may be adversely affected by legislative or regulatory changes, including changes in accounting standards;
The ability to retain key personnel;
The failure of assumptions underlying the allowance for loan losses; and
Risks associated with mergers, acquisitions, and other expansion activities.
ITEM 1 – BUSINESS
American National Bankshares Inc. is a one-bank holding company organized under the laws of the Commonwealth of Virginia in 1984.  On September 1, 1984, the Company acquired all of the outstanding capital stock of American National Bank and Trust Company, a national banking association chartered in 1909 under the laws of the United States.  American National Bank and Trust Company is the only banking subsidiary of the Company.
On July 1, 2011, the Company completed its acquisition of MidCarolina Financial Corporation ("MidCarolina") pursuant to the terms and conditions of the Agreement and Plan of Reorganization, dated December 15, 2010, between the Company and MidCarolina.  MidCarolina was headquartered in Burlington, North Carolina, and engaged in banking operations through its subsidiary bank, MidCarolina Bank.  The transaction has expanded the Company's footprint in North Carolina, adding eight branches in Alamance and Guilford Counties.
On January 1, 2015, the Company completed its acquisition of MainStreet BankShares, Inc. ("MainStreet") pursuant to the terms and conditions of the Agreement and Plan of Reorganization, dated as of August 24, 2014, between the Company and MainStreet.  Immediately after the merger of MainStreet into the Company, Franklin Community Bank, N.A. ("Franklin Bank"), MainStreet's wholly-owned bank subsidiary, merged with and into the Bank.
Pursuant to the MainStreet Merger Agreement, the former holders of shares of MainStreet common stock received $3.46 in cash and 0.482 shares of the Company's common stock for each share of MainStreet common stock held immediately prior to the effective date of the merger, plus cash in lieu of fractional shares. Each option to purchase shares of MainStreet common stock that was outstanding immediately prior to the effective date of the merger vested upon the merger and was converted into an option to purchase shares of the Company's common stock, adjusted based on a 0.643 exchange ratio. Each share of the Company's common stock outstanding immediately prior to the merger remained outstanding and was unaffected by the merger. The cash portion of the merger consideration was funded through a cash dividend of $6,000,000 from the Bank to the Company, and no borrowing was incurred by the Company or the Bank in connection with the merger.
MainStreet was the holding company for Franklin Bank.  Immediately prior to the Company's acquisition of MainStreet on January 1, 2015, MainStreet had total net loans of approximately $122,000,000, total assets of approximately $164,000,000, and total deposits of approximately $137,000,000. Franklin Bank provided banking services to its customers from three banking offices located in Rocky Mount, Hardy, and Union Hall, Virginia, which are now branch offices of the Bank.

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As of December 31, 2015, the operations of the Company are conducted at twenty-five banking offices and two loan production offices in Roanoke, Virginia and Raleigh, North Carolina.  The Bank provides a full array of financial products and services, including commercial, mortgage, and consumer banking; trust and investment services; and insurance.  Services are also provided through thirty-three Automated Teller Machines ("ATMs"), "Online Banking," and "Telephone Banking."
The Company has two reportable segments, (i) community banking and (ii) trust and investment services. For more financial data and other information about each of the Company’s operating segments, refer to “Note 21 - Segment and Related Information” of the Consolidated Financial Statements contained in Item 8 of this Form 10-K.
Competition and Markets
Vigorous competition exists in the Company's service areas.  The Company competes not only with national, regional, and community banks, but also with other types of financial institutions including savings banks, finance companies, mutual and money market fund providers, brokerage firms, insurance companies, credit unions, and mortgage companies.
The Company has the largest deposit market share in the City of Danville, Virginia.  The Company had a deposit market share in the Danville Micropolitan Statistical Area of 32.8% at June 30, 2015, based on Federal Deposit Insurance Corporation ("FDIC") data. The Company has the second largest deposit market share in Pittsylvania County, Virginia.  The Company had a deposit market share in Pittsylvania County of 21.1% at June 30, 2015, based on FDIC data.
The Southern Virginia market, in which the Company has a significant presence, continues to experience slow economic growth, like much of the country. The region's economic base continues to be weighted toward the manufacturing sector.  Although the region was negatively impacted by the elimination of many textile plant closings over several decades, the area has experienced some new manufacturing plant openings as well as job growth in the technology area. Other important industries include farming, tobacco processing and sales, food processing, and packaging tape production.
The Company's market areas in North Carolina are Alamance County and Guilford County, North Carolina, where there is strong competition in attracting deposits and making loans. Its most direct competition for deposits comes from commercial banks, savings institutions and credit unions located in the market area, including large financial institutions that have greater financial and marketing resources available to them.  The Company had a deposit market share in Alamance County of 13.6% at June 30, 2015, based on FDIC data, which was the second largest of any FDIC-insured institution.
Supervision and Regulation
The Company and the Bank are extensively regulated under federal and state law.  The following information describes certain aspects of that regulation applicable to the Company and the Bank and does not purport to be complete.  Proposals to change the laws and regulations governing the banking industry are frequently raised in U.S. Congress, in state legislatures, and before the various bank regulatory agencies.  The likelihood and timing of any changes and the impact such changes might have on the Company and the Bank are impossible to determine with any certainty.  A change in applicable laws or regulations, or a change in the way such laws or regulations are interpreted by regulatory agencies or courts, may have a material impact on the business, operations, and earnings of the Company and the Bank.
American National Bankshares Inc.
American National Bankshares Inc. is qualified as a bank holding company ("BHC") within the meaning of the Bank Holding Company Act of 1956, as amended (the "BHC Act"), and is registered as such with the Board of Governors of the Federal Reserve System (the "FRB").  As a bank holding company, American National Bankshares Inc. is subject to supervision, regulation and examination by the FRB and is required to file various reports and additional information with the FRB.  American National Bankshares Inc. is also registered under the bank holding company laws of Virginia and is subject to supervision, regulation and examination by the Virginia State Corporation Commission (the "SCC").
Under the Gramm-Leach-Bliley Act, a BHC may elect to become a financial holding company and thereby engage in a broader range of financial and other activities than are permissible for traditional BHC's.  In order to qualify for the election, all of the depository institution subsidiaries of the BHC must be well capitalized, well managed, and have achieved a rating of "satisfactory" or better under the Community Reinvestment Act (the "CRA").  Financial holding companies are permitted to engage in activities that are "financial in nature" or incidental or complementary thereto as determined by the FRB.  The Gramm-Leach-Bliley Act identifies several activities as "financial in nature," including insurance underwriting and sales, investment advisory services, merchant banking and underwriting, and dealing or making a market in securities.  American National Bankshares Inc. has not elected to become a financial holding company, and has no plans to become a financial holding company.

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American National Bank and Trust Company
American National Bank and Trust Company is a federally chartered national bank and is a member of the Federal Reserve System.  It is subject to federal regulation by the Office of the Comptroller of the Currency (the "OCC"), the FRB, and the FDIC.
Depository institutions, including the Bank, are subject to extensive federal and state regulations that significantly affect their business and activities. Regulatory bodies have broad authority to implement standards and initiate proceedings designed to prohibit depository institutions from engaging in unsafe and unsound banking practices.  The standards relate generally to operations and management, asset quality, interest rate exposure, and capital.  The bank regulatory agencies are authorized to take action against institutions that fail to meet such standards.
As with other financial institutions, the earnings of the Bank are affected by general economic conditions and by the monetary policies of the FRB. The FRB exerts a substantial influence on interest rates and credit conditions, primarily through open market operations in U.S. Government securities, setting the reserve requirements of member banks, and establishing the discount rate on member bank borrowings. The policies of the FRB have a direct impact on loan and deposit growth and the interest rates charged and paid thereon. They also impact the source, cost of funds, and the rates of return on investments. Changes in the FRB's monetary policies have had a significant impact on the operating results of the Bank and other financial institutions and are expected to continue to do so in the future; however, the exact impact of such conditions and policies upon the future business and earnings cannot accurately be predicted.
The Dodd-Frank Act
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The Dodd-Frank Act significantly restructures the financial regulatory regime in the United States and has a broad impact on the financial services industry as a result of the significant regulatory and compliance changes required under the act. While significant rulemaking under the Dodd-Frank Act has occurred, certain of the act's provisions require additional rulemaking by the federal bank regulatory agencies, a process which will take years to fully implement.  The Company believes that short- and long-term compliance costs for the Company will be greater because of the Dodd-Frank Act.
A summary of certain provisions of the Dodd-Frank Act is set forth below:
Increased Capital Standards.  The federal banking agencies are required to establish minimum leverage and risk-based capital requirements for banks and bank holding companies. See "Capital Requirements" below.  Among other things, the Dodd-Frank Act provides for newer and stronger standards.
Deposit Insurance.  The Dodd-Frank Act makes permanent the $250,000 deposit insurance limit for insured deposits. Amendments to the Federal Deposit Insurance Act also revise the assessment base against which an insured depository institution's deposit insurance premiums paid to the Deposit Insurance Fund (the "DIF") will be calculated. Under the amendments, the assessment base will no longer be the institution's deposit base, but rather its average consolidated total assets less its average tangible equity during the assessment period.  Additionally, the Dodd-Frank Act makes changes to the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15% to 1.35% of the estimated amount of total insured deposits and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds. The Dodd-Frank Act also provides that depository institutions may pay interest on demand deposits.
The Consumer Financial Protection Bureau ("CFPB").  The CFPB is charged with establishing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services.
Compensation Practices.  The Dodd-Frank Act provides that the appropriate federal regulators must establish standards prohibiting as an unsafe and unsound practice any compensation plan of a bank holding company or bank that provides an insider or other employee with "excessive compensation" or could lead to a material financial loss to such firm. In June 2010, prior to the Dodd-Frank Act, the federal bank regulatory agencies promulgated the Interagency Guidance on Sound Incentive Compensation Policies, which requires that financial institutions establish metrics for measuring the impact of activities to achieve incentive compensation with the related risk to the financial institution of such behavior.
Although a significant number of the rules and regulations mandated by the Dodd-Frank Act have been finalized, certain of the act's requirements have yet to be implemented. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the federal bank regulatory agencies in the future, the full extent of the impact such requirements will have on the operations of the Company and the Bank is unclear. The changes resulting from the Dodd-Frank Act may affect the profitability of business activities, require changes to certain business practices, impose more

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stringent regulatory requirements or otherwise adversely affect the business and financial condition of the Company and the Bank. These changes may also require the Company to invest significant management attention and resources to evaluate and make necessary changes to comply with new statutory and regulatory requirements.
Deposit Insurance
The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the FDIC and are subject to deposit insurance assessments to maintain the DIF. On April 1, 2011, the deposit insurance assessment base changed from total deposits to average total assets minus average tangible equity, pursuant to a rule issued by the FDIC as required by the Dodd-Frank Act.
The Federal Deposit Insurance Act (the "FDIA"), as amended by the Federal Deposit Insurance Reform Act and the Dodd-Frank Act, requires the FDIC to set a ratio of deposit insurance reserves to estimated insured deposits of at least 1.35%. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank's capital level and supervisory rating. On February 27, 2009, the FDIC introduced three possible adjustments to an institution's initial base assessment rate: (i) a decrease of up to five basis points for long-term unsecured debt, including senior unsecured debt (other than debt guaranteed under the Temporary Liquidity Guarantee Program) and subordinated debt and, for small institutions, a portion of Tier 1 capital; (ii) an increase not to exceed 50% of an institution's assessment rate before the increase for secured liabilities in excess of 25% of domestic deposits; and (iii) for non-Risk Category I institutions, an increase not to exceed 10 basis points for brokered deposits in excess of 10% of domestic deposits.  In 2015 and 2014, the Company paid only the base assessment rate for "well capitalized" institutions, which totaled $750,000 and $647,000, respectively, in regular deposit insurance assessments.
In addition, all FDIC insured institutions are required to pay assessments to the FDIC at an annual rate of approximately one basis point of insured deposits to fund interest payments on bonds issued by the Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments will continue until the Financing Corporation bonds mature in 2017 through 2019.
Capital Requirements 
The FRB, the OCC and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to all banks and bank holding companies.  In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of these federal bank regulatory agencies that were effective through December 31, 2015, American National Bankshares Inc. and American National Bank were required to maintain a minimum ratio of total capital (which is defined as core capital and supplementary capital less certain specified deductions from total capital such as reciprocal holdings of depository institution capital instruments and equity investments) to risk-weighted assets of at least 8.0%.  In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet activities, recourse obligations, residual interests and direct credit substitutes, were multiplied by a risk-weight factor assigned by the capital regulation based on the risks believed inherent in the type of asset. 
On June 7, 2012, the FRB issued a series of proposed rules intended to revise and strengthen its risk-based and leverage capital requirements and its method for calculating risk-weighted assets. The rules were proposed to implement the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain provisions of the Dodd-Frank Act.  On July 2, 2013, the Federal Reserve approved certain revisions to the proposals and finalized new capital requirements for banking organizations.
Effective January 1, 2015, the final rules required the Company and the Bank to comply with the following new minimum capital ratios: (i) a new common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6% of risk-weighted assets (increased from the prior requirement of 4%); (iii) a total capital ratio of 8% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4% of total assets (unchanged from the prior requirement).  These are the initial capital requirements, which will be phased in over a four-year period.  When fully phased in on January 1, 2019, the rules will require the Company and the  Bank to maintain (i) a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% common equity Tier 1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation), and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets.

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The Tier 1 and total capital to risk-weighted asset ratios of the Company were 15.23% and 16.34%, respectively, as of December 31, 2015, thus exceeding the minimum requirements. The common equity Tier 1 capital ratio of the Company was 12.88% and the Bank was 14.58% as of December 31, 2015. The Tier 1 and total capital to risk-weighted asset ratios of the Bank were 14.58% and 15.67%, respectively, as of December 31, 2015 also exceeding the minimum requirements.
The capital conservation buffer requirement will be phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress.  Banking institutions with a ratio of common equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall.
With respect to the Bank, the rules also revised the "prompt corrective action" regulations pursuant to Section 38 of the FDIA by (i) introducing a common equity Tier 1 capital ratio requirement at each level (other than critically undercapitalized), with the required ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category, with the minimum ratio for well-capitalized status being 8.0% (as compared to the prior ratio of 6.0%); and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3.0% Tier 1 leverage ratio and still be well-capitalized.  These new thresholds were effective for the Bank as of January 1, 2015.  The minimum total capital to risk-weighted assets ratio (10.0%) and minimum leverage ratio (5.0%) for well-capitalized status were unchanged by the final rules.
The new capital requirements also included changes in the risk weights of assets to better reflect credit risk and other risk exposures. These include a 150% risk weight (up from 100%) for certain high volatility commercial real estate acquisition, development and construction loans and nonresidential mortgage loans that are 90 days past due or otherwise on nonaccrual status, a 20% (up from 0%) credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancelable, a 250% risk weight (up from 100%) for mortgage servicing rights and deferred tax assets that are not deducted from capital, and increased risk-weights (from 0% to up to 600%) for equity exposures.
Based on management's understanding and interpretation of the new capital rules, it believes that, as of December 31, 2015, the Company and the Bank meet all capital adequacy requirements under such rules on a fully phased-in basis as if such requirements were in effect as of such date.
Dividends
The Company's principal source of cash flow, including cash flow to pay dividends to its shareholders, is dividends it receives from the Bank.  Statutory and regulatory limitations apply to the Bank's payment of dividends to the Company. As a general rule, the amount of a dividend may not exceed, without prior regulatory approval, the sum of net income in the calendar year to date and the retained net earnings of the immediately preceding two calendar years. A depository institution may not pay any dividend if payment would cause the institution to become "undercapitalized" or if it already is "undercapitalized." The OCC may prevent the payment of a dividend if it determines that the payment would be an unsafe and unsound banking practice. The OCC also has advised that a national bank should generally pay dividends only out of current operating earnings.
Permitted Activities
As a bank holding company, American National Bankshares Inc. is limited to managing or controlling banks, furnishing services to or performing services for its subsidiaries, and engaging in other activities that the FRB determines by regulation or order to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In determining whether a particular activity is permissible, the FRB must consider whether the performance of such an activity reasonably can be expected to produce benefits to the public that outweigh possible adverse effects. Possible benefits include greater convenience, increased competition, and gains in efficiency. Possible adverse effects include undue concentration of resources, decreased or unfair competition, conflicts of interest, and unsound banking practices. Despite prior approval, the FRB may order a bank holding company or its subsidiaries to terminate any activity or to terminate ownership or control of any subsidiary when the FRB has reasonable cause to believe that a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company may result from such an activity.

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Banking Acquisitions; Changes in Control
The BHC Act requires, among other things, the prior approval of the FRB in any case where a bank holding company proposes to (i) acquire direct or indirect ownership or control of more than 5% of the outstanding voting stock of any bank or bank holding company (unless it already owns a majority of such voting shares), (ii) acquire all or substantially all of the assets of another bank or bank holding company, or (iii) merge or consolidate with any other bank holding company. In determining whether to approve a proposed bank acquisition, the FRB will consider, among other factors, the effect of the acquisition on competition, the public benefits expected to be received from the acquisition, the projected capital ratios and levels on a post-acquisition basis, and the acquiring institution's performance under the Community Reinvestment Act of 1977 (the "CRA") and its compliance with fair housing and other consumer protection laws.
Subject to certain exceptions, the BHC Act and the Change in Bank Control Act, together with the applicable regulations, require FRB approval (or, depending on the circumstances, no notice of disapproval) prior to any person or company acquiring "control" of a bank or bank holding company. A conclusive presumption of control exists if an individual or company acquires the power, directly or indirectly, to direct the management or policies of an insured depository institution or to vote 25% or more of any class of voting securities of any insured depository institution. A rebuttable presumption of control exists if a person or company acquires 10% or more but less than 25% of any class of voting securities of an insured depository institution and either the institution has registered its securities with the Securities and Exchange Commission under Section 12 of the Securities Exchange Act of 1934 (the "Exchange Act") or no other person will own a greater percentage of that class of voting securities immediately after the acquisition. The Company's common stock is registered under Section 12 of the Exchange Act.
In addition, Virginia law requires the prior approval of the SCC for (i) the acquisition of more than 5% of the voting shares of a Virginia bank or any holding company that controls a Virginia bank, or (ii) the acquisition by a Virginia bank holding company of a bank or its holding company domiciled outside Virginia.
Source of Strength
FRB policy has historically required bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. The Dodd-Frank Act codified this policy as a statutory requirement. Under this requirement, the Company is expected to commit resources to support the Bank, including at times when the Company may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.
Safety and Soundness
There are a number of obligations and restrictions imposed on bank holding companies and their subsidiary banks by law and regulatory policy that are designed to minimize potential loss to the depositors of such depository institutions and the FDIC insurance fund in the event of a depository institution default. For example, under the Federal Deposit Insurance Corporation Improvement Act of 1991, to avoid receivership of an insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any subsidiary bank that may become "undercapitalized" with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal bank regulatory agency up to the lesser of (i) an amount equal to 5% of the institution's total assets at the time the institution became undercapitalized or (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with such capital restoration plan.
Under the FDIA, the federal bank regulatory agencies have adopted guidelines prescribing safety and soundness standards. These guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines.
The Federal Deposit Insurance Corporation Improvement Act
Under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), the federal bank regulatory agencies possess broad powers to take prompt corrective action to resolve problems of insured depository institutions.  The extent of these powers depends upon whether the institution is "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," or "critically undercapitalized," as defined by the law. 

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Reflecting changes under the new Basel III capital requirements, the relevant capital measures that became effective on January 1, 2015 for prompt corrective action are the total capital ratio, the common equity Tier 1 capital ratio, the Tier 1 capital ratio and the leverage ratio.  A bank will be (i) "well capitalized" if the institution has a total risk-based capital ratio of 10.0% or greater, a common equity Tier 1 capital ratio of 6.5% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any capital directive order; (ii) "adequately capitalized" if the institution has a total risk-based capital ratio of 8.0% or greater, a common equity Tier 1 capital ratio of 4.5% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 4.0% or greater and is not "well capitalized"; (iii) "undercapitalized" if the institution has a total risk-based capital ratio that is less than 8.0%, a common equity Tier 1 capital ratio less than 4.5%, a Tier 1 risk-based capital ratio of less than 6.0% or a leverage ratio of less than 4.0%; (iv) "significantly undercapitalized" if the institution has a total risk-based capital ratio of less than 6.0%, a common equity Tier 1 capital ratio less than 3.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 3.0%; and (v) "critically undercapitalized" if the institution's tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank's capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank's overall financial condition or prospects for other purposes.  Management believes, as of December 31, 2015 and 2014, the Company met the requirements for being classified as "well capitalized."
As required by FDICIA, the federal bank regulatory agencies also have adopted guidelines prescribing safety and soundness standards relating to, among other things, internal controls and information systems, internal audit systems, loan documentation, credit underwriting, and interest rate exposure.  In general, the guidelines require appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines.  In addition, the agencies adopted regulations that authorize, but do not require, an institution which has been notified that it is not in compliance with safety and soundness standard to submit a compliance plan.  If, after being so notified, an institution fails to submit an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the prompt corrective action provisions described above.
Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended (the "Interstate Banking Act"), generally permits well capitalized bank holding companies to acquire banks in any state, and preempts all state laws restricting the ownership by a bank holding company of banks in more than one state. The Interstate Banking Act also permits a bank to merge with an out-of-state bank and convert any offices into branches of the resulting bank if both states have not opted out of interstate branching; and permits a bank to acquire branches from an out-of-state bank if the law of the state where the branches are located permits the interstate branch acquisition. Under the Dodd-Frank Act, a bank holding company or bank must be well capitalized and well managed to engage in an interstate acquisition. Bank holding companies and banks are required to obtain prior FRB approval to acquire more than 5% of a class of voting securities, or substantially all of the assets, of a bank holding company, bank or savings association. The Interstate Banking Act and the Dodd-Frank Act permit banks to establish and operate de novo interstate branches to the same extent a bank chartered by the host state may establish branches.
Transactions with Affiliates
Pursuant to Sections 23A and 23B of the Federal Reserve Act and Regulation W, the authority of the Bank to engage in transactions with related parties or "affiliates" or to make loans to insiders is limited. Loan transactions with an affiliate generally must be collateralized and certain transactions between the Bank and its affiliates, including the sale of assets, the payment of money or the provision of services, must be on terms and conditions that are substantially the same, or at least as favorable to the Bank, as those prevailing for comparable nonaffiliated transactions. In addition, the Bank generally may not purchase securities issued or underwritten by affiliates.
Loans to executive officers, directors or to any person who directly or indirectly, or acting through or in concert with one or more persons, owns, controls or has the power to vote more than 10% of any class of voting securities of a bank (a "10% Shareholders"), are subject to Sections 22(g) and 22(h) of the Federal Reserve Act and their corresponding regulations (Regulation O) and Section 13(k) of the Exchange Act relating to the prohibition on personal loans to executives (which exempts financial institutions in compliance with the insider lending restrictions of Section 22(h) of the Federal Reserve Act). Among other things, these loans must be made on terms substantially the same as those prevailing on transactions made to unaffiliated individuals and certain extensions of credit to those persons must first be approved in advance by a disinterested majority of the entire board of directors. Section 22(h) of the Federal Reserve Act prohibits loans to any of those individuals where the aggregate amount exceeds an amount equal to 15% of an institution's unimpaired capital and surplus plus an

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additional 10% of unimpaired capital and surplus in the case of loans that are fully secured by readily marketable collateral, or when the aggregate amount on all of the extensions of credit outstanding to all of these persons would exceed the Bank's unimpaired capital and unimpaired surplus. Section 22(g) of the Federal Reserve Act identifies limited circumstances in which the Bank is permitted to extend credit to executive officers.
Consumer Financial Protection
The Company is subject to a number of federal and state consumer protection laws that extensively govern its relationship with its customers. These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Truth in Savings Act, the Electronic Fund Transfer Act, the Expedited Funds Availability Act, the Home Mortgage Disclosure Act, the Fair Housing Act, the Real Estate Settlement Procedures Act, the Fair Debt Collection Practices Act, the Service Members Civil Relief Act, laws governing flood insurance, federal and state laws prohibiting unfair and deceptive business practices, foreclosure laws ,and various regulations that implement some or all of the foregoing. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits, making loans, collecting loans and providing other services. If the Company fails to comply with these laws and regulations, it may be subject to various penalties. Failure to comply with consumer protection requirements may also result in failure to obtain any required bank regulatory approval for merger or acquisition transactions the Company may wish to pursue or being prohibited from engaging in such transactions even if approval is not required.
The Dodd-Frank Act centralized responsibility for consumer financial protection by creating a new agency, the CFPB, and giving it responsibility for implementing, examining, and enforcing compliance with federal consumer protection laws. The CFPB focuses on (i) risks to consumers and compliance with the federal consumer financial laws, (ii) the markets in which firms operate and risks to consumers posed by activities in those markets, (iii) depository institutions that offer a wide variety of consumer financial products and services, and (iv) non-depository companies that offer one or more consumer financial products or services. The CFPB has broad rule making authority for a wide range of consumer financial laws that apply to all banks, including, among other things, the authority to prohibit "unfair, deceptive or abusive" acts and practices. Abusive acts or practices are defined as those that materially interfere with a consumer's ability to understand a term or condition of a consumer financial product or service or take unreasonable advantage of a consumer's (i) lack of financial savvy, (ii) inability to protect himself in the selection or use of consumer financial products or services, or (iii) reasonable reliance on a covered entity to act in the consumer's interests. The CFPB can issue cease-and-desist orders against banks and other entities that violate consumer financial laws. The CFPB may also institute a civil action against an entity in violation of federal consumer financial law in order to impose a civil penalty or injunction.
Community Reinvestment Act
The CRA requires the appropriate federal banking agency, in connection with its examination of a bank, to assess the bank's record in meeting the credit needs of the communities served by the bank, including low and moderate income neighborhoods.  Furthermore, such assessment is also required of banks that have applied, among other things, to merge or consolidate with or acquire the assets or assume the liabilities of an insured depository institution, or to open or relocate a branch.  In the case of a BHC applying for approval to acquire a bank or BHC, the record of each subsidiary bank of the applicant BHC is subject to assessment in considering the application.  Under the CRA, institutions are assigned a rating of "outstanding," "satisfactory," "needs to improve," or "substantial non-compliance."  The Company was rated "satisfactory" in its most recent CRA evaluation.
Anti-Money Laundering Legislation
The Company is subject to the Bank Secrecy Act and other anti-money laundering laws and regulations, including the USA Patriot Act of 2001.  Among other things, these laws and regulations require the Company to take steps to prevent the use of the Company for facilitating the flow of illegal or illicit money, to report large currency transactions, and to file suspicious activity reports.  The Company is also required to carry out a comprehensive anti-money laundering compliance program.  Violations can result in substantial civil and criminal sanctions.  In addition, provisions of the USA Patriot Act require the federal bank regulatory agencies to consider the effectiveness of a financial institution's anti-money laundering activities when reviewing bank mergers and BHC acquisitions.

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Privacy Legislation
Several recent laws, including the Right to Financial Privacy Act, and related regulations issued by the federal bank regulatory agencies, also provide new protections against the transfer and use of customer information by financial institutions. A financial institution must provide to its customers information regarding its policies and procedures with respect to the handling of customers' personal information. Each institution must conduct an internal risk assessment of its ability to protect customer information. These privacy provisions generally prohibit a financial institution from providing a customer's personal financial information to unaffiliated parties without prior notice and approval from the customer.
Incentive Compensation
In June 2010, the federal bank regulatory agencies issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of financial institutions do not undermine the safety and soundness of such institutions by encouraging excessive risk-taking. The Interagency Guidance on Sound Incentive Compensation Policies, which covers all employees that have the ability to materially affect the risk profile of a financial institutions, either individually or as part of a group, is based upon the key principles that a financial institution's incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the institution's ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the financial institution's board of directors.
The FRB will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of financial institutions, such as the Company, that are not "large, complex banking organizations." These reviews will be tailored to each financial institution based on the scope and complexity of the institution's activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the institution's supervisory ratings, which can affect the institution's ability to make acquisitions and take other actions. Enforcement actions may be taken against a financial institution if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the institution's safety and soundness and the financial institution is not taking prompt and effective measures to correct the deficiencies. At December 31, 2015, the Company had not been made aware of any instances of non-compliance with the final guidance.
Volcker Rule
The Volcker Rule under the Dodd-Frank Act prohibits banks and their affiliates from engaging in proprietary trading and investing in and sponsoring hedge funds and private equity funds. The Volcker Rule, which became effective in July 2015, does not significantly impact the operations of the Company or the Bank, as they do not have any significant engagement in the businesses prohibited by the Volcker Rule.
Ability-to-Repay and Qualified Mortgage Rule
Pursuant to the Dodd-Frank Act, the CFPB issued a final rule on January 10, 2013 (effective on January 10, 2014), amending Regulation Z as implemented by the Truth in Lending Act, requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Mortgage lenders are required to determine consumers' ability to repay in one of two ways. The first alternative requires the mortgage lender to consider the following eight underwriting factors when making the credit decision: (i) current or reasonably expected income or assets; (ii) current employment status; (iii) the monthly payment on the covered transaction; (iv) the monthly payment on any simultaneous loan; (v) the monthly payment for mortgage-related obligations; (vi) current debt obligations, alimony, and child support; (vii) the monthly debt-to-income ratio or residual income; and (viii) credit history. Alternatively, the mortgage lender can originate "qualified mortgages," which are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a "qualified mortgage" is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. In addition, to be a qualified mortgage the points and fees paid by a consumer cannot exceed 3% of the total loan amount. Qualified mortgages that are "higher-priced" (e.g. subprime loans) garner a rebuttable presumption of compliance with the ability-to-repay rules, while qualified mortgages that are not "higher-priced" (e.g. prime loans) are given a safe harbor of compliance. The Company is predominantly an originator of compliant qualified mortgages.

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Cybersecurity
In March 2015, federal regulators issued two related statements regarding cybersecurity. One statement indicates that financial institutions should design multiple layers of security controls to establish lines of defense and to ensure that their risk management processes also address the risk posed by compromised customer credentials, including security measures to reliably authenticate customers accessing internet-based services of the financial institution. The other statement indicates that a financial institution’s management is expected to maintain sufficient business continuity planning processes to ensure the rapid recovery, resumption and maintenance of the institution’s operations after a cyber-attack involving destructive malware. A financial institution is also expected to develop appropriate processes to enable recovery of data and business operations and address rebuilding network capabilities and restoring data if the institution or its critical service providers fall victim to this type of cyber-attack. If the Company fails to observe the regulatory guidance, it could be subject to various regulatory sanctions, including financial penalties.
Effect of Governmental Monetary Policies
The Company's operations are affected not only by general economic conditions, but also by the policies of various regulatory authorities.  In particular, the FRB regulates money and credit conditions and interest rates to influence general economic conditions.  These policies have a significant impact on overall growth and distribution of loans, investments and deposits; they affect interest rates charged on loans or paid for time and savings deposits.  FRB monetary policies have had a significant effect on the operating results of commercial banks, including the Company, in the past and are expected to do so in the future.  As a result, it is difficult for the Company to predict the potential effects of possible changes in monetary policies upon its future operating results.
Employees
At December 31, 2015, the Company employed 303 full-time equivalent persons.  In the opinion of the management of the Company, the relationship with employees of the Company and the Bank is good.
Internet Access to Company Documents
The Company provides access to its Securities and Exchange Commission (the "SEC") filings through a link on the Investor Relations page of the Company's website at www.amnb.com.  Reports available include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after the reports are filed electronically with the SEC. The information on the Company's website is not incorporated into this Annual Report on Form 10-K or any other filing the Company makes with the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

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Executive Officers of the Company
The following table lists, as of December 31, 2015, the executive officers of the Company, their ages, and their positions:
Name
 
Age
 
Position
Jeffrey V. Haley
 
55
 
President and Chief Executive Officer of the Company and Bank since January 2013; prior thereto, President of the Company and Chief Executive Officer of the Bank since January 2012; prior thereto, Executive Vice President of the Company from June 2010 to December 2011; prior thereto, Senior Vice President of the Company from July 2008 to May 2010; President of the Bank since June 2010; prior thereto, Executive Vice President of the Bank, as well as President of Trust and Financial Services from July 2008 to May 2010; prior thereto, Executive Vice President and Chief Operating Officer of the Bank from November 2005 to June 2007. 
William W. Traynham
 
60
 
Executive Vice President, Chief Financial Officer, Treasurer and Secretary of the Company since January 2015. Executive Vice President, Chief Financial Officer, and Cashier of the Bank since April 2009.
H. Gregg Strader
 
57
 
Executive Vice President and Chief Banking Officer of the Company since January 2015. Executive Vice President and Chief Banking Officer of the Bank since January 2014. Executive Vice President of the Bank from June 2013 until December 2013. Executive Vice President and Chief Credit Officer of IBERIABANK Corporation from 2010 to June 2013.
R. Helm Dobbins
 
64
 
Executive Vice President and Chief Credit Officer of the Company since January 2015. Executive Vice President and Chief Credit Officer of the Bank since 2005.
Dabney T.P. Gilliam, Jr.
 
61
 
Executive Vice President and Chief Administrative Officer of the Company since January 2015. Executive Vice President and Chief Administrative Officer of the Bank since 2008.
ITEM 1A – RISK FACTORS
Risks Related to the Company's Business
The Company's business is subject to interest rate risk, and variations in interest rates may negatively affect financial performance.
Changes in the interest rate environment may reduce the Company's profits.  It is expected that the Company will continue to realize income from the spread between the interest earned on loans, securities, and other interest earning assets, and interest paid on deposits, borrowings and other interest bearing liabilities.  Net interest spreads are affected by the difference between the maturities and repricing characteristics of interest earning assets and interest bearing liabilities.  In addition, loan volume and yields are affected by market interest rates on loans, and the current interest rate environment encourages extreme competition for new loan originations from qualified borrowers.  Management cannot ensure that it can minimize the Company's interest rate risk. While an eventual increase in the general level of interest rates may increase the loan yield and the net interest margin, it may adversely affect the ability of certain borrowers with variable rate loans to pay the interest and principal of their obligations.  Accordingly, changes in levels of market interest rates could materially and adversely affect the net interest spread, asset quality, loan origination volume, and overall profitability of the Company.
The Company faces strong competition from financial services companies and other companies that offer banking and other financial services, which could negatively affect the Company's business.
The Company encounters substantial competition from other financial institutions in its market area.  Ultimately, the Company may not be able to compete successfully against current and future competitors. Many competitors offer the same banking services that the Company offers.  These competitors include national, regional, and community banks.  The Company also faces competition from many other types of financial institutions, including savings banks, finance companies, mutual and money market fund providers, brokerage firms, insurance companies, credit unions, financial subsidiaries of certain industrial corporations, and mortgage companies.  In particular, competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and ATMs and conduct extensive promotional and advertising campaigns. Increased competition may result in reduced business for the Company.

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Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain loans and deposits, and range and quality of products and services provided, including new technology-driven products and services.  Technological innovation continues to contribute to greater competition in domestic and international financial services markets as technological advances enable more companies to provide financial services.  If the Company is unable to attract and retain banking customers, it may be unable to continue to grow loan and deposit portfolios and its results of operations and financial condition may be adversely affected.
Changes in economic conditions could materially and negatively affect the Company's business.
The Company's business is directly impacted by economic, political, and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies, and inflation, all of which are beyond the Company's control.  A deterioration in economic conditions, whether caused by global, national or local events, especially within the Company's market area, could result in potentially negative material consequences such as the following, among others: loan delinquencies increasing; problem assets and foreclosures increasing; demand for products and services decreasing; low cost or noninterest bearing deposits decreasing; and collateral for loans, especially real estate, declining in value, in turn reducing customers' borrowing power, and reducing the value of assets and collateral associated with existing loans.  Each of these consequences may have a material adverse effect on the Company's financial condition and results of operations.
Trust division income is a major source of non-interest income for the Company.  Trust and Investment Services fee revenue is largely dependent on the fair market value of assets under management and on trading volumes in the brokerage business. General economic conditions and their subsequent effect on the securities markets tend to act in correlation.  When general economic conditions deteriorate, securities markets generally decline in value, and the Company's Trust and Investment Service revenues are negatively impacted as asset values and trading volumes decrease.
The Company's credit standards and its on-going credit assessment processes might not protect it from significant credit losses.
The Company takes credit risk by virtue of making loans and extending loan commitments and letters of credit.  The Company manages credit risk through a program of underwriting standards, the review of certain credit decisions and an on-going process of assessment of the quality of the credit already extended.  The Company's exposure to credit risk is managed through the use of consistent underwriting standards that emphasize local lending while avoiding highly leveraged transactions as well as excessive industry and other concentrations.  The Company's credit administration function employs risk management techniques to help ensure that problem loans are promptly identified.  While these procedures are designed to provide the Company with the information needed to implement policy adjustments where necessary and to take appropriate corrective actions, and have proven to be reasonably effective to date, there can be no assurance that such measures will be effective in avoiding future undue credit risk.
The Company's focus on lending to small to mid-sized community-based businesses may increase its credit risk.
Most of the Company's commercial business and commercial real estate loans are made to small business or middle market customers.  These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and have a heightened vulnerability to economic conditions.  If general economic conditions in the market areas in which the Company operates negatively impact this important customer sector, the Company's results of operations and financial condition may be adversely affected.  Moreover, a portion of these loans have been made by the Company in recent years and the borrowers may not have experienced a complete business or economic cycle.  The deterioration of the borrowers' businesses may hinder their ability to repay their loans with the Company, which could have a material adverse effect on the Company's financial condition and results of operations.

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The Company depends on the accuracy and completeness of information about clients and counterparties, and its financial condition could be adversely affected if it relies on misleading information.
In deciding whether to extend credit or to enter into other transactions with clients and counterparties, the Company may rely on information furnished to it by or on behalf of clients and counterparties, including financial statements and other financial information, which the Company does not independently verify.  The Company also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors.  For example, in deciding whether to extend credit to clients, the Company may assume that a customer's audited financial statements conform with accounting principles generally accepted in the United States ("GAAP") and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer.  The Company's financial condition and results of operations could be negatively impacted to the extent it relies on financial statements that do not comply with GAAP or are materially misleading.
The allowance for loan losses may not be adequate to cover actual losses.
In accordance with accounting principles generally accepted in the United States, an allowance for loan losses is maintained to provide for loan losses.  The allowance for loan losses may not be adequate to cover actual credit losses, and future provisions for credit losses could materially and adversely affect operating results.  The allowance for loan losses is based on prior experience, as well as an evaluation of the risks in the current portfolio.  The amount of future losses is susceptible to changes in economic, operating, and other outside forces and conditions, including changes in interest rates, all of which are beyond the Company's control; and these losses may exceed current estimates.  Federal bank regulatory agencies, as a part of their examination process, review the Company's loans and allowance for loan losses.  While management believes that the allowance for loan losses is adequate to cover current losses, it cannot make assurances that it will not further increase the allowance for loan losses or that regulators will not require it to increase this allowance.  Either of these occurrences could adversely affect earnings.
Nonperforming assets take significant time to resolve and adversely affect the Company's results of operations and financial condition.
The Company's nonperforming assets adversely affect its net income in various ways.  The Company does not record interest income on nonaccrual loans, which adversely affects its income and increases credit administration costs.  When the Company receives collateral through foreclosures and similar proceedings, it is required to mark the related asset to the then fair market value of the collateral less estimated selling costs, which may, and often does, result in a loss.  An increase in the level of nonperforming assets also increases the Company's risk profile and may impact the capital levels regulators believe are appropriate in light of such risks.  The Company utilizes various techniques such as workouts, restructurings and loan sales to manage problem assets.  Increases in or negative adjustments in the value of these problem assets, the underlying collateral, or in the borrowers' performance or financial condition, could adversely affect the Company's business, results of operations and financial condition.  In addition, the resolution of nonperforming assets requires significant commitments of time from management and staff, which can be detrimental to the performance of their other responsibilities, including generation of new loans.  There can be no assurance that the Company will avoid increases in nonperforming loans in the future.
A downturn in the local real estate market could materially and negatively affect the Company's business.
The Company offers a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity lines of credit, consumer and other loans. Many of these loans are secured by real estate (both residential and commercial) located in the Company's market area. A downturn in the real estate market in the areas in which the Company conducts its operations could negatively affect the Company's business because significant portions of its loans are secured by real estate.  At December 31, 2015, the Company had approximately $1.0 billion in loans, of which approximately $822.0 million (81.8%) were secured by real estate.  The ability to recover on defaulted loans by selling the real estate collateral could then be diminished and the Company would be more likely to suffer losses.
Substantially all of the Company's real property collateral is located in its market area.  If there is a decline in real estate values, especially in the Company's market area, the collateral for loans would deteriorate and provide significantly less security.

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The Company relies upon independent appraisals to determine the value of the real estate which secures a significant portion of its loans, and the values indicated by such appraisals may not be realizable if the Company is forced to foreclose upon such loans.
A significant portion of the Company's loan portfolio consists of loans secured by real estate. The Company relies upon independent appraisers to estimate the value of such real estate.  Appraisals are only estimates of value and the independent appraisers may make mistakes of fact or judgment which adversely affect the reliability of their appraisals. In addition, events occurring after the initial appraisal may cause the value of the real estate to increase or decrease.  As a result of any of these factors, the real estate securing some of the Company's loans may be more or less valuable than anticipated at the time the loans were made.  If a default occurs on a loan secured by real estate that is less valuable than originally estimated, the Company may not be able to recover the outstanding balance of the loan and will suffer a loss.
The Company is dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect the Company's operations and prospects.
The Company currently depends on the services of a number of key management personnel.  The loss of key personnel could materially and adversely affect the results of operations and financial condition.  The Company's success also depends in part on the ability to attract and retain additional qualified management personnel.  Competition for such personnel is strong and the Company may not be successful in attracting or retaining the personnel it requires.
The inability of the Company to successfully manage its growth or implement its growth strategy may adversely affect the Company's results of operations and financial condition.
The Company may not be able to successfully implement its growth strategy if it is unable to identify attractive markets, locations or opportunities to expand in the future.  In addition, the ability to manage growth successfully depends on whether the Company can maintain adequate capital levels, cost controls and asset quality, and successfully integrate any businesses acquired into the Company.
As the Company continues to implement its growth strategy by opening new branches or acquiring branches or banks, it expects to incur increased personnel, occupancy and other operating expenses.  In the case of new branches, the Company must absorb those higher expenses while it begins to generate new deposits; there is also further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets.  The Company's plans to expand could depress earnings in the short run, even if it efficiently executes a branching strategy leading to long-term financial benefits.
Difficulties in combining the operations of acquired entities with the Company's own operations may prevent the Company from achieving the expected benefits from acquisitions.
The Company may not be able to achieve fully the strategic objectives and operating efficiencies expected in an acquisition.  Inherent uncertainties exist in integrating the operations of an acquired entity.  In addition, the markets and industries in which the Company and its potential acquisition targets operate are highly competitive.  The Company may lose customers or the customers of acquired entities as a result of an acquisition; the Company may lose key personnel, either from the acquired entity or from itself; and the Company may not be able to control the incremental increase in noninterest expense arising from an acquisition in a manner that improves its overall operating efficiencies.  These factors could contribute to the Company's not achieving the expected benefits from its acquisitions within desired time frames, if at all.  Future business acquisitions could be material to the Company and it may issue additional shares of common stock to pay for those acquisitions, which would dilute current shareholders' ownership interests.  Acquisitions also could require the Company to use substantial cash or other liquid assets or to incur debt; the Company could therefore become more susceptible to economic downturns and competitive pressures.
The Company is subject to extensive regulation which could adversely affect its business.
The Company's operations as a publicly traded corporation, a bank holding company, and an insured depository institution are subject to extensive regulation by federal, state, and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of the Company's operations.  Because the Company's business is highly regulated, the laws, rules, and regulations applicable to it are subject to frequent and sometimes extensive change. Such changes could include higher capital requirements, increased insurance premiums, increased compliance costs, reductions of non-interest income and limitations on services that can be provided.  Actions by regulatory agencies or significant litigation against the Company could cause it to devote significant time and resources to defend itself and may lead to liability or penalties that materially affect the Company and its shareholders. Any future changes in the laws, rules or regulations applicable to the Company may negatively affect the Company's business and results of operations.

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The Dodd-Frank Act substantially changes the regulation of the financial services industry and it could have a material adverse effect upon the Company.
The Dodd-Frank Act provides wide-ranging changes in the way banks and financial services firms generally are regulated and affects the way the Company and its customers and counterparties do business with each other.  Among other things, it requires increased capital and regulatory oversight for banks and their holding companies, changes the deposit insurance assessment system, changes responsibilities among regulators, establishes the new Consumer Financial Protection Bureau, and makes various changes in the securities laws and corporate governance that affect public companies, including the Company.  The Dodd-Frank Act also requires numerous studies and regulations related to its implementation.  The Company is continually evaluating the effects of the Dodd-Frank Act, together with implementing the regulations that have been proposed and adopted.  The ultimate effects of the Dodd-Frank Act and the resulting rulemaking cannot be predicted at this time, but it has increased the Company's operating and compliance costs in the short-term, and it could have a material adverse effect on the Company's results of operation and financial condition.
Recently enacted capital standards may have an adverse effect on the Company's profitability, lending, and ability to pay dividends on the Company's securities.
In July 2013, the FRB released its final rules which implement the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act. Under the final rules, minimum requirements for both the quality and quantity of capital held by banking organizations have increased. Consistent with the international Basel framework, the rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets that applies to all supervised financial institutions. The rule also, among other things, raised the minimum ratio of Tier 1 capital to risk-weighted assets from 4% to 6% and included a minimum leverage ratio of 4% for all banking organizations. The new rules became effective January 1, 2015. The potential impact of the new capital rules includes, but is not limited to, reduced lending and negative pressure on profitability and return on equity due to the higher capital requirements. To the extent the Company is required to increase capital in the future to comply with the new capital rules, its ability to pay dividends on its securities may be reduced.
New regulations issued by the Consumer Financial Protection Bureau could adversely the Company's earnings.
The CFPB has broad rule making authority to administer and carry out the provisions of the Dodd-Frank Act with respect to financial institutions that offer covered financial products and services to consumers. Pursuant to the Dodd-Frank Act, the CFPB issued a final rule effective January 10, 2014, requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms, or to originate "qualified mortgages" that meet specific requirements with respect to terms, pricing and fees. The new rule also contains new disclosure requirements at mortgage loan origination and in monthly statements. These requirements could limit the Company's ability to make certain types of loans or loans to certain borrowers, or could make it more expensive and/or time consuming to make these loans, which could adversely impact the Company's profitability.
Changes in accounting standards could impact reported earnings.
From time to time, with increasing frequency, there are changes in the financial accounting and reporting standards that govern the preparation of the Company's financial statements.  These changes can materially impact how the Company records and reports its financial condition and results of operations.  In some instances, the Company could be required to apply a new or revised standard retroactively, resulting in the restatement of prior period financial statements.
Failure to maintain effective systems of internal and disclosure control could have a material adverse effect on the Company's results of operation and financial condition.
Effective internal and disclosure controls are necessary for the Company to provide reliable financial reports and effectively prevent fraud and to operate successfully as a public company.  If the Company cannot provide reliable financial reports or prevent fraud, its reputation and operating results would be harmed.  As part of the Company's ongoing monitoring of internal control, it may discover material weaknesses or significant deficiencies in its internal control that require remediation.  A "material weakness" is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company's annual or interim financial statements will not be prevented or detected on a timely basis.
The Company has in the past discovered, and may in the future discover, areas of its internal controls that need improvement.  Even so, the Company is continuing to work to improve its internal controls.  The Company cannot be certain

17


that these measures will ensure that it implements and maintains adequate controls over its financial processes and reporting in the future.  Any failure to maintain effective controls or to timely effect any necessary improvement of the Company's internal and disclosure controls could, among other things, result in losses from fraud or error, harm the Company's reputation or cause investors to lose confidence in the Company's reported financial information, all of which could have a material adverse effect on the Company's results of operation and financial condition.
The carrying value of goodwill may be adversely impacted.
When the Company completes an acquisition, generally goodwill is recorded on the date of acquisition as an asset.  Current accounting guidance requires for goodwill to be tested for impairment, which the Company performs an impairment analysis at least annually, rather than amortizing it over a period of time.  A significant adverse change in expected future cash flows or sustained adverse change in the Company's common stock could require the asset to become impaired.  If impaired, the Company would incur a non-cash charge to earnings that would have a significant impact on the results of operations.  The carrying value of goodwill was approximately $43.9 million at December 31, 2015.
The Company may need to raise additional capital in the future to continue to grow, but may be unable to obtain additional capital on favorable terms or at all.
Federal and state banking regulators and safe and sound banking practices require the Company to maintain adequate levels of capital to support its operations.  Although the Company currently has no specific plans for additional offices, its business strategy calls for it to continue to grow in its existing banking markets (internally and through additional offices) and to expand into new markets as appropriate opportunities arise. Continued growth in the Company's earning assets, which may result from internal expansion and new branch offices, at rates in excess of the rate at which its capital is increased through retained earnings, will reduce the Company's capital ratios. If the Company's capital ratios fell below "well capitalized" levels, the FDIC deposit insurance assessment rate would increase until capital was restored and maintained at a "well capitalized" level. A higher assessment rate would cause an increase in the assessments the Company pays for federal deposit insurance, which would have an adverse effect on the Company's operating results.
Management of the Company believes that its current and projected capital position is sufficient to maintain capital ratios significantly in excess of regulatory requirements for the next several years and allow the Company flexibility in the timing of any possible future efforts to raise additional capital.   However, if, in the future, the Company needs to increase its capital to fund additional growth or satisfy regulatory requirements, its ability to raise that additional capital will depend on conditions at that time in the capital markets, economic conditions, the Company's financial performance and condition, and other factors, many of which are outside its control.  There is no assurance that the Company will be able to raise additional capital on terms favorable to it or at all.  Any future inability to raise additional capital on terms acceptable to the Company may have a material adverse effect on its ability to expand operations, and on its financial condition, results of operations and future prospects.
The Company relies on other companies to provide key components of the Company's business infrastructure.
Third parties provide key components of the Company's business operations such as data processing, recording and monitoring transactions, online banking interfaces and services, Internet connections and network access.  While the Company has selected these third party vendors carefully, it does not control their actions.  Any problem caused by these third parties, including those resulting from disruptions in communication services provided by a vendor, failure of a vendor to handle current or higher volumes, failures of a vendor to provide services for any reason or poor performance of services, could adversely affect the Company's ability to deliver products and services to its customers and otherwise conduct its business.  Financial or operational difficulties of a third party vendor could also hurt the Company's operations if those difficulties interface with the vendor's ability to serve the Company.  Replacing these third party vendors could also create significant delay and expense.  Accordingly, use of such third parties creates an unavoidable inherent risk to the Company's business operations.
The Company's exposure to operational, technological and organizational risk may adversely affect the Company.
The Company is exposed to many types of operational risks, including reputation, legal, and compliance risk, the risk of fraud or theft by employees or outsiders, unauthorized transactions by employees or operational errors, clerical or record-keeping errors, and errors resulting from faulty or disabled computer or telecommunications systems.
Negative public opinion can result from the actual or alleged conduct in any number of activities, including lending practices, corporate governance, and acquisitions, and from actions taken by government regulators and community organizations in response to those activities.  Negative public opinion can adversely affect the Company's ability to attract and retain customers and can expose it to litigation and regulatory action.

18


Certain errors may be repeated or compounded before they are discovered and successfully rectified. The Company's necessary dependence upon automated systems to record and process its transactions may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect.  The Company may also be subject to disruptions of its operating systems arising from events that are wholly or partially beyond its control (for example, computer viruses or electrical or telecommunications outages), which may give rise to disruption of service to customers and to financial loss or liability. The Company is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as is the Company) and to the risk that the Company's (or its vendors') business continuity and data security systems prove to be inadequate.
The Company's operations may be adversely affected by cyber security risks.
The Company relies heavily on communications and information systems to conduct business.  Any failure, interruption, or breach in security of these systems could result in failures or disruptions in the Company's internet banking, deposit, loan, and other systems.  While the Company has policies and procedures designed to prevent or limit the effect of such failure, interruption, or security breach of the Company's information systems, there can be no assurance that they will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failure, interruption or security breach of the Company's communications and information systems could damage the Company's reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the Company to civil litigation and possible financial liability.  Additionally, the Company outsources its data processing to a third party. If the Company's third party provider encounters difficulties or if the Company has difficulty in communicating with such third party, it will significantly affect the Company's ability to adequately process and account for customer transactions, which would significantly affect its business operations.
In the ordinary course of business, the Company collects and stores sensitive data, including proprietary business information and personally identifiable information of its customers and employees in systems and on networks. The secure processing, maintenance and use of this information is critical to operations and the Company's business strategy. The Company has invested in accepted technologies, and annually reviews processes and practices that are designed to protect its networks, computers and data from damage or unauthorized access. Despite these security measures, the Company's computer systems and infrastructure may be vulnerable to attacks by hackers or breached due to employee error, malfeasance or other disruptions. A breach of any kind could compromise systems and the information stored there could be accessed, damaged or disclosed. A breach in security could result in legal claims, regulatory penalties, disruption in operations, and damage to the Company's reputation, which could adversely affect the Company's business.  Furthermore, as cyber threats continue to evolve and increase, the Company may be required to expend significant additional resources to modify or enhance its protective measures, or to investigate and remediate any identified information security vulnerabilities.
Multiple major U.S. retailers, financial institutions, government agencies and departments have recently experienced data systems incursions reportedly resulting in the thefts of credit and debit card information, online account information, and other financial data of tens of millions of individuals and customers. Retailer incursions affect cards issued and deposit accounts maintained by many financial institutions, including the Bank. Although neither the Company's nor the Bank's systems are breached in government or retailer incursions, these events can cause the Bank to reissue a significant number of cards and take other costly steps to avoid significant theft loss to the Bank and its customers.  In some cases, the Bank may be required to reimburse customers for the losses they incur. Other possible points of intrusion or disruption not within the Company's nor the Bank's control include internet service providers, electronic mail portal providers, social media portals, distant-server ("cloud") service providers, electronic data security providers, telecommunications companies, and smart phone manufacturers.
The Company’s risk-management framework may not be effective in mitigating risk and loss.
The Company maintains an enterprise risk management program that is designed to identify, quantify, monitor, report, and control the risks that it faces. These risks include, but are not limited to: interest-rate, credit, liquidity, operations, reputation, compliance and litigation. While the Company assesses and improves this program on an ongoing basis, there can be no assurance that its approach and framework for risk management and related controls will effectively mitigate all risk and limit losses in its business. If conditions or circumstances arise that expose flaws or gaps in the Company’s risk-management program, or if its controls break down, the Company’s results of operations and financial condition may be adversely affected.


19


Current and proposed regulation addressing consumer privacy and data use and security could increase the Company's costs and impact its reputation.
The Company is subject to a number of laws concerning consumer privacy and data use and security, including information safeguard rules under the Gramm-Leach-Bliley Act. These rules require that financial institutions develop, implement and maintain a written, comprehensive information security program containing safeguards that are appropriate to the financial institution's size and complexity, the nature and scope of the financial institution's activities, and the sensitivity of any customer information at issue. The United States has experienced a heightened legislative and regulatory focus on privacy and data security, including requiring consumer notification in the event of a data breach. In addition, most states have enacted security breach legislation requiring varying levels of consumer notification in the event of certain types of security breaches.  New regulations in these areas may increase our compliance costs, which could negatively impact our earnings. In addition, failure to comply with the privacy and data use and security laws and regulations to which we are subject, including by reason of inadvertent disclosure of confidential information, could result in fines, sanctions, penalties or other adverse consequences and loss of consumer confidence, which could materially adversely affect our results of operations, overall business, and reputation.
Consumers may increasingly decide not to use the Bank to complete their financial transactions because of technological and other changes, which would have a material adverse impact on the Company's financial condition and operations.
Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as "disintermediation," could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on the Company's financial condition and results of operations.
Negative perception of the Company through social media may adversely affect the Company’s reputation and business.
The Company’s reputation is critical to the success of its business. The Company believes that its brand image has been well received by customers, reflecting the fact that the brand image, like the Company’s business, is based in part on trust and confidence. The Company’s reputation and brand image could be negatively affected by rapid and widespread distribution of publicity through social media channels. The Company’s reputation could also be affected by the Company’s association with clients affected negatively through social media distribution, or other third parties, or by circumstances outside of the Company’s control. Negative publicity, whether true or untrue, could affect the Company’s ability to attract or retain customers, or cause the Company to incur additional liabilities or costs, or result in additional regulatory scrutiny.
The Company is subject to claims and litigation pertaining to fiduciary responsibility.
From time to time, customers make claims and take legal action pertaining to the performance of the Company's fiduciary responsibilities. Whether customer claims and legal action related to the performance of the Company's fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Company, they may result in significant financial liability and/or adversely affect the market perception of the Company and its products and services, as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Company's business, which, in turn, could have a material adverse effect on the Company's financial condition and results of operations.
Risks Related to the Company's Common Stock
While the Company's common stock is currently traded on the NASDAQ Global Select Market, it has less liquidity than stocks for larger companies quoted on a national securities exchange.
The trading volume in the Company's common stock on the NASDAQ Global Select Market has been relatively low when compared with larger companies listed on the NASDAQ Global Select Market or other stock exchanges.  There is no assurance that a more active and liquid trading market for the common stock will exist in the future.  Consequently, shareholders may not be able to sell a substantial number of shares for the same price at which shareholders could sell a smaller number of shares.  In addition, we cannot predict the effect, if any, that future sales of the Company's common stock in the market, or the availability of shares of common stock for sale in the market, will have on the market price of the common stock.

20


Economic and other conditions may cause volatility in the price of the Company’s common stock.
In the current economic environment, the prices of publicly traded stocks in the financial services sector have been volatile. However, even in a more stable economic environment the price of the Company’s common stock can be affected by a variety of factors such as expected or actual results of operations, changes in analysts’ recommendations or projections, announcements of developments related to its businesses, operating and stock performance of other companies deemed to be peers, news or expectations based on the performance of others in the financial services industry, and expected impacts of a changing regulatory environment. These factors not only impact the price of the Company’s common stock but could also affect the liquidity of the stock given the Company’s size, geographical footprint, and industry. The price for shares of the Company’s common stock may fluctuate significantly in the future, and these fluctuations may be unrelated to the Company’s performance. General market price declines or market volatility in the future could adversely affect the price for shares of the Company’s common stock, and the current market price of such shares may not be indicative of future market prices.
Future issuances of the Company's common stock could adversely affect the market price of the common stock and could be dilutive.
The Company is not restricted from issuing additional shares of common stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, shares of common stock.  Issuances of a substantial number of shares of common stock, or the expectation that such issuances might occur, including in connection with acquisitions by the Company, could materially adversely affect the market price of the shares of the common stock and could be dilutive to shareholders.  Because the Company's decision to issue common stock in the future will depend on market conditions and other factors, it cannot predict or estimate the amount, timing or nature of possible future issuances of its common stock.  Accordingly, the Company's shareholders bear the risk that future issuances will reduce the market price of the common stock and dilute their stock holdings in the Company.
The primary source of the Company's income from which it pays cash dividends is the receipt of dividends from its subsidiary bank.
The availability of dividends from the Company is limited by various statutes and regulations.  It is possible, depending upon the financial condition of the Bank and other factors, that the OCC could assert that payment of dividends or other payments is an unsafe or unsound practice.  In the event the Bank was unable to pay dividends to the Company, or be limited in the payment of such dividends, the Company would likely have to reduce or stop paying common stock dividends.  The Company's reduction, limitation or failure to pay such dividends on its common stock could have a material adverse effect on the market price of the common stock.
The Company's governing documents and Virginia law contain anti-takeover provisions that could negatively impact its shareholders.
The Company's Articles of Incorporation and Bylaws and the Virginia Stock Corporation Act contain certain provisions designed to enhance the ability of the Company's Board of Directors to deal with attempts to acquire control of the Company.  These provisions and the ability to set the voting rights, preferences and other terms of any series of preferred stock that may be issued, may be deemed to have an anti-takeover effect and may discourage takeovers (which certain shareholders may deem to be in their best interest).  To the extent that such takeover attempts are discouraged, temporary fluctuations in the market price of the Company's common stock resulting from actual or rumored takeover attempts may be inhibited.  These provisions also could discourage or make more difficult a merger, tender offer, or proxy contest, even though such transactions may be favorable to the interests of shareholders, and could potentially adversely affect the market price of the Company's common stock.
ITEM 2 – PROPERTIES
As of December 31, 2015, the Company maintained twenty-five banking offices.  The Company's Virginia banking offices are located in the cities of Danville, Martinsville and Lynchburg, and in the counties of Bedford, Campbell, Franklin, Halifax, Henry, Nelson and Pittsylvania.  In North Carolina, the Company's banking offices are located in the cities of Burlington, Greensboro, Mebane and Graham and in the counties of Alamance, Caswell, and Guilford.  The Company also operates two loan production offices.
The principal executive offices of the Company are located at 628 Main Street in the business district of Danville, Virginia.  This building, owned by the Company, was originally constructed in 1973 and has three floors totaling approximately 27,000 square feet.

21


The Company owns a building located at 103 Tower Drive in Danville, Virginia.  This three-story facility serves as an operations center for data processing and deposit operations.
The Company has an office at 445 Mount Cross Road in Danville, Virginia where it consolidated two banking offices in January 2009 and gained additional administrative space.
The Company has an office at 3101 South Church Street in Burlington, North Carolina.  This building serves as the head office for our North Carolina operations.
The Company owns fourteen other offices for a total of eighteen owned buildings.  There are no mortgages or liens against any of the properties owned by the Company.  The Company operates thirty-three ATMs on owned or leased facilities.  The Company leases seven office locations and two storage warehouses.  The Company occupies space rent-free for its limited service office in the Village of Brookwood Retirement Center under an agreement with the owners of that facility.
ITEM 3 – LEGAL PROCEEDINGS
In the ordinary course of operations, the Company and the Bank are parties to various legal proceedings. Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on the business, financial condition, or results of operations of the Company.
ITEM 4 – MINE SAFETY DISCLOSURES
None.

22


PART II
ITEM 5 – MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company's common stock is traded on the NASDAQ Global Select Market under the symbol "AMNB." At December 31, 2015, the Company had 3,235 shareholders of record. The following table presents the high and low sales prices for the Company's common stock and dividends declared for the past two years.
 
 
Sales Price
 
Dividends
Declared
2015
 
High
 
Low
 
Per Share
 
 
 
 
 
 
 
1st quarter
 
$
24.72

 
$
21.31

 
$
0.23

2nd quarter
 
24.31

 
21.68

 
0.23

3rd quarter
 
24.28

 
21.88

 
0.23

4th quarter
 
26.42

 
23.02

 
0.24

 
 
 

 
 

 
$
0.93

 
 
 
 
 
 
 
 
 
Sales Price
 
Dividends
Declared
2014
 
High
 
Low
 
Per Share
 
 
 
 
 
 
 
1st quarter
 
$
26.08

 
$
21.54

 
$
0.23

2nd quarter
 
24.06

 
20.65

 
0.23

3rd quarter
 
23.53

 
20.90

 
0.23

4th quarter
 
25.00

 
21.69

 
0.23

 
 
 

 
 

 
$
0.92

Stock Compensation Plans
The Company maintains the 2008 Stock Incentive Plan ("2008 Plan"), which is designed to attract and retain qualified personnel in key positions, provide employees with an equity interest in the Company as an incentive to contribute to the success of the Company, and reward employees for outstanding performance and the attainment of targeted goals. The 2008 Plan and stock compensation in general is discussed in Note 13 of the Consolidated Financial Statements contained in Item 8 of this Form 10-K.
The following table summarizes information, as of December 31, 2015, relating to the Company's equity based compensation plans, pursuant to which grants of options to acquire shares of common stock have been and may be granted from time to time.
 
December 31, 2015
 
Number of Shares to be Issued Upon Exercise of Outstanding Options
 
Weighted-Average Per Share Exercise Price of Outstanding Options
 
Number of Shares Remaining Available for Future Issuance Under Stock Compensation Plans
Equity compensation plans approved by shareholders
67,871

 
$
24.47

 
131,096

Equity compensation plans not approved by shareholders

 

 

Total
67,871

 
$
24.47

 
131,096


Stock Repurchase Program
In years prior to 2014 the Company had, in the normal course of business, operated certain stock repurchase programs. Authority to repurchase shares under these programs had been expired for some time.

23


On April 17, 2014, the Company filed a Form 8-K with the SEC to announce the approval by its Board of Directors of a stock repurchase program. The plan authorized the repurchase of up to 250,000 shares of the Company's common shares over a two year period. The share purchase limit was equal to approximately 3% of the 7,900,000 shares then outstanding at the time the Board approved the program.
During 2015, the Company repurchased 150,656 shares at an average cost of $23.27 per share, for a total cost of $3,506,000. In 2014, the Company repurchased 70,184 shares at an average cost of $21.45 per share, for a total cost of $1,508,000.
On November 19, 2015, the Company filed a Form 8-K with the SEC to announce the approval by its Board of Directors of another stock repurchase program. The plan authorizes the repurchase of up to 300,000 shares of the Company's common shares over a two year period. The share purchase limit was equal to approximately 3.5% of the 8,622,000 shares then outstanding at the time the Board approved the program.
Comparative Stock Performance
The following graph compares the Company's cumulative total return to its shareholders with the returns of two indexes for the five-year period ended December 31, 2015.  The cumulative total return was calculated taking into consideration changes in stock price, cash dividends, stock dividends, and stock splits since December 31, 2010.  The indexes are the NASDAQ Composite Index; the SNL Bank $1 Billion - $5 Billion Index, which includes bank holding companies with assets of $1 billion to $5 billion and is published by SNL Financial, LC.
American National Bankshares Inc.

24


 
Period Ending
Index
12/31/10

 
12/31/11

 
12/31/12

 
12/31/13

 
12/31/14

 
12/31/15

American National Bankshares Inc.
$
100.00

 
$
86.84

 
$
93.91

 
$
127.22

 
$
125.23

 
$
134.47

NASDAQ Composite
100.00

 
99.21

 
116.82

 
163.75

 
188.03

 
201.40

SNL Bank $1B-$5B
100.00

 
91.20

 
112.45

 
163.52

 
170.98

 
191.39


25


ITEM 6 - SELECTED FINANCIAL DATA
The following table sets forth selected financial data for the Company for the last five years:
(Amounts in thousands, except per share information and ratios)
 
December 31,
 
2015
 
2014
 
2013
 
2012
 
2011
Results of Operations:
 
 
 
 
 
 
 
 
 
Interest income
$
55,169

 
$
47,455

 
$
52,956

 
$
57,806

 
$
49,187

Interest expense
5,904

 
5,730

 
6,583

 
8,141

 
8,780

Net interest income
49,265

 
41,725

 
46,373

 
49,665

 
40,407

Provision for loan losses
950

 
400

 
294

 
2,133

 
3,170

Noninterest income
13,287

 
11,176

 
10,827

 
11,410

 
9,244

Noninterest expense
40,543

 
34,558

 
35,105

 
36,643

 
30,000

Income before income tax provision
21,059

 
17,943

 
21,801

 
22,299

 
16,481

Income tax provision
6,020

 
5,202

 
6,054

 
6,293

 
4,910

Net income
$
15,039

 
$
12,741

 
$
15,747

 
$
16,006

 
$
11,571

 
 
 
 
 
 
 
 
 
 
Financial Condition:
 

 
 

 
 

 
 

 
 

Assets
$
1,547,599

 
$
1,346,492

 
$
1,307,512

 
$
1,283,687

 
$
1,304,706

Loans, net of unearned income
1,005,525

 
840,925

 
794,671

 
788,705

 
824,758

Securities
345,661

 
349,250

 
351,013

 
340,533

 
339,385

Deposits
1,262,660

 
1,075,837

 
1,057,675

 
1,027,667

 
1,058,754

Shareholders' equity
197,835

 
173,780

 
167,551

 
163,246

 
152,829

Shareholders' equity, tangible
151,280

 
132,692

 
125,349

 
119,543

 
107,335

 
 
 
 
 
 
 
 
 
 
Per Share Information:
 

 
 

 
 

 
 

 
 

Earnings per share, basic
$
1.73

 
$
1.62

 
$
2.00

 
$
2.04

 
$
1.64

Earnings per share, diluted
1.73

 
1.62

 
2.00

 
2.04

 
1.64

Cash dividends paid
0.93

 
0.92

 
0.92

 
0.92

 
0.92

Book value
22.95

 
22.07

 
21.23

 
20.80

 
19.58

Book value, tangible
17.55

 
16.86

 
15.89

 
15.23

 
13.75

 
 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding, basic
8,680,502

 
7,867,198

 
7,872,870

 
7,834,351

 
6,982,524

Weighted average common shares outstanding, diluted
8,688,450

 
7,877,576

 
7,884,561

 
7,845,652

 
6,989,877

 
 
 
 
 
 
 
 
 
 
Selected Ratios:
 

 
 

 
 

 
 

 
 

Return on average assets
0.99
%
 
0.97
%
 
1.20
 %
 
1.23
%
 
1.07
%
Return on average equity (1)
7.65
%
 
7.40
%
 
9.52
 %
 
10.08
%
 
8.88
%
Return on average tangible equity (2)
10.62
%
 
10.31
%
 
13.75
 %
 
15.25
%
 
12.97
%
Dividend payout ratio
53.60
%
 
56.80
%
 
46.03
 %
 
45.06
%
 
55.50
%
Efficiency ratio (3)
63.81
%
 
63.41
%
 
57.57
 %
 
58.23
%
 
58.48
%
Net interest margin
3.69
%
 
3.66
%
 
4.10
 %
 
4.44
%
 
4.35
%
 
 
 
 
 
 
 
 
 
 
Asset Quality Ratios:
 

 
 

 
 

 
 

 
 

Allowance for loan losses to period end loans
1.25
%
 
1.48
%
 
1.59
 %
 
1.54
%
 
1.28
%
Allowance for loan losses to period end non-performing loans
242.09
%
 
302.21
%
 
248.47
 %
 
227.95
%
 
76.76
%
Non-performing assets to total assets
0.48
%
 
0.46
%
 
0.65
 %
 
0.90
%
 
1.46
%
Net charge-offs to average loans
0.08
%
 
0.07
%
 
(0.02
)%
 
0.07
%
 
0.16
%
 
 
 
 
 
 
 
 
 
 
Capital Ratios:
 

 
 

 
 

 
 

 
 

Total risk-based capital ratio
16.34
%
 
17.86
%
 
18.14
 %
 
17.00
%
 
15.55
%
Common equity tier 1 capital ratio
12.88
%
 
n/a

 
n/a

 
n/a

 
n/a

Tier 1 capital ratio
15.23
%
 
16.59
%
 
16.88
 %
 
15.75
%
 
14.36
%
Tier 1 leverage ratio
12.05
%
 
12.16
%
 
11.81
 %
 
11.27
%
 
10.32
%
Tangible equity to tangible assets ratio (4)
10.08
%
 
10.00
%
 
9.91
 %
 
9.64
%
 
8.52
%


26


(1)
Return on average common equity is calculated by dividing net income available to common shareholders by average common equity.
(2)
Return on average tangible common equity is calculated by dividing net income available to common shareholders plus amortization of intangibles tax effected by average common equity less average intangibles.
(3)
The efficiency ratio is calculated by dividing noninterest expense excluding gains or losses on the sale of other real estate owned by net interest income including tax equivalent income on nontaxable loans and securities and excluding (a) gains or losses on securities and (b) gains or losses on sale of premises and equipment.
(4)
Tangible equity to tangible assets ratio is calculated by dividing period-end common equity less period-end intangibles by period-end assets less period-end intangibles.
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The purpose of this discussion is to focus on significant changes in the financial condition and results of operations of the Company during the past three years.  The discussion and analysis are intended to supplement and highlight information contained in the accompanying Consolidated Financial Statements and the selected financial data presented elsewhere in this Annual Report on Form 10-K.
RECLASSIFICATION
In certain circumstances, reclassifications have been made to prior period information to conform to the 2015 presentation.  There were no material reclassifications.
CRITICAL ACCOUNTING POLICIES
The accounting and reporting policies followed by the Company conform with GAAP and they conform to general practices within the banking industry.  The Company's critical accounting policies, which are summarized below, relate to (1) the allowance for loan losses, (2) mergers and acquisitions, (3) acquired loans with specific credit-related deterioration and (4) goodwill impairment.  A summary of the Company's significant accounting policies is set forth in Note 1 to the Consolidated Financial Statements.
The financial information contained within the Company's financial statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred.  A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset, or relieving a liability.  In addition, GAAP itself may change from one previously acceptable method to another method.
Allowance for Loan Losses
The purpose of the allowance for loan losses ("ALLL") is to provide for probable losses inherent in the loan portfolio.  The allowance is increased by the provision for loan losses and by recoveries of previously charged-off loans.  Loan charge-offs decrease the allowance.
The goal of the Company is to maintain an appropriate, systematic, and consistently applied process to determine the amounts of the ALLL and the provision for loan loss expense.
The Company uses certain practices to manage its credit risk.  These practices include (1) appropriate lending limits for loan officers, (2) a loan approval process, (3) careful underwriting of loan requests, including analysis of borrowers, cash flows, collateral, and market risks, (4) regular monitoring of the portfolio, including diversification by type and geography, (5) review of loans by the Loan Review department, which operates independently of loan production (the Loan Review function consists of a co-sourced arrangement using both internal personnel and external vendors to provide the Company with a more robust review function of the loan portfolio ), (6) regular meetings of the Credit Committee to discuss portfolio and policy changes and make decisions on large or unusual loan requests, and (7) regular meetings of the Asset Quality Committee which reviews the status of individual loans.
Risk grades are assigned as part of the loan origination process. From time to time, risk grades may be modified as warranted by the facts and circumstances surrounding the credit.
Calculation and analysis of the ALLL is prepared quarterly by the Finance Department.  The Company's Credit Committee, Capital Management Committee, Audit Committee, and the Board of Directors review the allowance for adequacy.

27


The Company's ALLL has two basic components:  the formula allowance and the specific allowance.  Each of these components is determined based upon estimates and judgments.
The formula allowance uses historical loss experience as an indicator of future losses, along with various qualitative factors, including levels and trends in delinquencies, nonaccrual loans, charge-offs and recoveries, trends in volume and terms of loans, effects of changes in underwriting standards, experience of lending staff, economic conditions, and portfolio concentrations, regulatory, legal, competition, quality of loan review system, and value of underlying collateral. In the formula allowance for commercial and commercial real estate loans, the historical loss rate is combined with the qualitative factors, resulting in an adjusted loss factor for each risk-grade category of loans.  The period-end balances for each loan risk-grade category are multiplied by the adjusted loss factor.  Allowance calculations for residential real estate and consumer loans are calculated based on historical losses for each product category without regard to risk grade. This loss rate is combined with qualitative factors resulting in an adjusted loss factor for each product category.
The specific allowance uses various techniques to arrive at an estimate of loss for specifically identified impaired loans. These include:
The present value of expected future cash flows discounted at the loan's effective interest rate.  The effective interest rate on a loan is the rate of return implicit in the loan (that is, the contractual interest rate adjusted for any net deferred loan fees or costs and any premium or discount existing at the origination or acquisition of the loan);
The loan's observable market price, or
The fair value of the collateral, net of estimated costs to dispose, if the loan is collateral dependent.
 
The use of these computed values is inherently subjective and actual losses could be greater or less than the estimates.

No single statistic, formula, or measurement determines the adequacy of the allowance.  Management makes subjective and complex judgments about matters that are inherently uncertain, and different amounts would be reported under different conditions or using different assumptions.  For analytical purposes, management allocates a portion of the allowance to specific loan categories and specific loans.  However, the entire allowance is used to absorb credit losses inherent in the loan portfolio, including identified and unidentified losses.
The relationships and ratios used in calculating the allowance, including the qualitative factors, may change from period to period as facts and circumstances evolve.  Furthermore, management cannot provide assurance that in any particular period the Bank will not have sizeable credit losses in relation to the amount reserved.  Management may find it necessary to significantly adjust the allowance, considering current factors at the time.
Mergers and Acquisitions
Business combinations are accounted for under the Financial Accounting Standards Board (the "FASB") Accounting Standards Codification ("ASC") 805, Business Combinations, using the acquisition method of accounting. The acquisition method of accounting requires an acquirer to recognize the assets acquired and the liabilities assumed at the acquisition date measured at their fair values as of that date. To determine the fair values, the Company will rely on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques. Under the acquisition method of accounting, the Company will identify the acquirer and the closing date and apply applicable recognition principles and conditions.
Acquisition-related costs are costs the Company incurs to effect a business combination. Those costs include advisory, legal, accounting, valuation, and other professional or consulting fees. Some other examples of costs to the Company include systems conversions, integration planning, consultants, and advertising costs. The Company will account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities will be recognized in accordance with other applicable GAAP. These acquisition-related costs have been and will be included within the Consolidated Statements of Income classified within the noninterest expense caption.
Acquired Loans with Specific Credit-Related Deterioration
Acquired loans with specific credit deterioration are accounted for by the Company in accordance with FASB ASC 310-30, Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality. Certain acquired loans, those for which specific credit-related deterioration, since origination, is identified, are recorded at fair value reflecting the present value of the amounts expected to be collected. Income recognition on these loans is based on a reasonable expectation about the timing and amount of cash flows to be collected. Acquired loans deemed impaired and considered collateral dependent, with the timing of the sale of loan collateral indeterminate, remain on non-accrual status and have no accretable yield.

28


Goodwill Impairment
The Company performs its annual analysis as of June 30 each fiscal year. Accounting guidance permits preliminary assessment of qualitative factors to determine whether more substantial impairment testing is required. The Company chose to bypass the preliminary assessment and utilized a two-step process for impairment testing of goodwill. The first step tests for impairment, while the second step, if necessary, measures the impairment.  No indicators of impairment were identified during the years ended December 31, 2015, 2014, and 2013.
NON-GAAP PRESENTATIONS
Non-GAAP presentations are provided because the Company believes these may be valuable to investors. These include (1) the analysis of net interest income presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets and (2) the impact to net interest income and pretax income from accretable and amortizable fair value adjustments attributable to the merger with MidCarolina in July 2011 and MainStreet in January 2015.
INTERNET ACCESS TO CORPORATE DOCUMENTS
The Company provides access to its SEC filings through a link on the Investor Relations page of the Company's website at www.amnb.com. Reports available include annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after the reports are filed electronically with the SEC. The information on the Company's website is not incorporated into this report or any other filing the Company makes with the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

ACQUISITION OF MAINSTREET BANKSHARES, INC.
On January 1, 2015, the Company completed its acquisition of MainStreet. The merger of MainStreet with and into the Company was effected pursuant to the terms and conditions of the Agreement and Plan of Reorganization, dated as of August 24, 2014, between the Company and MainStreet.  Immediately after the merger of MainStreet into the Company, Franklin Bank, MainStreet's wholly-owned bank subsidiary, merged with and into the Bank.
Pursuant to the MainStreet merger agreement, the former holders of shares of MainStreet common stock received $3.46 in cash and 0.482 shares of the Company's common stock for each share of MainStreet common stock held immediately prior to the effective date of the merger, plus cash in lieu of fractional shares. Each option to purchase shares of MainStreet common stock that was outstanding immediately prior to the effective date of the merger vested upon the merger and was converted into an option to purchase shares of the Company's common stock, adjusted based on a 0.643 exchange ratio. Each share of the Company's common stock outstanding immediately prior to the merger remained outstanding and was unaffected by the merger. The cash portion of the merger consideration was funded through a cash dividend of $6,000,000 from the Bank to the Company, and no borrowing was incurred by the Company or the Bank in connection with the merger.
MainStreet was the holding company for Franklin Bank.  Immediately prior to the Company's acquisition of MainStreet on January 1, 2015, MainStreet had net loans of approximately $122,000,000, total assets of approximately $164,000,000, and total deposits of approximately $137,000,000. Franklin Community Bank, N.A. provided banking services to its customers from three banking offices located in Rocky Mount, Hardy, and Union Hall, Virginia, which are now branch offices of the Bank.
RESULTS OF OPERATIONS
Net Income
Net income for 2015 was $15,039,000 compared to $12,741,000 for 2014, an increase of $2,298,000 or 18.0%. Basic and diluted earnings per share were $1.73 for 2015 compared to $1.62 for 2014. This net income produced for 2015 a return on average assets of 0.99%, a return on average equity of 7.65%, and a return on average tangible equity of 10.62%.
Net income for 2014 was $12,741,000 compared to $15,747,000 for 2013, a decrease of $3,006,000 or 19.1%. Basic and diluted earnings per share were $1.62 for 2014 compared to $2.00 for 2013. This net income produced for 2014 a return on average assets of 0.97%, a return on average equity of 7.40%, and a return on average tangible equity of 10.31%.
Earnings for 2015, 2014, and 2013 were favorably impacted by the 2011 acquisition of MidCarolina and the 2015 acquisition of MainStreet. The financial impact of the mergers was mostly manifested in a significant increase in earning assets.

29


Net Interest Income
Net interest income is the difference between interest income on earning assets, primarily loans and securities, and interest expense on interest bearing liabilities, primarily deposits.  Fluctuations in interest rates as well as volume and mix changes in earning assets and interest bearing liabilities can materially impact net interest income.  The 2011 acquisition of MidCarolina impacted net interest income positively for 2015 and 2014, through increased earning assets. The 2015 acquisition of MainStreet impacted net interest income positively for 2015, through increased earning assets
The following discussion of net interest income is presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets, such as certain state and municipal securities.  A tax rate of 35% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent basis.  Net interest income divided by average earning assets is referred to as the net interest margin. The net interest spread represents the difference between the average rate earned on earning assets and the average rate paid on interest bearing liabilities.  All references in this section relate to average yields and rates and average asset and liability balances during the periods discussed.
Net interest income on a taxable equivalent basis increased $7,466,000 or 17.0% in 2015 from 2014, following a $4,819,000 or 9.9% decrease in 2014 from 2013.  The increase in net interest income in 2015 was primarily due to increased volumes of earning assets and accretion income related to the MainStreet acquired loan portfolio, and accounted for $6,430,000 or 86% of the total increase.
Yields on loans were 4.81% in 2015 compared to 4.88% in 2014.   Cost of funds was 0.58% in 2015 compared to 0.64% in 2014. Between 2015 and 2014, deposit rates for demand, money market, and savings accounts remained basically stable while time deposit rates decreased to 1.09% from 1.17%.  Management regularly reviews deposit pricing and attempts to keep costs as low as possible, while remaining competitive. The net interest margin was 3.69% for 2015, 3.66% for 2014, and 4.10% for 2013.
During 2008, the Federal Open Market Committee ("FOMC") of the FRB reduced the federal funds rate seven times from 4.25% to 0.25%, where it has remained, unchanged, through mid December 2015. On December 17, 2015, the FOMC raised the target federal funds rate from 0.25% to 0.50%. The increase in rates is expected to have a nominal positive impact on net interest income. Given recent economic and geopolitical events in early 2016, it is uncertain if there will be further rate increases in the near term.
Net interest income on a taxable equivalent basis decreased $4,819,000 or 9.9% in 2014 from 2013, following a $3,357,000 or 6.5% decrease in 2013 from 2012.  The decrease in net interest income in 2014 was primarily due to lower accretion income related to the MidCarolina acquired loan portfolio, which accounted for $4,721,000 or 97.9% of the decrease. Excluding the change in accretion income, declines in yields on earnings assets were almost offset by decreased cost of interest bearing liabilities.
Yields on loans were 4.88% in 2014 compared to 5.65% in 2013.   Cost of funds was 0.64% in 2014 compared to 0.72% in 2013. Between 2014 and 2013, deposit rates for demand accounts decreased to 0.04% from 0.07%, money market accounts decreased to 0.13% from 0.19%, and time deposits decreased to 1.17% from 1.22%.  Management regularly reviews deposit pricing and attempts to keep costs as low as possible, while remaining competitive. The net interest margin was 3.66% for 2014, 4.10% for 2013, and 4.44% for 2012.
The following presentation is an analysis of net interest income and related yields and rates, on a taxable equivalent basis, for the last three years.  Nonaccrual loans are included in average balances.  Interest income on nonaccrual loans, if recognized, is recorded on a cash basis or when the loan returns to accrual status.

30


Net Interest Income Analysis
(in thousands, except yields and rates)
 
Average Balance
 
Interest Income/Expense
 
Average Yield/Rate
 
2015
 
2014
 
2013
 
2015
 
2014
 
2013
 
2015
 
2014
 
2013
Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
156,646

 
$
122,434

 
$
125,283

 
$
6,893

 
$
5,436

 
$
6,082

 
4.40
%
 
4.44
%
 
4.85
%
Real estate
809,545

 
677,633

 
663,224

 
39,362

 
33,508

 
38,425

 
4.86

 
4.94

 
5.79

Consumer
9,669

 
4,792

 
5,847

 
730

 
354

 
403

 
7.55

 
7.39

 
6.89

Total loans
975,860

 
804,859

 
794,354

 
46,985

 
39,298

 
44,910

 
4.81

 
4.88

 
5.65

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Securities:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Federal agencies and GSEs
88,384

 
74,390

 
55,435

 
1,364

 
852

 
532

 
1.54

 
1.15

 
0.96

Mortgage-backed and CMOs
61,741

 
61,377

 
74,909

 
1,346

 
1,453

 
1,442

 
2.18

 
2.37

 
1.93

State and municipal
183,208

 
187,595

 
193,254

 
6,746

 
7,307

 
7,750

 
3.68

 
3.90

 
4.01

Other
15,783

 
15,106

 
15,007

 
532

 
477

 
430

 
3.37

 
3.16

 
2.87

Total securities
349,116

 
338,468

 
338,605

 
9,988

 
10,089

 
10,154

 
2.86

 
2.98

 
3.00

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Federal funds sold
5,230

 

 

 
6

 

 

 
0.11

 

 

Deposits in other banks
61,280

 
52,768

 
53,857

 
204

 
156

 
151

 
0.33

 
0.30

 
0.28

Total interest earning assets
1,391,486

 
1,196,095

 
1,186,816

 
57,183

 
49,543

 
55,215

 
4.11

 
4.14

 
4.65

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nonearning assets
132,280

 
116,377

 
120,338

 
 

 
 

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total assets
$
1,523,766

 
$
1,312,472

 
$
1,307,154

 
 

 
 

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deposits:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Demand
$
223,825

 
$
183,994

 
$
161,602

 
82

 
71

 
111

 
0.04

 
0.04

 
0.07

Money market
196,828

 
177,046

 
178,235

 
260

 
232

 
338

 
0.13

 
0.13

 
0.19

Savings
109,697

 
88,629

 
84,162

 
53

 
47

 
71

 
0.05

 
0.05

 
0.08

Time
404,366

 
368,712

 
405,213

 
4,416

 
4,304

 
4,940

 
1.09

 
1.17

 
1.22

Total deposits
934,716

 
818,381

 
829,212

 
4,811

 
4,654

 
5,460

 
0.51

 
0.57

 
0.66

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Customer repurchase agreements
48,105

 
43,724

 
47,816

 
9

 
7

 
40

 
0.02

 
0.02

 
0.08

Other short-term borrowings
14

 
701

 
1

 

 
2

 

 
0.36

 
0.29

 
0.40

Long-term borrowings
37,515

 
37,398

 
37,437

 
1,084

 
1,067

 
1,083

 
2.89

 
2.85

 
2.89

Total interest bearing liabilities
1,020,350

 
900,204

 
914,466

 
5,904

 
5,730

 
6,583

 
0.58

 
0.64

 
0.72

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing demand deposits
297,483

 
234,149

 
220,980

 
 

 
 

 
 

 
 

 
 

 
 

Other liabilities
9,415

 
5,912

 
6,370

 
 

 
 

 
 

 
 

 
 

 
 

Shareholders' equity
196,518

 
172,207

 
165,338

 
 

 
 

 
 

 
 

 
 

 
 

Total liabilities and shareholders' equity
$
1,523,766

 
$
1,312,472

 
$
1,307,154

 
 

 
 

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate spread
 

 
 

 
 

 
 

 
 

 
 

 
3.53
%
 
3.50
%
 
3.93
%
Net interest margin
 

 
 

 
 

 
 

 
 

 
 

 
3.69
%
 
3.66
%
 
4.10
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income (taxable equivalent basis)
 
 

 
51,279

 
43,813

 
48,632

 
 
 
 
 
 

Less: Taxable equivalent adjustment
 
 

 
2,014

 
2,088

 
2,259

 
 
 
 

 
 

Net interest income
 
 

 
 

 
$
49,265

 
$
41,725

 
$
46,373

 
 
 
 

 
 


31


The following table presents the dollar amount of changes in interest income and interest expense, and distinguishes between changes resulting from fluctuations in average balances of interest earning assets and interest bearing liabilities (volume), and changes resulting from fluctuations in average interest rates on such assets and liabilities (rate).  Changes attributable to both volume and rate have been allocated proportionately (dollars in thousands):
Changes in Net Interest Income (Rate / Volume Analysis)
 
2015 vs. 2014
 
2014 vs. 2013
 
Increase
 
Change
Attributable to
 
Increase
 
Change
Attributable to
Interest income
(Decrease)
 
Rate
 
Volume
 
(Decrease)
 
Rate
 
Volume
Loans:
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
1,457

 
$
(49
)
 
$
1,506

 
$
(646
)
 
$
(510
)
 
$
(136
)
Real estate
5,854

 
(568
)
 
6,422

 
(4,917
)
 
(5,736
)
 
819

Consumer
376

 
8

 
368

 
(49
)
 
27

 
(76
)
Total loans
7,687

 
(609
)
 
8,296

 
(5,612
)
 
(6,219
)
 
607

Securities:
 

 
 

 
 

 
 
 
 

 
 
Federal agencies and GSEs
512

 
332

 
180

 
320

 
116

 
204

Mortgage-backed and CMOs
(107
)
 
(116
)
 
9

 
11

 
298

 
(287
)
State and municipal
(561
)
 
(393
)
 
(168
)
 
(443
)
 
(219
)
 
(224
)
Other securities
55

 
33

 
22

 
47

 
44

 
3

Total securities
(101
)
 
(144
)
 
43

 
(65
)
 
239

 
(304
)
Federal funds sold
6

 
6

 

 

 

 

Deposits in other banks
48

 
21

 
27

 
5

 
8

 
(3
)
Total interest income
7,640

 
(726
)
 
8,366

 
(5,672
)
 
(5,972
)
 
300

 
 
 
 
 
 
 
 
 
 
 
 
Interest expense
 

 
 

 
 

 
 

 
 

 
 

Deposits:
 

 
 

 
 

 
 

 
 

 
 

Demand
11

 
(4
)
 
15

 
(40
)
 
(54
)
 
14

Money market
28

 
2

 
26

 
(106
)
 
(104
)
 
(2
)
Savings
6

 
(4
)
 
10

 
(24
)
 
(28
)
 
4

Time
112

 
(288
)
 
400

 
(636
)
 
(204
)
 
(432
)
Total deposits
157

 
(294
)
 
451

 
(806
)
 
(390
)
 
(416
)
Customer repurchase agreements
2

 
1

 
1

 
(33
)
 
(30
)
 
(3
)
Other borrowings
15

 
31

 
(16
)
 
(14
)
 
(33
)
 
19

Total interest expense
174

 
(262
)
 
436

 
(853
)
 
(453
)
 
(400
)
Net interest income
$
7,466

 
$
(464
)
 
$
7,930

 
$
(4,819
)
 
$
(5,519
)
 
$
700

Noninterest Income
For the year ended December 31, 2015, noninterest income increased $2,111,000 or 18.9% compared to the year ended December 31, 2014. Unless otherwise noted, these increases are primarily related to the January 2015 acquisition of MainStreet. Details of individual accounts are shown in the table on the following page.

32


 
Years Ended December 31,
 
(Dollars in thousands)
 
2015
 
2014
 
$ Change
 
% Change
Noninterest income:
 
 
 
 
 
 
 
 Trust fees
$
3,935

 
$
4,196

 
$
(261
)
 
(6.2
)%
 Service charges on deposit accounts
2,066

 
1,735

 
331

 
19.1

 Other fees and commissions
2,377

 
1,903

 
474

 
24.9

 Mortgage banking income
1,320

 
1,126

 
194

 
17.2

 Securities gains, net
867

 
505

 
362

 
71.7

 Brokerage fees
946

 
643

 
303

 
47.1

 Income from Small Business Investment Companies
912

 
176

 
736

 
80.7

 Other
2,722

 
1,711

 
1,011

 
59.1

Total noninterest income
$
15,145

 
$
11,995

 
$
3,150

 
26.3
 %
A substantial portion of trust fees are earned based on account fair values, so changes in the equity markets may have a large and potentially volatile impact on revenue. Trust income decreased for 2015 compared to 2014, largely related to the 2014 recognition of a one-time estate fee revenue of approximately $110,000. Trust income was not immediately impacted by the MainStreet acquisition. Service charge income was positively impacted by increases in overdraft and returned check fee income and higher fee income from debit card activity. These categories were higher based on larger transaction volume. Mortgage banking income was higher in 2015 based on greater loan demand volume in existing markets and the impact of the MainStreet acquisition. Secondary market mortgage loan volume for 2015 was $59,030,000 compared to $49,565,000 for 2014. Securities gains also increased, which related to the Company's decision to reduce its exposure to states with unusually large unfunded pension obligations and states sensitive to the large decline in the price of oil, notably Texas. Other income was positively impacted by increased income from Small Business Investment Company ("SBIC") investments. Approximately $735,000 or 72.7% of the increase in this category was directly related to SBIC income, which is volatile and difficult to predict.
 
Years Ended December 31,
 
(Dollars in thousands)
 
2014
 
2013
 
$ Change
 
% Change
Noninterest income:
 
 
 
 
 
 
 
 Trust fees
$
4,196

 
$
3,689

 
$
507

 
13.7
 %
 Service charges on deposit accounts
1,735

 
1,750

 
(15
)
 
(0.9
)
 Other fees and commissions
1,903

 
1,864

 
39

 
2.1

 Mortgage banking income
1,126

 
2,008

 
(882
)
 
(43.9
)
 Securities gains, net
505

 
192

 
313

 
163.0

 Brokerage fees
643

 
469

 
174

 
37.1

 Income from Small Business Investment Companies
176

 
12

 
164

 
1,366.7

 Other
1,711

 
1,324

 
387

 
29.2

Total noninterest income
$
11,995

 
$
11,308

 
$
687

 
6.1
 %
A substantial portion of trust fees are earned based on account market values, so changes in the equity markets may have a large and potentially volatile impact on revenue. Trust income increased for 2014 compared to 2013. The size of the increase was negatively impacted by a $330,000 refund, paid in the first quarter of 2013, related to a long running error in a trust agreement. Mortgage banking income decreased in 2014 from 2013 due to increases in mortgage interest rates, which slowed demand for mortgage loan refinancing and, accordingly, reduced volume and income. Also contributing to the decline in demand in 2014, was that most credit worthy customers who desired a mortgage refinance had taken advantage of the low interest rates in prior years. Secondary market mortgage loan volume for 2014 was $49,565,000 compared to $79,392,000 for 2013. Securities gains increased in 2014 from 2013 as a result of the Company selling bonds consistent with the ongoing asset liability and liquidity objectives. Most of these sales were related to issuers located in states with which management had some significant credit or economic concerns. The increase in other income in 2014 compared to 2013 was primarily attributable to

33


brokerage income, which was up $174,000 and income from an equity investment in a SBIC, which was up $164,000. Income from the SBIC investment is erratic and unpredictable.

Noninterest Expense
For the year ended December 31, 2015, noninterest expense increased $5,985,000 or 17.3% as compared to the year ended December 31, 2014. Unless otherwise noted, these increases are primarily related to the January 2015 acquisition of MainStreet. Details of individual accounts are shown in the table below.
 
Years Ended December 31,
 
(Dollars in thousands)
 
2015
 
2014
 
$ Change
 
% Change
Noninterest Expense:
 
 
 
 
 
 
 
 Salaries
$
16,554

 
$
14,688

 
$
1,866

 
12.7
 %
 Employee benefits
4,311

 
2,988

 
1,323

 
44.3

 Occupancy and equipment
4,425

 
3,727

 
698

 
18.7

 FDIC assessment
750

 
647

 
103

 
15.9

 Bank franchise tax
898

 
901

 
(3
)
 
NM
 Core deposit intangible amortization
1,201

 
1,114

 
87

 
7.8

 Data processing
1,725

 
1,448

 
277

 
19.1

 Software
1,158

 
1,019

 
139

 
13.6

 Other real estate owned, net
99

 
240

 
(141
)
 
(58.8
)
 Merger related expenses
1,998

 
780

 
1,218

 
156.2

 Other
7,424

 
7,006

 
418

 
6.0

Total noninterest expense
$
40,543

 
$
34,558

 
$
5,985

 
17.3
 %
NM- Not meaningful
 
 
 
 
 
 
 
Salaries expense increased significantly in 2015 compared to 2014 primarily related to the MainStreet acquisition. The increase in salaries expense represents 31.2% of the total increase in noninterest expense between 2015 and 2014. Total full time equivalent employees increased to 303 in 2015 from 284 in 2014. Employee benefits were impacted by the acquisition and also increased health care and pension settlement expense. Data processing expense increased due to higher transaction volumes, increased usage of the Company's core information management system, and also a delay in the operational conversion for MainStreet from March to May 2015. Other real estate owned expense includes gains and losses on sale of foreclosed properties, adjustments related to re-appraisals of foreclosed properties, and operating expenses related to maintaining foreclosed properties. It is inherently volatile from period to period. Nonrecurring MainStreet acquisition related expenses represent 20.4% of the total increase in noninterest expense between 2015 and 2014.

34


 
Years Ended December 31,
 
(Dollars in thousands)
 
2014
 
2013
 
$ Change
 
% Change
Noninterest Expense:
 
 
 
 
 
 
 
 Salaries
$
14,688

 
$
14,059

 
$
629

 
4.5
 %
 Employee benefits
2,988

 
3,848

 
(860
)
 
(22.3
)
 Occupancy and equipment
3,727

 
3,614

 
113

 
3.1

 FDIC assessment
647

 
647

 

 

 Bank franchise tax
901

 
745

 
156

 
20.9

 Core deposit intangible amortization
1,114

 
1,501

 
(387
)
 
(25.8
)
 Data processing
1,448

 
1,248

 
200

 
16.0

 Software
1,019

 
923

 
96

 
10.4

 Other real estate owned, net
240

 
1,523

 
(1,283
)
 
(84.2
)
 Merger related expenses
780

 

 
780

 
NM
 Other
7,006

 
6,997

 
9

 
0.1

Total noninterest expense
$
34,558

 
$
35,105

 
$
(547
)
 
(1.6
)%
NM - Not meaningful
 
 
 
 
 
 
 
Salaries expense increased modestly in 2014 from 2013, mostly related to normal annual increases. Employee benefits expense decreased substantially in 2014 from 2013. A large portion of this decrease, $778,000, was related to pension expense. Pension expense is impacted by market interest rates and participant decisions regarding retirement distributions, both of which can be difficult for the Company to predict. Total full time equivalent employees were 284 at the end of 2014 compared to 290 at the end of 2013. Other real estate owned expense includes gains and losses on sale of foreclosed properties, adjustments related to re-appraisals of foreclosed properties, and operating expenses related to maintaining foreclosed properties. It is inherently volatile from period to period. Merger related expenses are related to the MainStreet acquisition.
Other Real Estate Owned ("OREO") expense, includes gains and losses on sale of foreclosed properties, adjustments related to re-appraisals of foreclosed properties, and operating expenses related to maintaining foreclosed properties. The activity related to this noninterest expense for the years ended December 31, 2015, 2014, and 2013 are shown below (dollars in thousands):
 
2015
 
2014
 
2013
(Gain) on sale of OREO
$
(185
)
 
$
(66
)
 
$
(85
)
OREO valuation adjustments
86

 
68

 
1,070

OREO related expense
198

 
238

 
538

 
$
99

 
$
240

 
$
1,523

Income Taxes
Income taxes on 2015 earnings amounted to $6,020,000, resulting in an effective tax rate of 28.6%, compared to 29.0% in 2014 and 27.8% in 2013.  The effective tax rate is lower than the statutory rate of 35% due to income that is not taxable for federal income tax purposes. The primary non-taxable income is that of state and municipal securities and loans. The decrease in the effective rate is related to a higher level of tax exempt municipal loans.

35


Fair Value Impact to Pretax Income
The July 2011 merger with MidCarolina and the January 2015 merger with MainStreet had a material and positive impact on earnings. The ongoing financial impact of the mergers was mostly the result of the increase in earnings assets. However, the specific financial impact of the fair value related accounting adjustments is reflected in the following tables. The tables present the actual effect of the accretable and amortizable fair value adjustments attributable to the mergers on net interest income and pretax income for the years ended December 31, 2015, 2014, and 2013, respectively (dollars in thousands):
 
 
 
 
 
December 31, 2015
 
 
 
Income Statement Effect
 
Premium/(Discount) Balance on December 31, 2014
 
Additions for the year ended
Accretion (Amortization) For the year ended
 
Remaining Premium/ (Discount) Balance
 
 
Interest income/(expense):
 
 
 
 
 
 
 
 
 
 
Acquired performing loans
Income
 
$
(3,358
)
 
$
(1,279
)
$
1,576

 
$
(3,061
)
 
 
Purchase acquired impaired loans
Income
 
(3,424
)
 
(5,097
)
1,455

 
(7,066
)
 
(1)
Time deposits
Income
 

 
(288
)
288

 

 
 
Time deposits - brokered
Income
 

 
(2
)
2

 

 
 
FHLB advances
Expense
 
65

 

(23
)
 
42

 
 
Trust preferred securities
Expense
 
1,862

 

(101
)
 
1,761

 
 
Net Interest Income
 
 
 

 
(6,666
)
3,197

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
Non-interest (expense)
 
 
 

 
 
 

 
 

 
 
Amortization of core deposit intangible
Expense
 
$
2,045

 
1,839

(1,201
)
 
$
2,683

 
 
Net non-interest expense