ALLOWANCE FOR LOAN LOSSES AND CREDIT QUALITY INFORMATION

Allowance for Loan Losses

We maintain an allowance for loan losses which represents our best estimate of probable losses in our loan portfolio. As losses are realized, they are charged to this allowance. We established our allowance in accordance with guidance provided in the SEC’s Staff Accounting Bulletin 102 (SAB 102), Selected Loan Loss Allowance Methodology and Documentation Issues, ASC 450, Contingencies and ASC 310, Receivables. When we have reason to believe it is probable that we will not be able to collect all contractually due amounts of principal and interest, loans are evaluated for impairment on an individual basis and a specific allocation of the allowance is assigned in accordance with ASC 310-10. We also maintain an allowance for loan losses on acquired loans when: (i) for loans accounted for under ASC 310-30, there is deterioration in credit quality subsequent to acquisition and (ii) for loans accounted for under ASC 310-20, the inherent losses in the loans exceed the remaining credit discount recorded at the time of acquisition. The determination of the allowance for loan losses requires significant judgment reflecting our best estimate of impairment related to specifically identified impaired loans as well as probable loan losses in the remaining loan portfolio. Our evaluation is based on a continuing review of these portfolios. The following are included in our allowance for loan losses:


•	Specific reserves for impaired loans


•	An allowance for each pool of homogenous loans based on historical loss experience


•	Adjustments for qualitative and environmental factors allocated to pools of homogenous loans

When it is probable that the Bank will be unable to collect all amounts due (interest and principal) in accordance with the contractual terms of the loan agreement, it assigns a specific reserve to that loan, if necessary. Unless loans are well-secured and collection is imminent, loans greater than 90 days past due are deemed impaired and their respective reserves are generally charged-off once the loss has been confirmed. Estimated specific reserves are based on collateral values, estimates of future cash flows or market valuations. We charge loans off when they are deemed to be uncollectible. During the three months ended March 31, 2018 and 2017, net charge-offs totaled $3.4 million, or 0.29%, of average loans annualized, and $2.1 million, or 0.19%, of average loans annualized, respectively.

Allowances for pooled homogeneous loans, that are not deemed impaired, are based on historical net loss experience. Estimated losses for pooled portfolios are determined differently for commercial loan pools and retail loan pools. Commercial loans are pooled as follows: commercial, owner-occupied commercial, commercial mortgages and construction. Each pool is further segmented by internally assessed risk ratings. Loan losses for commercial loans are estimated by determining the probability of default and expected loss severity upon default. The probability of default is calculated based on the historical rate of migration to impaired status during the last 29 quarters. During the three months ended March 31, 2018, we increased the look-back period to 29 quarters from the 28 quarters used at December 31, 2017. This increase in the look-back period allows us to continue to anchor to the fourth quarter of 2010 to ensure that the core reserves calculated by the ALLL model are adequately considering the losses within a full credit cycle.

Loss severity upon default is calculated as the actual loan losses (net of recoveries) on impaired loans in their respective pool during the same time frame. Retail loans are pooled into the following segments: residential mortgage, consumer secured and consumer unsecured loans. Pooled reserves for retail loans are calculated based solely on average net loss rates over the same 29 quarter look-back period.

Qualitative adjustment factors consider various current internal and external conditions which are allocated among loan types and take into consideration:


•	Current underwriting policies, staff, and portfolio mix,


•	Internal trends of delinquency, nonaccrual and criticized loans by segment,


•	Risk rating accuracy, control and regulatory assessments/environment,


•	General economic conditions - locally and nationally,


•	Market trends impacting collateral values, and


•	The competitive environment, as it could impact loan structure and underwriting.

The above factors are based on their relative standing compared to the period in which historic losses are used in core reserve estimates and current directional trends. Qualitative factors in our model can add to or subtract from core reserves.

The allowance methodology uses a loss emergence period (LEP), which is the period of time between an event that triggers the probability of a loss and the confirmation of the loss. We estimate the commercial LEP to be approximately nine quarters as of March 31, 2018. Our residential mortgage and consumer LEP remained at four quarters as of March 31, 2018. We evaluate LEP quarterly for reasonableness and complete a detailed historical analysis of our LEP annually for our commercial portfolio and review the current four quarter LEP for the retail portfolio to determine the continued reasonableness of this assumption.

Our loan officers and risk managers meet at least quarterly to discuss and review the conditions and risks associated with individual problem loans. In addition, various regulatory agencies periodically review our loan ratings and allowance for loan losses and the Bank’s internal loan review department performs loan reviews.

The following tables provide the activity of our allowance for loan losses and loan balances for the three months ended March 31, 2018:



(Dollars in thousands)	Commercial			Owner-occupied Commercial			Commercial Mortgages			Construction			Residential⁽¹⁾			Consumer			Total
Allowance for loan losses
Beginning balance	$	16,732		$	5,422		$	5,891		$	2,861		$	1,798		$	7,895		$	40,599
Charge-offs	(3,360		)	(10		)	(48		)	—			—			(462		)	(3,880		)
Recoveries	80			5			134			1			14			207			441
Provision (credit)	2,650			(58		)	617			27			(129		)	548			3,655
Provision for acquired loans	—			—			23			(25		)	(3		)	—			(5		)
Ending balance	$	16,102		$	5,359		$	6,617		$	2,864		$	1,680		$	8,188		$	40,810

Loans individually evaluated for impairment	$	2,632		$	—		$	—		$	—		$	643		$	186		$	3,461
Loans collectively evaluated for impairment	13,296			5,347			6,528			2,857			1,001			7,994			37,023
Acquired loans evaluated for impairment	174			12			89			7			35			9			326
Ending balance	$	16,102		$	5,359		$	6,617		$	2,864		$	1,679		$	8,189		$	40,810

Loans individually evaluated for impairment ⁽²⁾	$	16,993		$	4,342		$	5,946		$	6,490		$	12,861		$	7,677		$	54,309
Loans collectively evaluated for impairment	1,361,517			938,166			970,750			267,293			145,753			541,644			4,225,123
Acquired nonimpaired loans	107,183			133,007			178,518			15,259			67,722			33,152			534,841
Acquired impaired loans	3,870			5,147			9,210			901			777			249			20,154
Ending balance⁽³⁾	$	1,489,563		$	1,080,662		$	1,164,424		$	289,943		$	227,113		$	582,722		$	4,834,427


⁽¹⁾	Period-end loan balance excludes reverse mortgages, at fair value of $20.0 million.


⁽²⁾	The difference between this amount and nonaccruing loans represents accruing troubled debt restructured loans of $20.2 million for the period ending March 31, 2018. Accruing troubled debt restructured loans are considered impaired loans.


⁽³⁾	Ending loan balances do not include net deferred fees.

The following table provides the activity of the allowance for loan losses and loan balances for the three months ended March 31, 2017:



(Dollars in thousands)	Commercial			Owner - occupied Commercial			Commercial Mortgages			Construction			Residential⁽¹⁾			Consumer			Total
Allowance for loan losses
Beginning balance	$	13,339		$	6,588		$	8,915		$	2,838		$	2,059		$	6,012		$	39,751
Charge-offs	(1,255		)	(192		)	(104		)	(14		)	(11		)	(1,143		)	(2,719		)
Recoveries	84			75			46			2			120			305			632
Provision (credit)	1,949			(441		)	(518		)	158			(114		)	1,080			2,114
Provision for acquired loans	88			—			(4		)	(23		)	—			(13		)	48
Ending balance	$	14,205		$	6,030		$	8,335		$	2,961		$	2,054		$	6,241		$	39,826

Loans individually evaluated for impairment	$	1,860		$	—		$	1,395		$	500		$	887		$	194		$	4,836
Loans collectively evaluated for impairment	12,165			6,015			6,763			2,397			1,144			6,042			34,526
Acquired loans evaluated for impairment	180			15			177			64			23			5			464
Ending balance	$	14,205		$	6,030		$	8,335		$	2,961		$	2,054		$	6,241		$	39,826

Loans individually evaluated for impairment ⁽²⁾	$	16,767		$	4,020		$	9,771		$	3,130		$	14,280		$	9,029		$	56,997
Loans collectively evaluated for impairment	1,175,911			919,508			928,925			225,718			158,430			405,285			3,813,777
Acquired nonimpaired loans	141,933			156,724			216,410			24,540			85,679			50,321			675,607
Acquired impaired loans	5,256			12,040			10,450			2,372			866			263			31,247
Ending balance⁽³⁾	$	1,339,867		$	1,092,292		$	1,165,556		$	255,760		$	259,255		$	464,898		$	4,577,628


⁽¹⁾	Period-end loan balance excludes reverse mortgages, at fair value of $22.5 million.


⁽²⁾	The difference between this amount and nonaccruing loans represents accruing troubled debt restructured loans of $17.3 million for the period ending March 31, 2017. Accruing troubled debt restructured loans are considered impaired loans.


⁽³⁾	Ending loan balances do not include net deferred fees.

Nonaccrual and Past Due Loans

Nonaccruing loans are those on which the accrual of interest has ceased. Typically, we discontinue accrual of interest on originated loans after payments become more than 90 days past due or earlier if we do not expect the full collection of principal or interest in accordance with the terms of the loan agreement. Interest accrued but not collected at the date a loan is placed on nonaccrual status is reversed and charged against interest income. In addition, the accretion of net deferred loan fees and amortization of net deferred loan costs is suspended when a loan is placed on nonaccrual status. Subsequent cash receipts are applied either to the outstanding principal balance or recorded as interest income, depending on our assessment of the ultimate collectability of principal and interest. Loans greater than 90 days past due and still accruing are defined as loans contractually past due 90 days or more as to principal or interest payments, but which remain in accrual status because they are considered well secured and are in the process of collection.

The following tables show our nonaccrual and past due loans at the dates indicated:



	March 31, 2018
(Dollars in thousands)	30–59 Days Past Due and Still Accruing			60–89 Days Past Due and Still Accruing			Greater Than 90 Days Past Due and Still Accruing			Total Past Due And Still Accruing			Accruing Current Balances			Acquired Impaired Loans			Nonaccrual Loans			Total Loans
Commercial	$	403		$	708		$	31		$	1,142		$	1,467,695		$	3,870		$	16,856		$	1,489,563
Owner-occupied commercial	1,529			—			—			1,529			1,069,644			5,147			4,342			1,080,662
Commercial mortgages	616			34			46			696			1,149,408			9,210			5,110			1,164,424
Construction	2,024			—			—			2,024			285,580			901			1,438			289,943
Residential⁽¹⁾	2,446			211			155			2,812			219,366			777			4,158			227,113
Consumer	532			179			323			1,034			579,283			249			2,156			582,722
Total ⁽²⁾	$	7,550		$	1,132		$	555		$	9,237		$	4,770,976		$	20,154		$	34,060		$	4,834,427
% of Total Loans	0.16		%	0.02		%	0.01		%	0.19		%	98.69		%	0.42		%	0.70		%	100		%


⁽¹⁾	Residential accruing current balances excludes reverse mortgages at fair value of $20.0 million.


⁽²⁾	The balances above include a total of $534.8 million of acquired non-impaired loans.



	December 31, 2017
(Dollars in thousands)	30–59 Days Past Due and Still Accruing			60–89 Days Past Due and Still Accruing			Greater Than 90 Days Past Due and Still Accruing			Total Past Due And Still Accruing			Accruing Current Balances			Acquired Impaired Loans			Nonaccrual Loans			Total Loans
Commercial	$	1,050		$	—		$	—		$	1,050		$	1,440,291		$	4,156		$	19,057		$	1,464,554
Owner-occupied commercial	2,069			233			—			2,302			1,067,488			5,803			3,654			1,079,247
Commercial mortgages	320			90			—			410			1,171,701			9,724			5,870			1,187,705
Construction	—			—			—			—			278,864			940			1,804			281,608
Residential⁽¹⁾	2,058			731			356			3,145			225,434			784			4,124			233,487
Consumer	1,117			463			105			1,685			554,634			247			1,927			558,493
Total⁽²⁾	$	6,614		$	1,517		$	461		$	8,592		$	4,738,412		$	21,654		$	36,436		$	4,805,094
% of Total Loans	0.14		%	0.03		%	0.01		%	0.18		%	98.61		%	0.45		%	0.76		%	100		%


⁽¹⁾	Residential accruing current balances excludes reverse mortgages, at fair value of $19.8 million.


⁽²⁾	The balances above include a total of $565.5 million of acquired non-impaired loans.

Impaired Loans

Loans for which it is probable we will not collect all principal and interest due according to their contractual terms, which is assessed based on the credit characteristics of the loan and/or payment status, are measured for impairment in accordance with the provisions of SAB 102 and FASB ASC 310, Receivables (ASC 310). The amount of impairment is required to be measured using one of three methods: (1) the present value of expected future cash flows discounted at the loan’s effective interest rate; (2) the fair value of collateral, if the loan is collateral dependent or (3) the loan’s observable market price. If the measure of the impaired loan is less than the recorded investment in the loan, a related allowance is allocated for the impairment.

The following tables provide an analysis of our impaired loans at March 31, 2018 and December 31, 2017:



	March 31, 2018
(Dollars in thousands)	Ending Loan Balances		Loans with No Related Reserve ⁽¹⁾		Loans with Related Reserve		Related Reserve		Contractual Principal Balances		Average Loan Balances
Commercial	$	18,592	$	3,038	$	15,554	$	2,806	$	24,842	$	17,941
Owner-occupied commercial	6,032		4,342		1,690		12		6,360		6,103
Commercial mortgages	7,427		5,946		1,481		89		16,370		11,103
Construction	6,718		6,490		228		7		7,239		5,134
Residential	13,261		8,195		5,066		679		15,992		14,334
Consumer	7,911		6,480		1,431		194		8,953		8,136
Total⁽²⁾	$	59,941	$	34,491	$	25,450	$	3,787	$	79,756	$	62,751


⁽¹⁾	Reflects loan balances at or written down to their remaining book balance.


⁽²⁾	The above includes acquired impaired loans totaling $5.6 million in the ending loan balance and $6.6 million in the contractual principal balance.



	December 31, 2017
(Dollars in thousands)	Ending Loan Balances		Loans with No Related Reserve⁽¹⁾		Loans with Related Reserve		Related Reserve		Contractual Principal Balances		Average Loan Balances
Commercial	$	20,842	$	3,422	$	17,420	$	3,861	$	23,815	$	15,072
Owner-occupied commercial	5,374		3,654		1,720		12		5,717		5,827
Commercial mortgages	7,598		4,487		3,111		112		16,658		12,630
Construction	6,292		6,023		269		33		6,800		4,523
Residential	14,181		8,282		5,899		796		17,015		14,533
Consumer	7,819		6,304		1,515		203		8,977		8,158
Total ⁽²⁾	$	62,106	$	32,172	$	29,934	$	5,017	$	78,982	$	60,743


⁽¹⁾	Reflects loan balances at or written down to their remaining book balance.


⁽²⁾	The above includes acquired impaired loans totaling $5.8 million in the ending loan balance and $6.8 million in the contractual principal balance.

Interest income of $0.3 million was recognized on impaired loans during the three months ended March 31, 2018. Interest income of $0.3 million was recognized on impaired loans during the three months ended March 31, 2017.

As of March 31, 2018, there were 38 residential loans and 10 commercial loans in the process of foreclosure. The total outstanding balance on the loans was $3.3 million and $6.1 million, respectively. As of December 31, 2017, there were 33 residential loans and 8 commercial loans in the process of foreclosure. The total outstanding balance on the loans was $2.9 million and $6.0 million, respectively.

Reserves on Acquired Nonimpaired Loans

In accordance with FASB ASC 310, loans acquired by the Bank through its mergers with First National Bank of Wyoming, Alliance Bancorp, Inc. (Alliance) and Penn Liberty are required to be reflected on the balance sheet at their fair values on the date of acquisition as opposed to their contractual values. Therefore, on the date of acquisition establishing an allowance for acquired loans is prohibited. After the acquisition date the Bank performs a separate allowance analysis on a quarterly basis to determine if an allowance for loan loss is necessary. Should the credit risk calculated exceed the purchased loan portfolio’s remaining credit mark, additional reserves will be added to the Bank’s allowance. When a purchased loan becomes impaired after its acquisition, it is evaluated as part of the Bank’s reserve analysis and a specific reserve is established to be included in the Bank’s allowance.

Credit Quality Indicators

Below is a description of each of our risk ratings for all commercial loans:


•	Pass. These borrowers currently show no indication of deterioration or potential problems and their loans are considered fully collectible

•

Special Mention. Borrowers have potential weaknesses that deserve management’s close attention. Borrowers in this category may be experiencing adverse operating trends, for example, declining revenues or margins, high leverage, tight liquidity, or increasing inventory without increasing sales. These adverse trends can have a potential negative effect on the borrower’s repayment capacity. These assets are not adversely classified and do not expose the Bank to significant risk that would warrant a more severe rating. Borrowers in this category may also be experiencing significant management problems, pending litigation, or other structural credit weaknesses.

•

Substandard. Borrowers have well-defined weaknesses that require extensive oversight by management. Borrowers in this category may exhibit one or more of the following: inadequate debt service coverage, unprofitable operations, insufficient liquidity, high leverage, and weak or inadequate capitalization. Relationships in this category are not adequately protected by the sound financial worth and paying capacity of the obligor or the collateral pledged on the loan, if any. A distinct possibility exists that the Bank will sustain some loss if the deficiencies are not corrected.

•

Doubtful. Borrowers have well-defined weaknesses inherent in the Substandard category with the added characteristic that the possibility of loss is extremely high. Current circumstances in the credit relationship make collection or liquidation in full highly questionable. A doubtful asset has some pending event that may strengthen the asset that defers the loss classification. Such impending events include: perfecting liens on additional collateral, obtaining collateral valuations, an acquisition or liquidation preceding, proposed merger, or refinancing plan.


•	Loss. Borrowers are uncollectible or of such negligible value that continuance as a bankable asset is not supportable. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical to defer writing off this asset even though partial recovery may be recognized sometime in the future.

Residential and Consumer Loans

The residential and consumer loan portfolios are monitored on an ongoing basis using delinquency information and loan type as credit quality indicators. These credit quality indicators are assessed in the aggregate in these relatively homogeneous portfolios. Loans that are greater than 90 days past due are generally considered nonperforming and placed on nonaccrual status.

The following tables provide an analysis of loans by portfolio segment based on the credit quality indicators used to determine the Allowance for Loan Loss.

Commercial Credit Exposure



	March 31, 2018
(Dollars in thousands)	Commercial		Owner-occupied Commercial		Commercial Mortgages		Construction		Total Commercial⁽¹⁾
									Amount		%
Risk Rating:
Special mention	$	24,871	$	15,874	$	4,346	$	—	$	45,091
Substandard:
Accrual	33,960		18,055		2,399		5,796		60,210
Nonaccrual	14,224		4,342		5,110		1,438		25,114
Doubtful	2,632		—		—		—		2,632
Total Special Mention and Substandard	75,687		38,271		11,855		7,234		133,047		3	%
Acquired impaired	3,870		5,147		9,210		901		19,128		1	%
Pass	1,410,006		1,037,244		1,143,359		281,808		3,872,417		96	%
Total	$	1,489,563	$	1,080,662	$	1,164,424	$	289,943	$	4,024,592	100	%


⁽¹⁾	Table includes $434.0 million of acquired non-impaired loans as of March 31, 2018.



	December 31, 2017
(Dollars in thousands)	Commercial		Owner-occupied Commercial		Commercial Mortgages		Construction		Total Commercial⁽¹⁾
									Amount		%
Risk Rating:
Special mention	$	22,789	$	16,783	$	—	$	—	$	39,572
Substandard:
Accrual	34,332		19,386		1,967		4,965		60,650
Nonaccrual	15,370		3,654		5,852		1,804		26,680
Doubtful	3,687		—		18		—		3,705
Total Special Mention and Substandard	76,178		39,823		7,837		6,769		130,607		3	%
Acquired impaired	4,156		5,803		9,724		940		20,623		1	%
Pass	1,384,220		1,033,621		1,170,144		273,899		3,861,884		96	%
Total	$	1,464,554	$	1,079,247	$	1,187,705	$	281,608	$	4,013,114	100	%


⁽¹⁾	Table includes $457.3 million of acquired non-impaired loans as of December 31, 2017.

Residential and Consumer Credit Exposure



(Dollars in thousands)	Residential⁽²⁾				Consumer				Total Residential and Consumer⁽³⁾
	March 31,		December 31,		March 31,		December 31,		March 31, 2018				December 31, 2017
	2018		2017		2018		2017		Amount		Percent		Amount		Percent
Nonperforming⁽¹⁾	$	12,861	$	13,778	$	7,677	$	7,588	$	20,538	3	%	$	21,366	3	%
Acquired impaired loans	777		784		249		247		1,026		—	%	1,031		—	%
Performing	213,475		218,925		574,796		550,658		788,271		97	%	769,583		97	%
Total	$	227,113	$	233,487	$	582,722	$	558,493	$	809,835	100	%	$	791,980	100	%


⁽¹⁾	Includes $14.2 million as of March 31, 2018 and $15.3 million as of December 31, 2017 of troubled debt restructured mortgages and home equity installment loans that are performing in accordance with the loans’ modified terms and are accruing interest.


⁽²⁾	Residential performing loans excludes $20.0 million and $19.8 million of reverse mortgages at fair value as of March 31, 2018 and December 31, 2017, respectively.


⁽³⁾	Total includes $100.9 million and $108.2 million in acquired non-impaired loans as of March 31, 2018 and December 31, 2017, respectively.

Troubled Debt Restructurings (TDRs)

TDRs are recorded in accordance with FASB ASC 310-40, Troubled Debt Restructuring by Creditors (ASC 310-40).

The following table presents the balance of TDRs as of the indicated dates:



(Dollars in thousands)	March 31, 2018		December 31, 2017
Performing TDRs	$	20,248	$	20,061
Nonperforming TDRs	9,907		9,627
Total TDRs	$	30,155	$	29,688

Approximately $0.8 million and $1.0 million in related reserves have been established for these loans at March 31, 2018 and December 31, 2017, respectively.

The following table presents information regarding the types of loan modifications made for the three months ended March 31, 2018 and 2017:



	March 31, 2018					March 31, 2017
	Contractual payment reduction and term extension	Maturity Date Extension	Discharged in bankruptcy	Other ⁽¹⁾	Total	Contractual payment reduction and term extension	Maturity Date Extension	Discharged in bankruptcy	Other⁽¹⁾	Total
Commercial	—	—	—	—	—	—	1	—	—	1
Owner-occupied commercial	—	—	—	—	—	—	1	—	—	1
Commercial Mortgages	—	1	—	—	1	—	—	—	—	—
Construction	—	1	—	—	1	—	2	—	—	2
Residential	—	—	—	—	—	—	—	1	—	1
Consumer	1	1	—	2	4	—	—	6	1	7
Total	1	3	—	2	6	—	4	7	1	12


⁽¹⁾	Other includes underwriting exceptions.

Principal balances are generally not forgiven when a loan is modified as a TDR. Nonaccruing restructured loans remain in nonaccrual status until there has been a period of sustained repayment performance, which is typically six months, and payment is reasonably assured.

The following table presents loans identified as TDRs during the three months ended March 31, 2018 and 2017.



	Three Months Ended March 31,
	2018				2017
(Dollars in thousands)	Pre Modification		Post Modification		Pre Modification		Post Modification
Commercial	$	—	$	—	$	443	$	443
Owner-occupied commercial	—		—		3,071		3,071
Commercial mortgages	458		458		—		—
Construction	920		920		1,712		1,712
Residential	—		—		242		242
Consumer	262		262		584		584
Total	$	1,640	$	1,640	$	6,052	$	6,052

During the three months ended March 31, 2018, the TDRs set forth in the table above resulted in no increase in our allowance for loan losses and no additional charge-offs. For the same period of 2017, the TDRs set forth in the table above increased our allowance for loan losses by $0.3 million and resulted in no additional charge-offs. During the three months ended March 31, 2018, two TDRs defaulted that had received troubled debt modification during the past twelve months with a total loan amount of $0.1 million. During the three months ended March 31, 2017, three TDRs defaulted that had received troubled debt modification during the past twelve months with a total loan amount of $0.7 million.