10-K 1 emcf1231201710-k.htm EMCF 12.31.17 10-K Document

 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
(Mark One):
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended: December 31, 2017
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from: ___________ to ___________
 
Commission File Number: 000-18464
EMCLAIRE FINANCIAL CORP
(Exact name of registrant as specified in its charter)
Pennsylvania
25-1606091
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
612 Main Street, Emlenton, PA
16373
(Address of principal executive office)
(Zip Code)

Registrant’s telephone number: (844) 767-2311

Securities registered pursuant to Section 12(b) of the Act:
Common Stock, par value $1.25 per share
NASDAQ Capital Markets (NASDAQ)
(Title of Class)
(Name of exchange on which registered)

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 x.
 
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 x.
 
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 x 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 during the preceding 12 month (or for such shorter period that the registrant was required to submit and post such files). YES x NO ¨.
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 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, a smaller reporting company or an emerging growth company (do not check if a smaller reporting company).
Large accelerated filer  ¨
Accelerated filer  ¨
Non-accelerated filer  ¨
Smaller reporting company x
Emerging growth company ¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES ¨  NO x.

As of June 30, 2017, the aggregate value of the 1,845,863 shares of Common Stock of the Registrant issued and outstanding on such date, which excludes 355,081 shares held by the directors and officers of the Registrant as a group, was approximately $51.5 million. This figure is based on the last sales price of $27.88 per share of the Registrant’s Common Stock on June 30, 2017. The number of outstanding shares of common stock as of March 20, 2018, was 2,271,139.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Proxy Statement for the 2018 Annual Meeting of Stockholders are incorporated by reference in Part III of this Form 10-K.







EMCLAIRE FINANCIAL CORP
 
TABLE OF CONTENTS
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 1B.
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
 
Item 5.
 
 
 
Item 6.
 
 
 
Item 7.
 
 
 
Item 7A.
 
 
 
Item 8.
 
 
 
Item 9.
 
 
 
Item 9A.
 
 
 
Item 9B.
 
 
 
 
 
 
Item 10.
 
 
 
Item 11.
 
 
 
Item 12.
 
 
 
Item 13.
 
 
 
Item 14.
 
 
 
 
 
 
Item 15.
 
 
 

K-2




Discussions of certain matters in this Form 10-K and other related year end documents may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words or phrases such as “believe”, “plan”, “expect”, “intend”, “anticipate”, “estimate”, “project”, “forecast”, “may increase”, “may fluctuate”, “may improve” and similar expressions of future or conditional verbs such as “will”, “should”, “would”, and “could”. These forward-looking statements relate to, among other things, expectations of the business environment in which Emclaire Financial Corp operates, projections of future performance, potential future credit experience, perceived opportunities in the market and statements regarding the Corporation’s mission and vision. The Corporation’s actual results, performance and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. These factors include, but are not limited to, changes in interest rates, general economic conditions, the local economy, the demand for the Corporation’s products and services, accounting principles or guidelines, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, U.S. Treasury, and Federal Reserve, real estate markets, competition in the financial services industry, attracting and retaining key personnel, performance of new employees, regulatory actions, changes in and utilization of new technologies and other risks detailed in the Corporation’s reports filed with the Securities and Exchange Commission (SEC) from time to time. These factors should be considered in evaluating the forward-looking statements, and undue reliance should not be placed on such statements. The Corporation does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
 
PART I
 
Item 1. Business
 
General
 
Emclaire Financial Corp (the Corporation) is a Pennsylvania corporation and financial holding company that provides a full range of retail and commercial financial products and services to customers in western Pennsylvania through its wholly owned subsidiary bank, The Farmers National Bank of Emlenton (the Bank). The Corporation also provides real estate settlement services through its subsidiary, Emclaire Settlement Services, LLC (the Title Company).
 
The Bank was organized in 1900 as a national banking association and is a financial intermediary whose principal business consists of attracting deposits from the general public and investing such funds in real estate loans secured by liens on residential and commercial properties, consumer loans, commercial business loans, marketable securities and interest-earning deposits. The Bank currently operates through a network of seventeen retail branch offices in Venango, Allegheny, Butler, Clarion, Clearfield, Crawford, Elk, Jefferson and Mercer counties, Pennsylvania and Hancock county, West Virginia. The Corporation and the Bank are headquartered in Emlenton, Pennsylvania.
 
The Bank is subject to examination and comprehensive regulation by the Office of the Comptroller of the Currency (OCC), which is the Bank’s chartering authority, and the Federal Deposit Insurance Corporation (FDIC), which insures customer deposits held by the Bank to the full extent provided by law. The Bank is a member of the Federal Reserve Bank of Cleveland (FRB) and the Federal Home Loan Bank of Pittsburgh (FHLB). The Corporation is a registered bank holding company pursuant to the Bank Holding Company Act of 1956, as amended (BHCA), and a financial holding company under the Gramm-Leach Bliley Act of 1999 (GLBA).
 
On September 30, 2017, the Corporation completed the acquisition of Northern Hancock Bank and Trust Co. (NHB) in accordance with the terms of the Agreement and Plan of Merger, dated as of May 4, 2017, in exchange for 54,445 shares of common stock valued at $1.7 million and $22,000 in cash. In addition, on April 30, 2016, the Corporation completed its acquisition of United American Savings Bank (UASB) in accordance with the terms of the Agreement and Plan of Merger, dated December 30, 2015, in exchange for cash consideration of $13.2 million. These acquisitions expanded the Corporation's franchise into new markets and increased the Corporation's consolidated total assets, loans and deposits.
 
At December 31, 2017, the Corporation had $750.1 million in total assets, $59.1 million in stockholders’ equity, $577.2 million in net loans and $654.6 million in total deposits.
 


K-3




Lending Activities
 
General. The principal lending activities of the Corporation are the origination of residential mortgage, commercial mortgage, commercial business and consumer loans. Nearly all of the Corporation’s loans are originated in and secured by property within the Corporation’s primary market area.
 
One-to-Four Family Mortgage Loans. The Corporation offers first mortgage loans secured by one-to-four family residences located mainly in the Corporation’s primary lending area. One-to-four family mortgage loans amounted to 38.1% of the total loan portfolio at December 31, 2017. Typically such residences are single-family owner occupied units. The Corporation is an approved, qualified lender for the Federal Home Loan Mortgage Corporation (FHLMC) and the FHLB. As a result, the Corporation may sell loans to and service loans for the FHLMC and FHLB in market conditions and circumstances where this is advantageous in managing interest rate risk.
 
Home Equity Loans. The Corporation originates home equity loans secured by single-family residences. Home equity loans amounted to 17.1% of the total loan portfolio at December 31, 2017. These loans may be either a single advance fixed-rate loan with a term of up to 20 years or a variable rate revolving line of credit. These loans are made only on owner-occupied single-family residences.
 
Commercial Business and Commercial Real Estate Loans. Commercial lending constitutes a significant portion of the Corporation’s lending activities. Commercial business and commercial real estate loans amounted to 43.2% of the total loan portfolio at December 31, 2017. Commercial real estate loans generally consist of loans granted for commercial purposes secured by commercial or other nonresidential real estate. Commercial loans consist of secured and unsecured loans for such items as capital assets, inventory, operations and other commercial purposes.
 
Consumer Loans. Consumer loans generally consist of fixed-rate term loans for automobile purchases, home improvements not secured by real estate, capital and other personal expenditures. The Corporation also offers unsecured revolving personal lines of credit and overdraft protection. Consumer loans amounted to 1.6% of the total loan portfolio at December 31, 2017.
 
Loans to One Borrower. National banks are subject to limits on the amount of credit that they can extend to one borrower. Under current law, loans to one borrower are limited to an amount equal to 15% of unimpaired capital and surplus on an unsecured basis, and an additional amount equal to 10% of unimpaired capital and surplus if the loan is secured by readily marketable collateral. At December 31, 2017, the Bank’s loans to one borrower limit based upon 15% of unimpaired capital was $9.6 million. The Bank may grant credit to borrowers in excess of the legal lending limit as part of the Legal Lending Limit Pilot Program approved by the OCC which allows the Bank to exceed its legal lending limit within certain parameters. At December 31, 2017, the Bank’s largest single lending relationship had an outstanding balance of $7.6 million.
 

K-4




Loan Portfolio. The following table sets forth the composition and percentage of the Corporation’s loans receivable in dollar amounts and in percentages of the portfolio as of December 31:
 
 
2017
 
2016
 
2015
 
2014
 
2013
(Dollar amounts in thousands)
 
Dollar
Amount
 
%
 
Dollar
Amount
 
%
 
Dollar
Amount
 
%
 
Dollar
Amount
 
%
 
Dollar
Amount
 
%
Mortgage loans on real estate:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Residential mortgages
 
$
221,823

 
38.1
%
 
$
198,167

 
38.0
%
 
$
139,305

 
32.0
%
 
$
107,173

 
27.8
%
 
$
105,541

 
29.5
%
Home equity loans and lines of credit
 
99,940

 
17.1
%
 
91,359

 
17.5
%
 
87,410

 
20.1
%
 
89,106

 
23.2
%
 
87,928

 
24.6
%
Commercial real estate
 
193,068

 
33.1
%
 
166,994

 
32.1
%
 
129,691

 
29.8
%
 
110,810

 
28.8
%
 
101,499

 
28.5
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total real estate loans
 
514,831

 
88.3
%
 
456,520

 
87.6
%
 
356,406

 
81.9
%
 
307,089

 
79.8
%
 
294,968

 
82.6
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other loans:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Commercial business
 
58,941

 
10.1
%
 
57,788

 
11.1
%
 
71,948

 
16.5
%
 
70,185

 
18.2
%
 
53,214

 
14.9
%
Consumer
 
9,589

 
1.6
%
 
6,672

 
1.3
%
 
6,742

 
1.6
%
 
7,598

 
2.0
%
 
9,117

 
2.6
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total other loans
 
68,530

 
11.7
%
 
64,460

 
12.4
%
 
78,690

 
18.1
%
 
77,783

 
20.2
%
 
62,331

 
17.4
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total loans receivable
 
583,361

 
100.0
%
 
520,980

 
100.0
%
 
435,096

 
100.0
%
 
384,872

 
100.0
%
 
357,299

 
100.0
%
Less:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Allowance for loan losses
 
6,127

 
 

 
5,545

 
 

 
5,205

 
 

 
5,224

 
 

 
4,869

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net loans receivable
 
$
577,234

 
 

 
$
515,435

 
 

 
$
429,891

 
 

 
$
379,648

 
 

 
$
352,430

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The following table sets forth the final maturity of loans in the Corporation’s portfolio as of December 31, 2017. Demand loans having no stated schedule of repayment and no stated maturity are reported as due within one year.
 
 
Due in one
 
Due from one
 
Due from five
 
Due after
 
 
(Dollar amounts in thousands)
 
year or less
 
to five years
 
to ten years
 
ten years
 
Total
Residential mortgages
 
$
6,870

 
$
3,601

 
$
13,704

 
$
197,648

 
$
221,823

Home equity loans and lines of credit
 
697

 
10,396

 
23,769

 
65,078

 
99,940

Commercial real estate
 
1,170

 
24,230

 
64,773

 
102,895

 
193,068

Commercial business
 
968

 
13,254

 
18,305

 
26,414

 
58,941

Consumer
 
271

 
5,179

 
2,678

 
1,461

 
9,589

 
 
 
 
 
 
 
 
 
 
 
 
 
$
9,976

 
$
56,660

 
$
123,229

 
$
393,496

 
$
583,361

 
 
 
 
 
 
 
 
 
 
 
 
The following table sets forth the dollar amount of the Corporation’s fixed and adjustable rate loans with maturities greater than one year as of December 31, 2017:
 
 
Fixed
 
Adjustable
(Dollar amounts in thousands)
 
rates
 
rates
Residential mortgages
 
$
203,556

 
$
11,397

Home equity loans and lines of credit
 
85,010

 
14,233

Commercial real estate
 
60,390

 
131,508

Commercial business
 
25,667

 
32,306

Consumer
 
7,605

 
1,713

 
 
 
 
 
 
 
$
382,228

 
$
191,157

 
 
 
 
 


K-5




Contractual maturities of loans do not reflect the actual term of the Corporation’s loan portfolio. The average life of mortgage loans is substantially less than their contractual terms because of loan prepayments and enforcement of due-on-sale clauses, which give the Corporation the right to declare a loan immediately payable in the event, among other things, that the borrower sells the real property subject to the mortgage. Scheduled principal amortization also reduces the average life of the loan portfolio. The average life of mortgage loans tends to increase when current market mortgage rates substantially exceed rates on existing mortgages and conversely, decrease when rates on existing mortgages substantially exceed current market interest rates.
 
Delinquencies and Classified Assets
 
Delinquent Loans and Other Real Estate Acquired Through Foreclosure (OREO). Typically, a loan is considered past due and a late charge is assessed when the borrower has not made a payment within 15 days from the payment due date. When a borrower fails to make a required payment on a loan, the Corporation attempts to cure the deficiency by contacting the borrower. The initial contact with the borrower is made shortly after the 17th day following the due date for which a payment was not received. In most cases, delinquencies are cured promptly.
 
If the delinquency exceeds 60 days, the Corporation works with the borrower to set up a satisfactory repayment schedule. Typically, loans are considered nonaccruing upon reaching 90 days delinquent unless the credit is well secured and in the process of collection, although the Corporation may be receiving partial payments of interest and partial repayments of principal on such loans. When a loan is placed in nonaccrual status, previously accrued but unpaid interest is deducted from interest income. The Corporation institutes foreclosure action on secured loans only if all other remedies have been exhausted. If an action to foreclose is instituted and the loan is not reinstated or paid in full, the property is sold at a judicial or trustee’s sale at which the Corporation may be the buyer.
 
Real estate properties acquired through, or in lieu of, foreclosure are to be sold and are initially recorded at fair value at the date of foreclosure less costs to sell, thereby establishing a new cost basis. After foreclosure, management periodically performs valuations and the real estate is carried at the lower of carrying amount or fair value less the cost to sell the property. Revenue and expenses from operations and changes in the valuation allowance are included in the loss on foreclosed real estate. The Corporation generally attempts to sell its OREO properties as soon as practical upon receipt of clear title.
 
As of December 31, 2017, the Corporation’s nonperforming assets were $4.2 million, or 0.56% of the Corporation’s total assets, compared to $3.6 million, or 0.52% of the Corporation’s total assets, at December 31, 2016. Nonperforming assets at December 31, 2017 included nonaccrual loans and OREO of $3.7 million and $492,000, respectively. Included in nonaccrual loans at December 31, 2017 were four loans totaling $433,000 considered to be troubled debt restructurings (TDRs).
 
Classified Assets. Regulations applicable to insured institutions require the classification of problem assets as “substandard,” “doubtful,” or “loss” depending upon the existence of certain characteristics as discussed below. A category designated “special mention” must also be maintained for assets currently not requiring the above classifications but having potential weakness or risk characteristics that could result in future problems. An asset is classified as substandard if not adequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. A substandard asset is characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have all the weaknesses inherent in those classified as substandard and these weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable or improbable. Assets classified as loss are considered uncollectible and of such little value that their continuance as assets is not warranted.
 
The Corporation’s classification of assets policy requires the establishment of valuation allowances for loan losses in an amount deemed prudent by management. Valuation allowances represent loss allowances that have been established to recognize the inherent risk associated with lending activities. When the Corporation classifies a problem asset as a loss, the portion of the asset deemed uncollectible is charged off immediately.
 
The Corporation regularly reviews the problem loans and other assets in its portfolio to determine whether any require classification in accordance with the Corporation’s policy and applicable regulations. As of December 31, 2017, the Corporation’s classified and criticized assets amounted to $14.8 million or 2.0% of total assets, with $3.2 million identified as special mention and $11.6 million classified as substandard.
 
Included in classified and criticized assets at December 31, 2017 are three large loan relationships exhibiting credit deterioration that may impact the ability of the borrowers to comply with their present loan repayment terms on a timely basis.
 

K-6




The first relationship, with an outstanding balance of $2.5 million at December 31, 2017, consists of one commercial mortgage originated for the construction of a hotel, restaurant and retail plaza secured by such property and the borrower’s personal residence. The hotel, restaurant and retail plaza are complete and operational; however, cash flows from operations have not been consistent and are impacted by the seasonal nature of the hotel. In addition, the borrower has limited liquidity. As a result, the borrower has listed substantial real estate holdings for sale. At December 31, 2017, the loan was performing and classified as substandard. Ultimately, due to the estimated value of the borrower’s significant real estate holdings, most of which are pledged as collateral for the subject loan, the Corporation does not currently expect to incur a loss on this loan.

The second relationship, with an outstanding balance of $2.1 million at December 31, 2017, consists of one commercial mortgage originated for the construction of a hotel and is secured by the hotel and all related furniture, fixtures and equipment. The hotel is complete and operational; however, cash flow from the first year of operations significantly lagged management’s projections, and as such, was insufficient for debt service requirements. Although results continue to evidence improvement in operating performance, cash flow remains deficient. The loan is guaranteed by the three principals, all of whom have significant net worth positions and the ability to support the operations of the hotel until stabilization can be achieved. At December 31, 2017, the loan was performing and classified as substandard. Ultimately, due to the estimated value of the hotel and the willingness and ability of the guarantors to support the loan, the Corporation does not currently expect to incur a loss on this loan.

The third relationship, with an outstanding balance of $1.9 million at December 31, 2017, consists of two commercial mortgages originated to acquire two separate commercial properties. The commercial properties, which are each leased to a national automobile service provider on a triple net basis, secure the subject loans. The financial performance of the first property is weak due to lower than expected rental income whereas the financial performance of the second property is satisfactory. The borrower is in the process of selling the second property, the proceeds of which will repay the loan related to the second property and substantially reduce the principal balance on the loan related to the first property, which will be re-amortized over the remaining term. Upon completion, cash flow of the first property is expected to be sufficient for the re-calculated debt service requirements. Irrespective of the pending sale, due to the estimated value of the two properties, the Corporation does not currently expect to incur a loss on the loans in this relationship.

The following table sets forth information regarding the Corporation’s nonperforming assets as of December 31:
(Dollar amounts in thousands)
 
2017
 
2016
 
2015
 
2014
 
2013
Nonperforming loans
 
$
3,693

 
$
3,323

 
$
3,069

 
$
6,942

 
$
5,207

 
 
 
 
 
 
 
 
 
 
 
Total as a percentage of gross loans
 
0.63
%
 
0.64
%
 
0.71
%
 
1.80
%
 
1.46
%
 
 
 
 
 
 
 
 
 
 
 
Repossessions
 

 

 

 

 

Real estate acquired through foreclosure
 
492

 
291

 
160

 
124

 
107

Total as a percentage of total assets
 
0.07
%
 
0.04
%
 
0.03
%
 
0.02
%
 
0.02
%
 
 
 
 
 
 
 
 
 
 
 
Total nonperforming assets
 
$
4,185

 
$
3,614

 
$
3,229

 
$
7,066

 
$
5,314

 
 
 
 
 
 
 
 
 
 
 
Total nonperforming assets as a percentage of total assets
 
0.56
%
 
0.52
%
 
0.54
%
 
1.21
%
 
1.01
%
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses as a percentage of nonperforming loans
 
165.91
%
 
166.87
%
 
169.60
%
 
75.25
%
 
93.51
%
 
 
 
 
 
 
 
 
 
 
 

Allowance for Loan Losses. Management establishes allowances for estimated losses on loans based upon its evaluation of the pertinent factors underlying the types and quality of loans; historical loss experience based on volume and types of loans; trend in portfolio volume and composition; level and trend of nonperforming assets; detailed analysis of individual loans for which full collectability may not be assured; determination of the existence and realizable value of the collateral and guarantees securing such loans and the current economic conditions affecting the collectability of loans in the portfolio. The Corporation analyzes its loan portfolio at least quarterly for valuation purposes and to determine the adequacy of its allowance for loan losses. Based upon the factors discussed above, management believes that the Corporation’s allowance for loan losses as of December 31, 2017 of $6.1 million was adequate to cover probable incurred losses in the portfolio at such time.

K-7




The following table sets forth an analysis of the allowance for losses on loans receivable for the years ended December 31: 
(Dollar amounts in thousands)
 
2017
 
2016
 
2015
 
2014
 
2013
Balance at beginning of period
 
$
5,545

 
$
5,205

 
$
5,224

 
$
4,869

 
$
5,350

 
 
 
 
 
 
 
 
 
 
 
Provision for loan losses
 
903

 
464

 
381

 
670

 
580

 
 
 
 
 
 
 
 
 
 
 
Charge-offs:
 
 

 
 

 
 

 
 

 
 

Residential mortgages
 
(40
)
 
(101
)
 
(79
)
 
(134
)
 
(36
)
Home equity loans and lines of credit
 
(114
)
 
(118
)
 
(221
)
 
(72
)
 
(68
)
Commercial real estate
 
(127
)
 
(18
)
 
(35
)
 
(2
)
 
(941
)
Commercial business
 
(14
)
 
(11
)
 
(182
)
 
(17
)
 

Consumer loans
 
(71
)
 
(48
)
 
(50
)
 
(139
)
 
(85
)
 
 
(366
)
 
(296
)
 
(567
)
 
(364
)
 
(1,130
)
 
 
 
 
 
 
 
 
 
 
 
Recoveries:
 
 

 
 

 
 

 
 

 
 

Residential mortgages
 

 

 

 

 
1

Home equity loans and lines of credit
 
23

 
3

 
30

 
1

 

Commercial real estate
 
8

 
158

 
88

 
18

 
8

Commercial business
 
2

 

 
31

 
7

 
18

Consumer loans
 
12

 
11

 
18

 
23

 
42

 
 
45

 
172

 
167

 
49

 
69

 
 
 
 
 
 
 
 
 
 
 
Net charge-offs
 
(321
)
 
(124
)
 
(400
)
 
(315
)
 
(1,061
)
 
 
 
 
 
 
 
 
 
 
 
Balance at end of period
 
$
6,127

 
$
5,545

 
$
5,205

 
$
5,224

 
$
4,869

 
 
 
 
 
 
 
 
 
 
 
Ratio of net charge-offs to average loans outstanding
 
0.06
%
 
0.03
%
 
0.10
%
 
0.08
%
 
0.30
%
 
 
 
 
 
 
 
 
 
 
 
Ratio of allowance to total loans at end of period
 
1.05
%
 
1.06
%
 
1.20
%
 
1.36
%
 
1.36
%
 
 
 
 
 
 
 
 
 
 
 
 
The following table provides a breakdown of the allowance for loan losses by major loan category for the years ended December 31:
(Dollar amounts in thousands)
 
2017
 
2016
 
2015
 
2014
 
2013
 
 
Dollar Amount
 
Percent of loans in each category to total loans
 
Dollar Amount
 
Percent of loans in each category to total loans
 
Dollar Amount
 
Percent of loans in each category to total loans
 
Dollar Amount
 
Percent of loans in each category to total loans
 
Dollar Amount
 
Percent of loans in each category to total loans
Loan Categories:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Residential mortgages
 
$
2,090

 
38.1
%
 
$
1,846

 
32.0
%
 
$
1,429

 
27.8
%
 
$
955

 
29.5
%
 
$
923

 
28.7
%
Home equity loans and lines of credit
 
646

 
17.1
%
 
633

 
20.1
%
 
586

 
23.2
%
 
543

 
24.6
%
 
625

 
25.2
%
Commercial real estate
 
2,753

 
33.1
%
 
2,314

 
29.8
%
 
2,185

 
28.8
%
 
2,338

 
28.4
%
 
2,450

 
29.2
%
Commercial business
 
585

 
10.1
%
 
700

 
16.5
%
 
960

 
18.2
%
 
1,336

 
14.9
%
 
822

 
13.4
%
Consumer loans
 
53

 
1.6
%
 
52

 
1.6
%
 
45

 
2.0
%
 
52

 
2.6
%
 
49

 
3.5
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
$
6,127

 
100
%
 
$
5,545

 
100
%
 
$
5,205

 
100
%
 
$
5,224

 
100
%
 
$
4,869

 
100
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

K-8




Investment Activities
 
General. The Corporation maintains an investment portfolio of securities such as U.S. government agencies, mortgage-backed securities, municipal and equity securities.
 
Investment decisions are made within policy guidelines as established by the Board of Directors. This policy is aimed at maintaining a diversified investment portfolio, which complements the overall asset/liability and liquidity objectives of the Corporation, while limiting the related credit risk to an acceptable level.

The following table sets forth certain information regarding the fair value, weighted average yields and contractual maturities of the Corporation’s securities as of December 31, 2017:
 
 
Due in 1
 
Due from 1
 
Due from 3
 
Due from 5
 
Due after
 
No 
scheduled
 
 
(Dollar amounts in thousands)
 
year or less
 
to 3 years
 
to 5 years
 
to 10 years
 
10 years
 
maturity
 
Total
U.S. Treasury
 
$

 
$
1,475

 
$
2,997

 
$

 
$

 
$

 
$
4,472

U.S. government sponsored entities and agencies
 

 
1,985

 
9,462

 
2,479

 

 

 
13,926

U.S. agency mortgage-backed securities: residential
 

 

 

 

 
20,758

 

 
20,758

U.S. agency collateralized mortgage obligations: residential
 

 

 

 
2,136

 
19,788

 

 
21,924

Corporate securities
 
1,499

 

 
2,493

 
4,538

 
500

 

 
9,030

State and political subdivision
 
350

 
4,112

 
9,767

 
11,509

 
3,502

 

 
29,240

Equity securities
 

 

 

 

 

 
1,817

 
1,817

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Estimated fair value
 
$
1,849

 
$
7,572

 
$
24,719

 
$
20,662

 
$
44,548

 
$
1,817

 
$
101,167

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average yield (1)
 
1.60
%
 
1.98
%
 
2.07
%
 
3.26
%
 
2.14
%
 
3.43
%
 
2.35
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1) Taxable equivalent adjustments have been made in calculating yields on state and political subdivision securities.
 
The following table sets forth the fair value of the Corporation’s investment securities as of December 31:
(Dollar amounts in thousands)
 
2017
 
2016
 
2015
U.S. Treasury
 
$
4,472

 
$
4,500

 
$
1,466

U.S. government sponsored entities and agencies
 
13,926

 
8,998

 
8,953

U.S. agency mortgage-backed securities: residential
 
20,758

 
25,626

 
33,150

U.S. agency collateralized mortgage obligations: residential
 
21,924

 
24,706

 
31,440

Corporate securities
 
9,030

 
7,932

 
7,487

State and political subdivision
 
29,240

 
27,608

 
28,591

Equity securities
 
1,817

 
2,190

 
1,894

 
 
$
101,167

 
$
101,560

 
$
112,981

 
 
 
 
 
 
 
 
For additional information regarding the Corporation’s investment portfolio see “Note 2 – Securities” to the consolidated financial statements on page F-15.
 

K-9




Sources of Funds
 
General. Deposits are the primary source of the Corporation’s funds for lending and investing activities. Secondary sources of funds are derived from loan repayments, investment maturities and borrowed funds. Loan repayments can be considered a relatively stable funding source, while deposit activity is greatly influenced by interest rates and general market conditions. The Corporation also has access to funds through other various sources. For additional information about the Corporation’s sources of funds, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity” in Item 7.
 
Deposits. The Corporation offers a wide variety of deposit account products to both consumer and commercial deposit customers, including time deposits, noninterest bearing and interest bearing demand deposit accounts, savings deposits and money market accounts.
 
Deposit products are promoted in periodic newspaper, radio and other forms of advertisements, along with notices provided in customer account statements. The Corporation’s marketing strategy is based on its reputation as a community bank that provides quality products and personalized customer service.
 
The Corporation sets interest rates on its interest bearing deposit products that are competitive with rates offered by other financial institutions in its market area. Management reviews interest rates on deposits bi-weekly and considers a number of factors, including: (1) the Corporation’s internal cost of funds; (2) rates offered by competing financial institutions; (3) investing and lending opportunities; and (4) the Corporation’s liquidity position.

The following table summarizes the Corporation’s deposits as of December 31:
(Dollar amounts in thousands)
 
2017
 
2016
 
 
Weighted
 
 
 
 
 
Weighted
 
 
 
 
Type of accounts
 
average rate
 
Amount
 
%
 
average rate
 
Amount
 
%
Non-interest bearing deposits
 

 
$
126,263

 
19.3
%
 

 
$
123,717

 
21.2
%
Interest bearing demand deposits
 
0.44
%
 
357,693

 
54.6
%
 
0.21
%
 
304,265

 
52.0
%
Time deposits
 
1.58
%
 
170,687

 
26.1
%
 
1.44
%
 
156,958

 
26.8
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
0.65
%
 
$
654,643

 
100.0
%
 
0.50
%
 
$
584,940

 
100.0
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The following table sets forth maturities of the Corporation’s time deposits of $100,000 or more at December 31, 2017 by time remaining to maturity:
(Dollar amounts in thousands)
 
Amount
 
 
 
Three months or less
 
$
6,426

Over three months to six months
 
6,025

Over six months to twelve months
 
11,063

Over twelve months
 
69,186

 
 
 

 
 
$
92,700

 
 
 
 

K-10




Borrowings. Borrowings may be used to compensate for reductions in deposit inflows or net deposit outflows, or to support lending and investment activities. These borrowings include FHLB advances, federal funds, repurchase agreements, advances from the Federal Reserve Discount Window and lines of credit at the Bank and the Corporation with other correspondent banks. The following table summarizes information with respect to borrowings at or for the years ending December 31: 
(Dollar amounts in thousands)
 
2017
 
2016
Ending balance
 
$
26,000

 
$
44,000

Average balance
 
40,537

 
37,482

Maximum balance
 
54,250

 
52,750

Average rate
 
3.00
%
 
3.08
%
 
For additional information regarding the Corporation’s deposit base and borrowed funds, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Deposits and Borrowed Funds” in Item 7 and “Note 8 – Deposits” on page F-26 and “Note 9 – Borrowed Funds” on page F-27 to the consolidated financial statements.
 
Subsidiary Activity
 
The Corporation has two wholly owned subsidiaries, the Bank and the Title Company. The Title Company provides real estate settlement services to the Bank and other customers. As of December 31, 2017, the Bank and the Title Company had no subsidiaries.
 
Personnel
 
At December 31, 2017, the Corporation had 137 full time equivalent employees, compared to 131 at December 31, 2016. There is no collective bargaining agreement between the Corporation and its employees, and the Corporation believes its relationship with its employees is satisfactory.

Competition
 
The Corporation competes for loans, deposits and customers with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions and other nonbank financial service providers.
 
Supervision and Regulation
 
General. Bank holding companies and banks are extensively regulated under both federal and state law. Set forth below is a summary description of certain provisions of certain laws that relate to the regulation of the Corporation and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
 
The Corporation. The Corporation is a registered bank holding company and subject to regulation and examination by the FRB under the BHCA. The Corporation is required to file periodic reports with the FRB and such additional information as the FRB may require. Recent changes to the Bank Holding Company rating system emphasize risk management and evaluation of the potential impact of non-depository entities on safety and soundness.
 
The FRB may require the Corporation to terminate an activity or terminate control of or liquidate or divest certain subsidiaries, affiliates or investments when the FRB believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. The FRB also has the authority to regulate provisions of certain bank holding company debt, including the authority to impose interest rate ceilings and reserve requirements on such debt. Under certain circumstances, the Corporation must file written notice and obtain FRB approval prior to purchasing or redeeming its equity securities.
 
The Corporation is required to obtain prior FRB approval for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior FRB approval is also required for the merger or consolidation of the Corporation and another bank holding company.
 

K-11




The BHCA generally prohibits a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or furnishing services to its subsidiaries. However, subject to the prior FRB approval, a bank holding company may engage in any, or acquire shares of companies engaged in, activities that the FRB deems to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
 
The BHCA also authorizes bank holding companies to engage in securities, insurance and other activities that are financial in nature or incidental to a financial activity. In order to undertake these activities, a bank holding company must become a financial holding company by submitting to the appropriate FRB a declaration that the company elects to be a financial holding company and a certification that all of the depository institutions controlled by the company are well capitalized and well managed. The Corporation submitted a declaration of election to become a financial holding company with the FRB which became effective in March 2007. Federal legislation also directed federal regulators to require depository institution holding companies to serve as a source of strength for their depository institution subsidiaries.

Under FRB regulations, the Corporation is required to serve as a source of financial and managerial strength to the Bank and may not conduct operations in an unsafe or unsound manner. In addition, it is the FRB’s policy that a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice or a violation of FRB regulations or both.
 
The Corporation is also a bank holding company within the meaning of the Pennsylvania Banking Code. As such, the Corporation and its subsidiaries are subject to examination by, and may be required to file reports with, the Pennsylvania Department of Banking and Securities.
 
The Corporation’s securities are registered with the SEC under the Exchange Act. As such, the Corporation is subject to the information, proxy solicitation, insider trading, corporate governance, and other requirements and restrictions of the Exchange Act. The public may obtain all forms and information filed with the SEC through its website http://www.sec.gov.
 
In December 2013, federal regulators adopted final rules to implement the provisions of the Dodd Frank Act commonly referred to as the Volcker Rule and established July 21, 2015 as the end of the conformance period. The regulations contain prohibitions and restrictions on the ability of financial institutions, holding companies and their affiliates to engage in proprietary trading and to hold certain interests in, or to have certain relationships with, various types of investment funds, including hedge funds and private equity funds.
 
The Bank. As a national banking association, the Bank is subject to primary supervision, examination and regulation by the OCC. The Bank is also subject to regulations of the FDIC as administrator of the Deposit Insurance Fund (DIF) and the FRB. If, as a result of an examination of the Bank, the OCC should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of the Bank’s operations are unsatisfactory or that the Bank is violating or has violated any law or regulation, various remedies are available to the OCC. Such remedies include the power to enjoin “unsafe or unsound practices,” to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the Bank’s growth, to assess civil monetary penalties, and to remove officers and directors. The FDIC has similar enforcement authority, in addition to its authority to terminate the Bank’s deposit insurance in the absence of action by the OCC and upon a finding that the Bank is operating in an unsafe or unsound condition, is engaging in unsafe or unsound activities, or that the Bank’s conduct poses a risk to the deposit insurance fund or may prejudice the interest of its depositors.
 
A national bank may have a financial subsidiary engaged in any activity authorized for national banks directly or certain permissible activities. Generally, a financial subsidiary is permitted to engage in activities that are “financial in nature” or incidental thereto, even though they are not permissible for the national bank itself. The definition of “financial in nature” includes, among other items, underwriting, dealing in or making a market in securities, including, for example, distributing shares of mutual funds. The subsidiary may not, however, engage as principal in underwriting insurance, issue annuities or engage in real estate development or investment or merchant banking.
 

K-12




The Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 established a comprehensive framework to modernize and reform the oversight of public company auditing, improve the quality and transparency of financial reporting by those companies and strengthen the independence of auditors. Among other things, the legislation (i) created a public company accounting oversight board that is empowered to set auditing, quality control and ethics standards, to inspect registered public accounting firms, to conduct investigations and to take disciplinary actions, subject to SEC oversight and review; (ii) strengthened auditor independence from corporate management by limiting the scope of consulting services that auditors can offer their public company audit clients; (iii) heightened the responsibility of public company directors and senior managers for the quality of the financial reporting and disclosure made by their companies; (iv) adopted a number of provisions to deter wrongdoing by corporate management; (v) imposed a number of new corporate disclosure requirements; (vi) adopted provisions which generally seek to limit and expose to public view possible conflicts of interest affecting securities analysis; and (vii) imposed a range of new criminal penalties for fraud and other wrongful acts and extended the period during which certain types of lawsuits can be brought against a company or its insiders.
 
2010 Regulatory Reform. On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was signed into law. The goals of the Dodd-Frank Act included restoring public confidence in the financial system following the financial crisis, preventing another financial crisis and permitting regulators to identify shortfalls in the system before another financial crisis can occur. The Dodd Frank Act is also intended to promote a fundamental restructuring of federal banking regulation by taking a systemic view of regulation rather than focusing on regulation of individual financial institutions.
 
Many of the provisions in the Dodd Frank Act require that regulatory agencies draft implementing regulations. Implementation of the Dodd Frank Act has had and will continue to have a broad impact on the financial services industry by introducing significant regulatory and compliance changes including, among other things: (i) changing the assessment base for federal deposit insurance from the amount of insured deposits to average consolidated total assets less average tangible equity, eliminating the ceiling and increasing the size of the floor of the DIF and offsetting the impact of the increase in the minimum floor on institutions with less than $10 billion in assets; (ii) making permanent the $250,000 limit for federal deposit insurance and increasing the cash limit of Securities Investor Protection Corporation protection to $250,000; (iii) eliminating the requirement that the FDIC pay dividends from the DIF when the reserve ratio is between 1.35% and 1.50%, but continuing the FDIC’s authority to declare dividends when the reserve ratio at the end of a calendar year is at least 1.50%; however, the FDIC is granted sole discretion in determining whether to suspend or limit the declaration or payment of dividends; (iv) repealing the federal prohibition on payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts; (v) implementing certain corporate governance revisions that apply to all public companies, including regulations that require publicly traded companies to give shareholders a non-binding advisory vote to approve executive compensation, commonly referred to as a “say-on-pay” vote and an advisory role on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions; new director independence requirements and considerations to be taken into account by compensation committees and their advisers relating to executive compensation; additional executive compensation disclosures; and a requirement that companies adopt a policy providing for the recovery of executive compensation in the event of a restatement of its financial statements, commonly referred to as a “clawback” policy; (vi) centralizing responsibility for consumer financial protection by creating a new independent federal agency, the Consumer Financial Protection Bureau (CFPB) responsible for implementing federal consumer protection laws to be applicable to all depository institutions; (vii) imposing new requirements for mortgage lending, including new minimum underwriting standards, limitations on prepayment penalties and imposition of new mandated disclosures to mortgage borrowers; (viii) imposing new limits on affiliate transactions and causing derivative transactions to be subject to lending limits and other restrictions including adoption of the “Volcker Rule” regulating transactions in derivative securities; (ix) limiting debit card interchange fees that financial institutions with $10 billion or more in assets are permitted to charge their customers; and (x) implementing regulations to incentivize and protect individuals, commonly referred to as whistleblowers to report violations of federal securities laws.

Many aspects of the Dodd Frank Act continue to be subject to rulemaking and will take effect over several additional years, making it difficult to anticipate the overall financial impact on us or across the industry. The changes resulting from the Dodd Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business.
 
Anti-Money Laundering. All financial institutions, including national banks, are subject to federal laws that are designed to prevent the use of the U.S. financial system to fund terrorist activities. Financial institutions operating in the United States must develop anti-money laundering compliance programs, due diligence policies and controls to ensure the detection and reporting of money laundering. Such compliance programs are intended to supplement compliance requirements, also applicable to financial institutions, under the Bank Secrecy Act and the Office of Foreign Assets Control Regulations. The Bank has established policies and procedures to ensure compliance with these provisions.

K-13




Privacy. Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. Pursuant to these rules, financial institutions must provide (i) initial notices to customers about their privacy policies, describing conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates; (ii) annual notices of their privacy policies to current customers and (iii) a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties. These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. The Corporation’s privacy policies have been implemented in accordance with the law.
 
Dividends and Other Transfers of Funds. Dividends from the Bank constitute the principal source of income to the Corporation. The Corporation is a legal entity separate and distinct from the Bank. The Bank is subject to various statutory and regulatory restrictions on its ability to pay dividends to the Corporation. In addition, the Bank’s regulators have the authority to prohibit the Bank from paying dividends, depending upon the Bank’s financial condition, if such payment is deemed to constitute an unsafe or unsound practice.
 
Limitations on Transactions with Affiliates. Transactions between national banks and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a national bank includes any company or entity which controls the national bank or that is controlled by a company that controls the national bank. In a holding company context, the holding company of a national bank (such as the Corporation) and any companies which are controlled by such holding company are affiliates of the national bank. Generally, Section 23A limits the extent to which the national bank of its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such bank’s capital stock and surplus, and contains an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus. Section 23B applies to “covered transactions” as well as certain other transactions and requires that all transactions be on terms substantially the same, or at least as favorable, to the national bank as those provided to a non-affiliate. The term “covered transaction” includes the making of loans to, purchase of assets from and issuance of a guarantee to an affiliate and similar transactions. Section 23B transactions also include the provision of services and the sale of assets by a national bank to an affiliate.

In addition, Sections 22(g) and (h) of the Federal Reserve Act place restrictions on loans to executive officers, directors and principal shareholders of the national bank and its affiliates. Under Section 22(h), loans to a director, an executive officer and to a greater than 10% shareholder of a national bank, and certain affiliated interests of either, may not exceed, together with all other outstanding loans to such person and affiliated interests, the national bank’s loans to one borrower limit (generally equal to 15% of the bank’s unimpaired capital and surplus). Section 22(h) also requires that loans to directors, executive officers and principal shareholders be made on terms substantially the same as offered in comparable transactions to other persons unless the loans are made pursuant to a benefit or compensation program that (i) is widely available to employees of the bank and (ii) does not give preference to any director, executive officer or principal shareholder, or certain affiliated interests of either, over other employees of the national bank. Section 22(h) also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a national bank to all insiders cannot exceed the bank’s unimpaired capital and surplus. Furthermore, Section 22(g) places additional restrictions on loans to executive officers. The Bank currently is subject to Sections 22(g) and (h) of the Federal Reserve Act and at December 31, 2017, was in compliance with the above restrictions.
 
Loans to One Borrower Limitations. With certain limited exceptions, the maximum amount that a national bank may lend to any borrower (including certain related entities of the borrower) at one time may not exceed 15% of the unimpaired capital and surplus of the institution, plus an additional 10% of unimpaired capital and surplus for loans fully secured by readily marketable collateral. At December 31, 2017, the Bank’s loans-to-one-borrower limit was $9.6 million based upon the 15% of unimpaired capital and surplus measurement. The Bank may grant credit to borrowers in excess of the legal lending limit as part of the Legal Lending Limit Pilot Program approved by the OCC which allows the Bank to exceed its legal lending limit within certain parameters. At December 31, 2017, the Bank’s largest single lending relationship had an outstanding balance of $7.6 million.
 
Capital Standards. The Bank is required to comply with applicable capital adequacy standards established by the federal banking agencies. Beginning on January 1, 2015, the Bank became subject to a new comprehensive capital framework for U.S. banking organizations. In July 2013, the Federal Reserve Board, FDIC and OCC adopted a final rule that implements the Basel III changes to the international regulatory capital framework. The Basel III rules include requirements contemplated by the Dodd Frank Act as well as certain standards initially adopted by the Basel Committee on Banking Supervision in December 2010.


K-14




The Basel III rules include new risk-based and leverage capital ratio requirements that refine the definition of what constitutes “capital” for purposes of calculating those ratios. The minimum capital level requirements are (i) a new common equity Tier 1 risk-based capital ratio of 4.5%; (ii) a Tier 1 risk-based capital ratio of 6% (increased from 4%); (iii) a total risk-based capital ratio of 8% (unchanged from previous rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. Common equity Tier 1 capital will consist of retained earnings and common stock instruments, subject to certain adjustments.
 
The Basel III rules also establish a fully-phased “capital conservation buffer” of 2.5% above the new regulatory minimum risk-based capital requirements. The conversation buffer, when added to the capital requirements, results in the following minimum ratios: (i) a common equity Tier 1 risk-based capital ratio of 7.0%, (ii) a Tier 1 risk-based capital ratio of 8.5% and (iii) a total risk-based capital ratio of 10.5%. The new capital conservation buffer requirement is to be phased in beginning January 2016 at 0.625% of risk-weighted assets and will increase by that amount each year until fully implemented in January 2019. An institution is subject to limitations on certain activities including payment of dividends, share repurchases and discretionary bonuses to executive officers if its capital level is below the buffer amount.

The Basel III rules also revise the prompt corrective action framework, which is designed to place restrictions on insured depository institutions if their capital levels do not meet certain thresholds. These revisions were effective January 1, 2015. The prompt corrective action rules were modified to include a common equity Tier 1 capital component and to increase certain other capital requirements for the various thresholds. Under the proposed prompt corrective action rules, insured depository institutions are required to meet the following capital levels in order to qualify as “well capitalized”: (i) a new common equity Tier 1 risk-based capital ratio of 6.5%; (ii) a Tier 1 risk-based capital ratio of 8% (increased from 6%); (iii) a total risk-based capital ratio of 10% (unchanged from previous rules); and (iv) a Tier 1 leverage ratio of 5% (unchanged from previous rules).
 
The Basel III rules set forth certain changes in the methods of calculating risk-weighted assets, which in turn affect the calculation of risk based ratios. Under the Basel III rules, higher or more sensitive risk weights are assigned to various categories of assets including certain credit facilities that finance the acquisition, development or construction of real property, certain exposures of credits that are 90 days past due or on nonaccrual, foreign exposures and certain corporate exposures. In addition, Basel III rules include (i) alternate standards of credit worthiness consistent with the Dodd Frank Act; (ii) greater recognition of collateral guarantees and (iii) revised capital treatment for derivatives and repo-style transactions.
 
In addition, the final rule includes certain exemptions to address concerns about the regulatory burden on community banks. Banking organizations with less than $15 billion in consolidated assets as of December 31, 2009 are permitted to include in Tier 1 capital trust preferred securities and cumulative perpetual preferred stock issued and included in Tier 1 capital prior to May 19, 2010 on a permanent basis without any phase out. Community banks were required to make this election by their March 31, 2015 quarterly filings with the appropriate federal regulator to opt-out of the requirement to include most accumulated other comprehensive income (AOCI) components in the calculation of Common equity Tier 1 capital and in effect retain the AOCI treatment under the current capital rules. The Bank made in its March 31, 2015 quarterly filing a one-time permanent election to continue to exclude accumulated other comprehensive income from capital. If it would not have made this election, unrealized gains and losses would have been included in the calculation of its regulatory capital.
 
The Basel III rules generally became effective beginning January 1, 2015; however, certain calculations under the Basel III rules have phase-in periods. In 2015, the Board of Governors of the Federal Reserve System amended its Small Bank Holding Company Policy Statement by increasing the policy’s consolidated assets threshold from $500 million to $1 billion. The primary benefit of being deemed a "small bank holding company" is the exemption from the requirement to maintain consolidated regulatory capital ratios; instead, regulatory capital ratios only apply at the subsidiary bank level.


K-15




The following table sets forth certain information concerning regulatory capital ratios of the Bank as of the dates presented. The capital adequacy ratios disclosed below are exclusive of the capital conservation buffer.
 
 
December 31, 2017
 
December 31, 2016
(Dollar amounts in thousands)
 
Amount
 
Ratio
 
Amount
 
Ratio
Total capital to risk-weighted assets:
 
 

 
 

 
 

 
 

Actual
 
$
64,221

 
12.96
%
 
$
58,605

 
13.23
%
For capital adequacy purposes
 
39,630

 
8.00
%
 
35,424

 
8.00
%
To be well capitalized
 
49,537

 
10.00
%
 
44,280

 
10.00
%
Tier 1 capital to risk-weighted assets:
 
 

 
 

 
 

 
 

Actual
 
$
58,088

 
11.73
%
 
$
53,050

 
11.98
%
For capital adequacy purposes
 
29,722

 
6.00
%
 
26,568

 
6.00
%
To be well capitalized
 
39,630

 
8.00
%
 
35,424

 
8.00
%
Common Equity Tier 1 capital to risk-weighted assets:
 
 

 
 

 
 

 
 

Actual
 
$
58,088

 
11.73
%
 
$
53,050

 
11.98
%
For capital adequacy purposes
 
22,292

 
4.50
%
 
19,926

 
4.50
%
To be well capitalized
 
32,199

 
6.50
%
 
28,782

 
6.50
%
Tier 1 capital to average assets:
 
 

 
 

 
 

 
 

Actual
 
$
58,088

 
7.71
%
 
$
53,050

 
7.84
%
For capital adequacy purposes
 
30,117

 
4.00
%
 
27,081

 
4.00
%
To be well capitalized
 
37,647

 
5.00
%
 
33,852

 
5.00
%
 
Prompt Corrective Action and Other Enforcement Mechanisms. Federal banking agencies possess broad powers to take corrective and other supervisory action to resolve the problems of insured depository institutions, including but not limited to those institutions that fall below one or more prescribed minimum capital ratios. Each federal banking agency has promulgated regulations defining the following five categories in which an insured depository institution will be placed, based on its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. At December 31, 2017, the Bank exceeded the required ratios for classification as “well capitalized.”
 
An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized, or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat a significantly undercapitalized institution as critically undercapitalized.
 
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation, or any condition imposed in writing by the agency or any written agreement with the agency. Finally, pursuant to an interagency agreement, the FDIC can examine any institution that has a substandard regulatory examination score or is considered undercapitalized – without the permission of the institution’s primary regulator.


K-16




Safety and Soundness Standards. The federal banking agencies have adopted guidelines designed to assist the federal banking agencies in identifying and addressing potential safety and soundness concerns before capital becomes impaired. The guidelines set forth operational and managerial standards relating to: (i) internal controls, information systems and internal audit systems, (ii) loan documentation, (iii) credit underwriting, (iv) asset growth, (v) earnings, and (vi) compensation, fees and benefits. In addition, the federal banking agencies have also adopted safety and soundness guidelines with respect to asset quality and earnings standards. These guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. Under these standards, an insured depository institution should: (i) conduct periodic asset quality reviews to identify problem assets, (ii) estimate the inherent losses in problem assets and establish reserves that are sufficient to absorb estimated losses, (iii) compare problem asset totals to capital, (iv) take appropriate corrective action to resolve problem assets, (v) consider the size and potential risks of material asset concentrations, and (vi) provide periodic asset quality reports with adequate information for management and the board of directors to assess the level of asset risk. These guidelines also set forth standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient for the maintenance of adequate capital and reserves.
 
Insurance of Accounts. Deposit accounts are currently insured by the DIF generally up to a maximum of $250,000 per separately insured depositor. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, insured institutions. It also may prohibit any insured institution from engaging in any activity determined by regulation or order to pose a serious threat to the FDIC. The FDIC also has the authority to initiate enforcement actions against insured institutions.

The Dodd Frank Act raises the minimum reserve ratio of the DIF from 1.15% to 1.35% and requires the FDIC to offset the effect of this increase on insured institutions with assets of less than $10 billion (small institutions). In March 2016, the FDIC adopted a rule to accomplish this by imposing a surcharge on larger institutions commencing when the reserve ratio reaches 1.15% and ending when it reaches 1.35%. The reserve ratio reached 1.15% effective as of June 30, 2016. The surcharge period began effective July 1, 2016 and is expected to end by December 31, 2018. Small institutions will receive credits for the portion of their regular assessments that contributed to growth in the reserve ratio between 1.15% and 1.35%. The credits will apply to reduce regular assessments by 2.0 basis points for quarters when the reserve ratio is at least 1.38%.
Effective July 1, 2016, the FDIC adopted changes that eliminated its risk-based premium system. Under the new premium system, the FDIC assesses deposit insurance premiums on the assessment base of a depository institution, which is its average total assets reduced by the amount of its average tangible equity. For a small institution (one with assets of less than $10 billion) that has been federally insured for at least five years, effective July 1, 2016, the initial base assessment rate ranges from 3 to 30 basis points, based on the institution’s CAMELS composite and component ratings and certain financial ratios; its leverage ratio; its ratio of net income before taxes to total assets; its ratio of nonperforming loans and leases to gross assets; its ratio of other real estate owned to gross assets; its brokered deposits ratio (excluding reciprocal deposits if the institution is well capitalized and has a CAMELS composite rating of 1 or 2); its one year asset growth ratio (which penalizes growth adjusted for mergers in excess of 10%); and its loan mix index (which penalizes higher risk loans based on historical industry charge off rates).  The initial base assessment rate is subject to downward adjustment (not below 1.5%) based on the ratio of unsecured debt the institution has issued to its assessment base, and to upward adjustment (which can cause the rate to exceed 30 basis points) based on its holdings of unsecured debt issued by other insured institutions. Institutions with assets of $10 billion or more are assessed using a scorecard method.
 
In addition, all FDIC insured institutions are required to pay assessments to the FDIC at an annual rate of approximately six tenths of a 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.
 
Under the Federal Deposit Insurance Act, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule order or condition imposed by the FDIC.
 
Interstate Banking and Branching. Banks have the ability, subject to certain state restrictions, to acquire, by acquisition or merger, branches outside its home state. In addition, federal legislation permits a bank headquartered in Pennsylvania to enter another state through de novo branching (as compared to an acquisition) if under the state law in the state which the proposed branch is to be located a state-chartered institution would be permitted to establish the branch. Interstate branches are subject to certain laws of the states in which they are located. Competition may increase further as banks branch across state lines and enter new markets.
 

K-17




Consumer Protection Laws and Regulations. The bank regulatory agencies are focusing greater attention on compliance with consumer protection laws and their implementing regulations. Examination and enforcement have become more intense in nature, and insured institutions have been advised to carefully monitor compliance with such laws and regulations. The Bank is subject to many federal consumer protection statutes and regulations, some of which are discussed below.

The Community Reinvestment Act (CRA) is intended to encourage insured depository institutions, while operating safely and soundly, to help meet the credit needs of their communities. The CRA specifically directs the federal regulatory agencies, in examining insured depository institutions, to assess a bank’s record of helping meet the credit needs of its entire community, including low- and moderate-income neighborhoods, in a manner consistent with safe and sound banking practices. CRA regulations (i) establish the definition of “Intermediate Small Bank” as an institution with total assets of $250 million to $1 billion, without regard to any holding company; and (ii) take into account abusive lending practices by a bank or its affiliates in determining a bank’s CRA rating. The CRA further requires the agencies to take a financial institution’s record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, mergers or acquisitions, or holding company formations. The agencies use the CRA assessment factors in order to provide a rating to the financial institution. The ratings range from a high of “outstanding” to a low of “substantial noncompliance.” In its last examination for CRA compliance, as of September 10, 2015, the Bank was rated “satisfactory.”
 
The Fair Credit Reporting Act (FCRA), as amended by the Fair and Accurate Credit Transactions Act of 2003 (FACTA), requires financial firms to help deter identity theft, including developing appropriate fraud response programs, and give consumers more control of their credit data. It also reauthorizes a federal ban on state laws that interfere with corporate credit granting and marketing practices. In connection with the FACTA, financial institution regulatory agencies proposed rules that would prohibit an institution from using certain information about a consumer it received from an affiliate to make a solicitation to the consumer, unless the consumer has been notified and given a chance to opt out of such solicitations. A consumer’s election to opt out would be applicable for at least five years.
 
The Federal Trade Commission (FTC), the federal bank regulatory agencies and the National Credit Union Administration (NCUA) have issued regulations (the Red Flag Rules) requiring financial institutions and creditors to develop and implement written identity theft prevention programs as part of the FACTA. The programs must provide for the identification, detection and response to patterns, practices or specific activities – known as red flags – that could indicate identity theft. These red flags may include unusual account activity, fraud alerts on a consumer report or attempted use of suspicious account application documents. The program must also describe appropriate responses that would prevent and mitigate the crime and detail a plan to update the program. The program must be managed by the Board of Directors or senior employees of the institution or creditor, include appropriate staff training and provide oversight of any service providers.
 
The Check Clearing for the 21st Century Act (Check 21) facilitates check truncation and electronic check exchange by authorizing a new negotiable instrument called a “substitute check,” which is the legal equivalent of an original check. Check 21 does not require banks to create substitute checks or accept checks electronically; however, it does require banks to accept a legally equivalent substitute check in place of an original.
 
The Equal Credit Opportunity Act (ECOA) generally prohibits discrimination in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs, or good faith exercise of any rights under the Consumer Credit Protection Act.
 
The Truth in Lending Act (TILA) is designed to ensure that credit terms are disclosed in a meaningful way so that consumers may compare credit terms more readily and knowledgeably. As a result of the TILA, all creditors must use the same credit terminology to express rates and payments, including the annual percentage rate, the finance charge, the amount financed, the total of payments and the payment schedule, among other things.

The Fair Housing Act (FHA) regulates many practices, including making it unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status. A number of lending practices have been found by the courts to be, or may be considered, illegal under the FHA, including some that are not specifically mentioned in the FHA itself.
 

K-18




The Home Mortgage Disclosure Act (HMDA) grew out of public concern over credit shortages in certain urban neighborhoods and provides public information that will help show whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located. The HMDA also includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes.
 
The term “predatory lending,” much like the terms “safety and soundness” and “unfair and deceptive practices,” is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. Generally speaking, predatory lending involves at least one, and perhaps all three, of the following elements (i) making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay an obligation (“asset-based lending”); (ii) inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced (“loan flipping”); and (iii) engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.
 
FRB regulations aimed at curbing such lending significantly widened the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers. Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid.
 
OCC guidelines require national banks and their operating subsidiaries to comply with certain standards when making or purchasing loans to avoid predatory or abusive residential mortgage lending practices. Failure to comply with the guidelines could be deemed an unsafe and unsound or unfair or deceptive practice, subjecting the bank to supervisory enforcement actions.
 
Finally, the Real Estate Settlement Procedures Act (RESPA) requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. Also, RESPA prohibits certain abusive practices, such as kickbacks, and places limitations on the amount of escrow accounts. Penalties under the above laws may include fines, reimbursements and other penalties. Due to heightened regulatory concern related to compliance with the CRA, FACTA, TILA, FHA, ECOA, HMDA and RESPA generally, the Bank may incur additional compliance costs or be required to expend additional funds for investments in its local community.
 
Federal Home Loan Bank System. The Bank is a member of the FHLB. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB. As an FHLB member, the Bank is required to own a certain amount of capital stock in the FHLB. At December 31, 2017, the Bank was in compliance with the stock requirements.
 
Federal Reserve System. The FRB requires all depository institutions to maintain noninterest bearing reserves at specified levels against their transaction accounts (primarily checking) and non-personal time deposits. At December 31, 2017, the Bank was in compliance with these requirements.

Item 1A. Risk Factors
 
Not required as the Corporation is a smaller reporting company.
 
Item 1B. Unresolved Staff Comments
 
None.
 
Item 2. Properties
 
The Corporation owns no real property but utilizes the main office of the Bank, which is owned by the Bank. The Corporation’s and the Bank’s executive offices are located at 612 Main Street, Emlenton, Pennsylvania. The Corporation pays no rent or other form of consideration for the use of this facility.
 
The Bank owns and leases numerous other premises for use in conducting business activities. The Bank considers these facilities owned or occupied under lease to be adequate. For additional information regarding the Bank’s properties, see “Note 5 - Premises and Equipment” to the consolidated financial statements on page F-25.
 

K-19




Item 3. Legal Proceedings
 
Neither the Bank nor the Corporation is involved in any material legal proceedings. The Bank, from time to time, is party to litigation that arises in the ordinary course of business, such as claims to enforce liens, claims involving the origination and servicing of loans, and other issues related to the business of the Bank. In the opinion of management, the resolution of any such issues would not have a material adverse impact on the financial position, results of operation, or liquidity of the Bank or the Corporation.
 
Item 4. Mine Safety Disclosures
 
Not applicable.

PART II
 
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Market, Holder and Dividend Information
 
Emclaire Financial Corp common stock is traded on NASDAQ Capital Market (NASDAQ) under the symbol “EMCF”. The listed market makers for the Corporation’s common stock include:
Boenning and Scattergood, Inc.
Janney Montgomery Scott LLC
Raymond James & Associates, Inc.
4 Tower Bridge
1717 Arch Street
222 South Riverside Plaza
200 Barr Harbor Drive, Suite 300
Philadelphia, PA  19103
Suite 2680
West Conshohocken, PA  19428-2979
Telephone:  (215) 665-6000
Chicago, IL  60606
Telephone:  (800) 883-1212
 
Telephone:  (312) 471-5100
 
The Corporation has traditionally paid regular quarterly cash dividends. Future dividends will be determined by the Board of Directors after giving consideration to the Corporation’s financial condition, results of operations, tax status, industry standards, economic conditions, regulatory requirements and other factors.
 
The following table sets forth the high and low sale and quarter-end closing market prices of our common stock for the last two years as reported by the Nasdaq Capital Market as well as cash dividends paid for the quarterly periods presented.
 
 
Market Price
 
Cash
 
 
High
 
Low
 
Close
 
Dividend
2017:
 
 

 
 

 
 

 
 

Fourth quarter
 
$
31.75

 
$
27.86

 
$
30.35

 
$
0.27

Third quarter
 
29.00

 
27.83

 
28.65

 
0.27

Second quarter
 
29.71

 
26.50

 
27.88

 
0.27

First quarter
 
31.50

 
26.13

 
29.25

 
0.27

 
 
 
 
 
 
 
 
 
2016:
 
 

 
 

 
 

 
 

Fourth quarter
 
$
30.00

 
$
24.02

 
$
29.25

 
$
0.26

Third quarter
 
24.95

 
23.29

 
24.62

 
0.26

Second quarter
 
25.00

 
23.61

 
23.94

 
0.26

First quarter
 
25.00

 
22.73

 
25.00

 
0.26

 
As of March 1, 2018, there were approximately 602 stockholders of record and 2,271,139 shares of common stock entitled to vote, receive dividends and considered outstanding for financial reporting purposes. The number of stockholders of record does not include the number of persons or entities who hold their stock in nominee or “street” name.
 

K-20




Common stockholders may have dividends reinvested to purchase additional shares through the Corporation’s dividend reinvestment plan. Participants may also make optional cash purchases of common stock through this plan. To obtain a plan document and authorization card to participate in the plan, please call 888-509-4619.
 
Purchases of Equity Securities
 
The Corporation did not repurchase any of its equity securities in the year ended December 31, 2017.
 
Item 6. Selected Financial Data
 
Not required as the Corporation is a smaller reporting company.
 
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis represents a review of the Corporation’s consolidated financial condition and results of operations for the years ended December 31, 2017 and 2016. This review should be read in conjunction with the consolidated financial statements beginning on page F-3.
 
Overview
 
The Corporation reported consolidated net income available to common stockholders of $4.3 million, or $1.93 per diluted common share for 2017, compared to $4.0 million, or $1.85 per diluted common share for 2016. Net income available to common stockholders was impacted by the following:
 
Net interest income increased $2.4 million, or 12.5%, in 2017. This increase primarily related to an increase in interest income of $3.0 million, or 12.7%, partially offset by an increase in interest expense of $548,000, or 13.9%. Driving the increase in interest income was a $69.7 million increase in the average balance of loans. The increase in interest expense was driven by increases in the Corporation's average balances of interest-bearing deposits and borrowed funds of $53.2 million and $3.1 million, respectively. The increases in the Corporation's interest-earning assets and interest-bearing liabilities includes the impact of the NHB acquisition in September 2017, which added $18.5 million in loans and $19.7 million in deposits at the time of the acquisition.
Noninterest income increased $1.4 million, or 37.4%, in 2017. This increase was primarily from a $1.3 million bargain purchase gain related to the acquisition of NHB. Also during 2017, the Corporation recorded a $508,000 other-than-temporary impairment charge on a subordinated debt investment, partially offset by securities gains of $346,000 realized during the same period.
Noninterest expense increased $2.2 million, or 12.6%, to $19.6 million for the year ended December 31, 2017 from $17.4 million for 2016. The increase primarily related to increases in acquisition costs, other noninterest expense, compensation and benefits and premises and equipment of $718,000, $714,000, $628,000 and $126,000, respectively. Acquisition costs related to the NHB acquisition totaled $1.1 million in 2017. Also contributing to the increases in noninterest expense were operating costs associated with this new office from the NHB acquisition as well as the full-year operation of two banking offices added during 2016.
Provision for income taxes increased $866,000, or 69.4%, to $2.1 million for the year ended December 31, 2017 from $1.2 million for 2016. This increase was primarily from an $827,000 write down of net deferred tax assets resulting from the enactment of the Tax Cuts and Jobs Act in December 2017.

Changes in Financial Condition
 
Total assets increased $57.9 million, or 8.4%, to $750.1 million at December 31, 2017 from $692.1 million at December 31, 2016. This increase primarily related to an increase in net loans receivable of $61.8 million, partially offset by a decrease in cash and cash equivalents of $3.2 million. Liabilities increased $52.9 million, or 8.3%, to $691.0 million at December 31, 2017 from $638.1 million at December 31, 2016 due to an increase in customer deposits of $69.7 million, partially offset by an $18.0 million decrease in borrowed funds. Loans and deposits acquired from NHB totaled $18.5 million and $19.7 million, respectively, at the time of the acquisition in September 2017.
 

K-21




Cash and cash equivalents. Cash and cash equivalents decreased $3.2 million, or 18.2%, to $14.4 million at December 31, 2017 from $17.6 million at December 31, 2016. This decrease primarily resulted from the funding of loans and the repayment of borrowed funds, partially offset by an increase in customer deposits.
 
Securities. Securities decreased $393,000 to $101.2 million at December 31, 2017 from $101.6 million at December 31, 2016. This decrease primarily resulted from investment security sales, maturities, calls and repayments totaling $29.8 million, partially offset by purchases totaling $29.5 million during the year.
 
Loans receivable. Net loans receivable increased $61.8 million, or 12.1%, to $577.2 million at December 31, 2017 from $515.4 million at December 31, 2016. The increase was driven by growth in the Corporation’s commercial mortgage, residential mortgage, home equity, consumer and commercial business portfolios of $26.1 million, $23.7 million, $8.6 million, $2.9 million and $1.2 million, respectively. Loans acquired from NHB totaled $18.5 million at the time of the acquisition in September 2017 and $17.4 million at December 31, 2017.
 
Nonperforming assets. Nonperforming assets include nonaccrual loans, loans 90 days past due and still accruing, repossessions and real estate owned. Nonperforming assets were $4.2 million, or 0.56% of total assets, at December 31, 2017 compared to $3.6 million, or 0.52% of total assets, at December 31, 2016. Nonperforming assets consisted of nonperforming loans and real estate owned of $3.6 million and $492,000, respectively, at December 31, 2017 and $3.3 million and $291,000, respectively, at December 31, 2016. At December 31, 2017, nonperforming loans consisted primarily of residential mortgage, commercial mortgage and commercial business loans.

Federal bank stocks. Federal bank stocks were comprised of FHLB stock and FRB stock of $3.3 million and $1.4 million, respectively, at December 31, 2017. These stocks are purchased and redeemed at par as directed by the federal banks and levels maintained are based primarily on borrowing and other correspondent relationships between the Corporation and the federal banks.

Bank-owned life insurance (BOLI). The Corporation maintains single premium life insurance policies on certain current and former officers and employees of the Bank. In addition to providing life insurance coverage, whereby the Bank as well as the officers and employees receive life insurance benefits, the appreciation of the cash surrender value of the BOLI will serve to offset and finance existing and future employee benefit costs. Increases in this account are typically associated with an increase in the cash surrender value of the policies, partially offset by certain administrative expenses. BOLI increased $334,000, or 2.9%, to $11.7 million at December 31, 2017 from $11.4 million at December 31, 2016.
 
Premises and equipment. Premises and equipment decreased $272,000, or 1.5%, to $18.0 million at December 31, 2017 from $18.3 million at December 31, 2016. The overall decrease in premises and equipment during the year was due to depreciation and amortizaton of $1.2 million, partially offset by capital expenditures of $204,000. Additions for 2017 also included $708,000 of fixed assets acquired from NHB.
 
Goodwill. Goodwill remained unchanged from $10.3 million at December 31, 2017 and December 31, 2016. Goodwill represents the excess of the total purchase price paid for the acquisition over the fair value of the identifiable assets acquired, net of the fair value of the liabilities assumed. Goodwill is evaluated for impairment at least annually and more frequently if events and circumstances indicate that the asset might be impaired. Management evaluated goodwill and concluded that no impairment existed at December 31, 2017.
 
Core deposit intangible. The core deposit intangible was $481,000 at December 31, 2017, compared to $560,000 at December 31, 2016. During 2017, the Corporation recorded a core deposit intangible of $167,000 related to the NHB acquisition. The core deposit intangible also includes amounts associated with the assumption of deposits in the 2016 UASB acquisition and the 2009 Titusville branch acquisition. This asset represents the long-term value of the core deposits acquired. In each instance, the fair value was determined using a third-party valuation expert specializing in estimating fair values of core deposit intangibles. The fair value was derived using an industry standard present value methodology. All-in costs and runoff balances by year were discounted by comparable term FHLB advance rates, used as an alternative cost of funds measure. This intangible asset amortizes utilizing the double declining balance method of amortization over a weighted average estimated life of the related deposits. The core deposit intangible asset is not estimated to have a significant residual value. The Corporation recorded $246,000 and $226,000 of intangible amortization in 2017 and 2016, respectively.
 

K-22




Deposits. Total deposits increased $69.7 million, or 11.9%, to $654.6 million at December 31, 2017 from $584.9 million at December 31, 2016. Noninterest bearing deposits increased $2.5 million, or 2.1%, during the year while interest bearing deposits increased $67.2 million, or 14.6%. Deposits assumed from NHB totaled $19.7 million at the time of the acquisition in September 2017 and $17.2 million at December 31, 2017
 
Borrowed funds. Borrowed funds decreased $18.0 million, or 40.9%, to $26.0 million at December 31, 2017 from $44.0 million at December 31, 2016 primarily as the Corporation repaid $15.0 million of FHLB borrowings which matured in November 2017. Borrowed funds at December 31, 2017 consisted of short-term borrowings of $2.5 million and long-term borrowings of $23.5 million. Long-term advances are utilized primarily to fund loan growth and short-term advances are utilized primarily to compensate for the normal deposit fluctuations.
 
Stockholders’ equity. Stockholders’ equity increased $5.0 million, or 9.3%, to $59.1 million at December 31, 2017 from $54.1 million at December 31, 2016. The increase was primarily due to proceeds from the exercise of stock options of $1.4 million, $1.7 million of common stock issued in connection with the acquisition of NHB and net income of $4.3 million for 2017, offset by common stock dividends paid of $2.4 million.

 Changes in Results of Operations
 
The Corporation reported net income before preferred stock dividends of $4.3 million and $4.0 million in 2017 and 2016, respectively. The following “Average Balance Sheet and Yield/Rate Analysis” and “Analysis of Changes in Net Interest Income” tables should be utilized in conjunction with the discussion of the interest income and interest expense components of net interest income.
 

K-23




Average Balance Sheet and Yield/Rate Analysis. The following table sets forth, for the periods indicated, information concerning the total dollar amounts of interest income from interest-earning assets and the resulting average yields, the total dollar amounts of interest expense on interest-bearing liabilities and the resulting average costs, net interest income, interest rate spread and the net interest margin earned on average interest-earning assets. For purposes of this table, average loan balances include nonaccrual loans and exclude the allowance for loan losses and interest income includes accretion of net deferred loan fees. Interest and yields on tax-exempt loans and securities (tax-exempt for federal income tax purposes) are shown on a fully tax equivalent basis. The information is based on average daily balances during the periods presented.
 
(Dollar amounts in thousands)
 
For the year ended December 31,
 
 
2017
 
2016
 
 
Average
 
 
 
Yield /
 
Average
 
 
 
Yield /
 
 
Balance
 
Interest
 
Rate
 
Balance
 
Interest
 
Rate
Interest-earning assets:
 
 

 
 

 
 
 
 

 
 

 
 
Loans, taxable
 
$
531,228

 
$
22,973

 
4.32%
 
$
459,253

 
$
19,966

 
4.35%
Loans, tax-exempt
 
23,637

 
1,088

 
4.60%
 
25,893

 
1,206

 
4.66%
Total loans receivable
 
554,865

 
24,061

 
4.34%
 
485,146

 
21,172

 
4.36%
Securities, taxable
 
73,914

 
1,615

 
2.18%
 
78,767

 
1,662

 
2.11%
Securities, tax-exempt
 
26,338

 
784

 
2.98%
 
28,453

 
865

 
3.04%
Total securities
 
100,252

 
2,399

 
2.39%
 
107,220

 
2,527

 
2.36%
Federal bank stocks
 
4,848

 
242

 
4.99%
 
3,758

 
186

 
4.95%
Interest-earning deposits with banks
 
22,321

 
235

 
1.05%
 
25,563

 
135

 
0.53%
Total interest-earning cash equivalents
 
27,169

 
477

 
1.76%
 
29,321

 
321

 
1.09%
Total interest-earning assets
 
682,286

 
26,937

 
3.95%
 
621,687

 
24,020

 
3.86%
Cash and due from banks
 
2,741

 
 

 
 
 
2,577

 
 

 
 
Other noninterest-earning assets
 
45,968

 
 

 
 
 
42,490

 
 

 
 
Total Assets
 
$
730,995

 
 

 
 
 
$
666,754

 
 

 
 
Interest-bearing liabilities:
 
 

 
 

 
 
 
 

 
 

 
 
Interest-bearing demand deposits
 
$
331,157

 
1,075

 
0.32%
 
$
290,559

 
607

 
0.21%
Time deposits
 
165,828

 
2,200

 
1.33%
 
153,268

 
2,184

 
1.42%
Total interest-bearing deposits
 
496,985

 
3,275

 
0.66%
 
443,827

 
2,791

 
0.63%
Borrowed funds, short-term
 
4,588

 
130

 
2.82%
 
2,341

 
78

 
3.34%
Borrowed funds, long-term
 
35,949

 
1,088

 
3.03%
 
35,141

 
1,076

 
3.06%
Total borrowed funds
 
40,537

 
1,218

 
3.00%
 
37,482

 
1,154

 
3.08%
Total interest-bearing liabilities
 
537,522

 
4,493

 
0.84%
 
481,309

 
3,945

 
0.82%
Noninterest-bearing demand deposits
 
126,808

 

 
 
122,181

 

 
Funding and cost of funds
 
664,330

 
4,493

 
0.68%
 
603,490

 
3,945

 
0.65%
Other noninterest-bearing liabilities
 
9,793

 
 

 
 
 
8,832

 
 

 
 
Total Liabilities
 
674,123

 
 

 
 
 
612,322

 
 

 
 
Stockholders' Equity
 
56,872

 
 

 
 
 
54,432

 
 

 
 
Total Liabilities and Stockholders' Equity
 
$
730,995

 
 

 
 
 
$
666,754

 
 

 
 
Net interest income
 
 

 
$
22,444

 
 
 
 

 
$
20,075

 
 
Interest rate spread (difference between weighted average rate on interest-earning assets and interest-bearing liabilities)
 
 

 
 

 
3.11%
 
 

 
 

 
3.04%
Net interest margin (net interest income as a percentage of average interest-earning assets)
 
 

 
 

 
3.29%
 
 

 
 

 
3.23%

K-24




Analysis of Changes in Net Interest Income. The following table analyzes the changes in interest income and interest expense in terms of: (1) changes in volume of interest-earning assets and interest-bearing liabilities and (2) changes in yields and rates. The table reflects the extent to which changes in the Corporation’s interest income and interest expense are attributable to changes in rate (change in rate multiplied by prior year volume), changes in volume (changes in volume multiplied by prior year rate) and changes attributable to the combined impact of volume/rate (change in rate multiplied by change in volume). The changes attributable to the combined impact of volume/rate are allocated on a consistent basis between the volume and rate variances. Changes in interest income on loans and securities reflect the changes in interest income on a fully tax equivalent basis.
(Dollar amounts in thousands)
 
2017 versus 2016
 
 
Increase (decrease) due to
 
 
Volume
 
Rate
 
Total
Interest income:
 
 

 
 

 
 

Loans
 
$
3,024

 
$
(135
)
 
$
2,889

Securities
 
(166
)
 
38

 
(128
)
Federal bank stocks
 
54

 
2

 
56

Interest-earning deposits with banks
 
(19
)
 
119

 
100

 
 
 
 
 
 
 
Total interest-earning assets
 
2,893

 
24

 
2,917

 
 
 
 
 
 
 
Interest expense:
 
 

 
 

 
 

Deposits
 
345

 
139

 
484

Borrowed funds, short term
 
65

 
(13
)
 
52

Borrowed funds, long term
 
25

 
(13
)
 
12

 
 
 
 
 
 
 
Total interest-bearing liabilities
 
435

 
113

 
548

 
 
 
 
 
 
 
Net interest income
 
$
2,458

 
$
(89
)
 
$
2,369

 
 
 
 
 
 
 
 
2017 Results Compared to 2016 Results
 
The Corporation reported net income of $4.3 million and $4.0 million for 2017 and 2016, respectively. The $291,000, or 7.3%, increase in net income was attributed to increases in net interest income and noninterest income of $2.4 million and $1.4 million, respectively, partially offset by increases in noninterest expense, the provision for income taxes and the provision for loan losses of $2.2 million, $866,000 and $439,000, respectively. Returns on average equity and assets were 7.52% and 0.59%, respectively, for 2017, compared to 7.32% and 0.60%, respectively, for 2016.
 
Net interest income. The primary source of the Corporation’s revenue is net interest income. Net interest income is the difference between interest income on earning assets, such as loans and securities, and interest expense on liabilities, such as deposits and borrowed funds, used to fund the earning assets. Net interest income is impacted by the volume and composition of interest-earning assets and interest-bearing liabilities, and changes in the level of interest rates. Tax equivalent net interest income increased $2.4 million to $22.4 million for 2017, compared to $20.1 million for 2016. This increase in net interest income can be attributed to an increase in tax equivalent interest income of $2.9 million, partially offset by an increase in interest expense of $548,000.
 
Interest income. Tax equivalent interest income increased $2.9 million, or 12.1%, to $26.9 million for 2017, compared to $24.0 million for 2016. This increase can be attributed to increases in interest earned on loans, deposits with banks and dividends received on federal bank stocks of $2.9 million, $100,000 and $56,000, respectively, partially offset by a decrease in interest earned on securities of $128,000.
 
Tax equivalent interest earned on loans receivable increased $2.9 million, or 13.6%, to $24.1 million for 2017, compared to $21.2 million for 2016. The average balance of loans increased $69.7 million, or 14.4%, generating $3.0 million of additional interest income on loans. Offsetting this favorable variance, the average yield on loans decreased 2 basis points to 4.34% for 2017, versus 4.36% for 2016 causing a $135,000 decrease in interest income.


K-25




Tax equivalent interest earned on securities decreased $128,000, or 5.1%, to $2.4 million f