The Quarterly
FDBC 2016 10-K

Fidelity D & D Bancorp Inc (FDBC) SEC Quarterly Report (10-Q) for Q1 2017

FDBC Q2 2017 10-Q
FDBC 2016 10-K FDBC Q2 2017 10-Q

Table Of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION      

Washington, D.C. 20549



FORM 10-Q



[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934



For the quarterly period ended March 31, 2017



OR

[  ] 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: 333-90273



FIDELITY D & D BANCORP, INC.



STATE OF INCORPORATION:  IRS EMPLOYER IDENTIFICATION NO:

PENNSYLVANIA                                     23-3017653





Address of principal executive offices:

BLAKELY & DRINKER ST.

DUNMORE, PENNSYLVANIA 18512



TELEPHONE:

570-342-8281





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 subjected to such filing requirements for the past 90 days.  [X] YES [  ] NO



Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). [X] YES [  ] NO



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.





Large accelerated filer [  ]                                             

Accelerated filer [  ]

Non-accelerated filer   [  ]

Smaller reporting company [X]

(Do not check if a smaller reporting company)

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 financial 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 Exchange Act). 

[  ] YES [X] NO



The number of outstanding shares of Common Stock of Fidelity D & D Bancorp, Inc. on April 30, 2017 , the latest practicable date, was 2,4 70 , 194 shares .

Table Of Contents

FIDELITY D & D BANCORP, INC.



Form 10-Q March 31, 2017



Index







 Part I.  Financial Information

Page

Item 1.

Financial Statements (unaudited):



Consolidated Balance Sheets as of March 31, 2017 and December 31, 201 6

3



Consolidated Stat ements of Income for the three months ended March 31, 2017 and 201 6

4



Consolidated Statements of Comprehensive Income for the three months ended March 31 , 201 7 and 201 6

5



Consolidated Statements of Changes in Shareholders' Equity for the three months ended March 31 , 201 7 and 201 6

6



Consolidated Statements of Cash Flows for the three months ended March 31, 2017 and 2016

7



Notes to Consolidated Financial Statements (Unaudited)

9

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations

31

Item 3.

Quantitative and Qualitative Disclosure about Market Risk

4 6

Item 4.

Controls and Procedures

5 2



 Part II.  Other Information

Item 1.

Legal Proceedings

5 3

Item 1A.

Risk Factors

5 3

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

5 3

Item 3.

Defaults upon Senior Securities

5 3

Item 4.

Mine Safety Disclosures

5 3

Item 5.

Other Information

5 3

Item 6.

Exhibits

5 3

 Signatures

5 5

 Exhibit index

5 6

















2

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PART I –

Financial

Information

Item 1: Financial Statements





Fidelity D & D Bancorp, Inc. and Subsidiary

Consolidated Balance Sheets

(Unaudited)

(dollars in thousands)

March 31, 2017

December 31, 2016

Assets:

Cash and due from banks

$

13,119 

$

12,856 

Interest-bearing deposits with financial institutions

15,997 

12,987 

Total cash and cash equivalents

29,116 

25,843 

Available-for-sale securities

154,223 

130,037 

Federal Home Loan Bank stock

2,467 

2,606 

Loans and leases, net (allowance for loan losses of

$9,548 in 2017; $9,364 in 2016)

611,621 

588,130 

Loans held-for-sale (fair value $1,999 in 2017, $2,907 in 2016)

1,961 

2,854 

Foreclosed assets held-for-sale

1,239 

1,306 

Bank premises and equipment, net

17,026 

17,164 

Cash surrender value of bank owned life insurance

19,542 

11,435 

Accrued interest receivable

2,284 

2,246 

Goodwill

209 

 -

Other assets

12,998 

11,323 

Total assets

$

852,686 

$

792,944 

Liabilities:

Deposits:

Interest-bearing

$

543,444 

$

492,306 

Non-interest-bearing

190,482 

211,153 

Total deposits

733,926 

703,459 

Accrued interest payable and other liabilities

4,868 

4,631 

Short-term borrowings

14,699 

4,223 

Long-term debt

17,000 

 -

Total liabilities

770,493 

712,313 

Shareholders' equity:

Preferred stock authorized 5,000,000 shares with no par value; none issued

 -

 -

Capital stock, no par value (10,000,000 shares authorized; shares issued and outstanding; 2,470,194 in 2017; and 2,453,805 in 2016)

27,488 

27,155 

Retained earnings

53,306 

52,095 

Accumulated other comprehensive income

1,399 

1,381 

Total shareholders' equity

82,193 

80,631 

Total liabilities and shareholders' equity

$

852,686 

$

792,944 



See notes to unaudited consolidated financial statements

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Fidelity D & D Bancorp, Inc. and Subsidiary

Consolidated Statements of Income

(Unaudited)

(dollars in thousands except per share data)

March 31, 2017

March 31, 2016

Interest income:

Loans and leases:

Taxable

$

6,160 

$

5,815 

Nontaxable

210 

191 

Interest-bearing deposits with financial institutions

22 

Investment securities:

U.S. government agency and corporations

619 

370 

States and political subdivisions (nontaxable)

346 

317 

Other securities

25 

21 

Total interest income

7,366 

6,736 

Interest expense:

Deposits

586 

580 

Securities sold under repurchase agreements

Other short-term borrowings and other

57 

10 

Long-term debt

38 

 -

Total interest expense

688 

598 

Net interest income

6,678 

6,138 

Provision for loan losses

325 

150 

Net interest income after provision for loan losses

6,353 

5,988 

Other income:

Service charges on deposit accounts

543 

488 

Interchange fees

400 

356 

Fees from trust fiduciary activities

195 

170 

Fees from financial services

146 

104 

Service charges on loans

220 

178 

Fees and other revenue

210 

197 

Earnings on bank-owned life insurance

107 

87 

Gain on sale of loans

284 

107 

Total other income

2,105 

1,687 

Other expenses:

Salaries and employee benefits

3,085 

2,875 

Premises and equipment

985 

918 

Advertising and marketing

235 

255 

Professional services

398 

389 

FDIC assessment

65 

125 

Loan collection

60 

44 

Other real estate owned

37 

22 

Office supplies and postage

123 

119 

Automated transaction processing

174 

127 

Data processing and communication

303 

188 

PA shares tax

164 

142 

Other

168 

184 

Total other expenses

5,797 

5,388 

Income before income taxes

2,661 

2,287 

Provision for income taxes

681 

586 

Net income

$

1,980 

$

1,701 

Per share data:

Net income - basic

$

0.80 

$

0.69 

Net income - diluted

$

0.80 

$

0.69 

Dividends

$

0.31 

$

0.27 



See notes to unaudited consolidated financial statements





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Fidelity D & D Bancorp, Inc. and Subsidiary

Consolidated Statements of Comprehensive Income

Three months ended

(Unaudited)

March 31,

(dollars in thousands)

2017

2016



Net income

$

1,980 

$

1,701 



Other comprehensive income, before tax:

Unrealized holding gain on available-for-sale securities

27 

1,084 

Reclassification adjustment for net gains realized in income

 -

 -

Net unrealized gain

27 

1,084 

Tax effect

(9)

(369)

Unrealized gain, net of tax

18 

715 

Other comprehensive income, net of tax

18 

715 

Total comprehensive income, net of tax

$

1,998 

$

2,416 



See notes to unaudited consolidated financial statements



5

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Fidelity D & D Bancorp, Inc. and Subsidiary

Consolidated Statements of Changes in Shareholders' Equity

For the three months ended March 31, 2017 and 2016

(Unaudited)

Accumulated



other



Capital stock

Retained

comprehensive

(dollars in thousands)

Shares

Amount

earnings

income

Total

Balance, December 31, 2015

2,443,405 

$

26,700 

$

47,463 

$

2,188 

$

76,351 

Net income

1,701 

1,701 

Other comprehensive income

715 

715 

Issuance of common stock through Employee Stock Purchase Plan

3,695 

111 

111 

Issuance of common stock from vested restricted share grants through stock compensation plans

5,855 

Issuance of common stock through exercise of stock options

500 

14 

14 

Stock-based compensation expense

84 

84 

Cash dividends declared

(667)

(667)

Balance, March 31, 2016

2,453,455 

$

26,909 

$

48,497 

$

2,903 

$

78,309 



Balance, December 31, 2016

2,453,805 

$

27,155 

$

52,095 

$

1,381 

$

80,631 

Net income

1,980 

1,980 

Other comprehensive income

18 

18 

Issuance of common stock through Employee Stock Purchase Plan

4,085 

126 

126 

Issuance of common stock through Dividend Reinvestment Plan

2,478 

90 

90 

Issuance of common stock from vested restricted share grants through stock compensation plans

9,307 

Issuance of common stock through exercise of stock options

519 

15 

15 

Stock-based compensation expense

102 

102 

Cash dividends declared

(769)

(769)

Balance, March 31, 2017

2,470,194 

$

27,488 

$

53,306 

$

1,399 

$

82,193 



See notes to unaudited consolidated financial statements



6

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Fidelity D & D Bancorp, Inc. and Subsidiary

Consolidated Statements of Cash Flows

(Unaudited)

Three months ended March 31,

(dollars in thousands)

2017

2016



Cash flows from operating activities:

Net income 

$

1,980 

$

1,701 

Adjustments to reconcile net income to net cash provided by

operating activities:

Depreciation, amortization and accretion

765 

865 

Provision for loan losses

325 

150 

Deferred income tax expense

403 

556 

Stock-based compensation expense

157 

118 

Excess tax benefit from exercise of stock options

 -

Proceeds from sale of loans held-for-sale

11,002 

6,563 

Originations of loans held-for-sale

(7,697)

(5,738)

Earnings from bank-owned life insurance

(107)

(87)

Net gain from sales of loans

(284)

(107)

Net gain from sale and write-down of foreclosed assets held-for-sale

(7)

 -

Change in:

Accrued interest receivable

(34)

Other assets

(1,788)

(2,245)

Accrued interest payable and other liabilities

120 

(285)

Net cash provided by operating activities

4,836 

1,499 



Cash flows from investing activities:

Available-for-sale securities:

Proceeds from sales

 -

 -

Proceeds from maturities, calls and principal pay-downs

4,576 

3,873 

Purchases

(29,001)

(6,628)

Decrease in FHLB stock

139 

700 

Net increase in loans and leases

(24,728)

(1,446)

Purchase of life insurance policies

(8,000)

 -

Acquisition of bank premises and equipment

(209)

(440)

Net cash acquired in acquisition of bank branch

11,817 

 -

Proceeds from sale of bank premises and equipment

 -

Proceeds from sale of foreclosed assets held-for-sale

240 

 -

Net cash used in investing activities

(45,160)

(3,941)



Cash flows from financing activities:

Net increase in deposits

16,659 

47,237 

Net increase (decrease) in short-term borrowings

10,476 

(15,439)

Proceeds from issuance of long-term debt advances

17,000 

 -

Proceeds from employee stock purchase plan participants

126 

111 

Exercise of stock options

15 

14 

Dividends paid, net of dividends reinvested

(679)

(667)

Net cash provided by financing  activities

43,597 

31,256 

Net increase in cash and cash equivalents

3,273 

28,814 

Cash and cash equivalents, beginning

25,843 

12,277 



Cash and cash equivalents, ending

$

29,116 

$

41,091 



See notes to unaudited consolidated financial statements



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Fidelity D & D Bancorp, Inc. and Subsidiary

Consolidated Statements of Cash Flows (continued)

(Unaudited)

Three months ended March 31,

(dollars in thousands)

2017

2016

Supplemental Disclosures of Cash Flow Information

Cash payments for:

Interest

$

574 

$

577 

Income tax

 -

 -

Supplemental Disclosures of Non-cash Investing Activities:

Net change in unrealized gains on available-for-sale securities

27 

1,084 

Transfers from loans to foreclosed assets held-for-sale

167 

691 

Transfers from loans to loans held-for-sale

2,318 

579 

Acquisition of West Scranton Branch from Wayne Bank

Non-cash assets acquired:

Loans

$

1,574 

Bank premises and equipment

264 

Goodwill

209 

Accrued interest receivable and other assets

Total non-cash assets acquired

$

2,051 

Liabilities assumed:

Deposits

$

13,809 

Accrued interest payable and other liabilities

59 

Total liabilities assumed

$

13,868 



See notes to unaudited consolidated financial statements





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FIDELITY D & D BANCORP, INC.



N otes to  C onsolidated Financial Statements

( U naudited)

1.   Nature of operations and critical accounting policies

Nature of operations

Fidelity Deposit and Discount Bank (the Bank) is a commercial bank chartered under the law of the Commonwealth of Pennsylvania and a wholly-owned subsidiary of Fidelity D & D Bancorp, Inc. (collectively, the Company).  Having commenced operations in 1903 , the Bank is committed to provide superior customer service, while offering a full range of banking products and financial and trust services to both our consumer and commercial customers from our main office located in Dunmore and other branches located throughout Lackawanna and Luzerne Counties.

Principles of consolidation

The accompanying unaudited consolidated financial statements of the Company and the Bank have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to this Form 10-Q and Rule 8-03 of Regulation S-X.  Accordingly, they do not include all of the information and footnote disclosures required by GAAP for complete financial statements.  In the opinion of management, all normal recurring adjustments necessary for a fair presentation of the financial condition and results of operations for the periods have been included.  All significant inter-company balances and transactions have been eliminated in consolidation.

For additional information and disclosures required under GAAP, refer to the Company's Annual Report on Form 10-K for the year ended December 31, 201 6 .

Management is responsible for the fairness, integrity and objectivity of the unaudited financial statements included in this report.  Management prepared the unaudited financial statements in accordance with GAAP.  In meeting its responsibility for the financial statements, management depends on the Company's accounting systems and related internal controls.  These systems and controls are designed to provide reasonable but not absolute assurance that the financial records accurately reflect the transactions of the Company, the Company's assets are safeguarded and that the financial statements present fairly the financial condition and results of operations of the Company.

In the opinion of management, the consolidated balance sheets as of March 31, 2017 and December 31, 201 6 and the related consolidated statements of income and consolidated statements of comprehensive income for the three months ended March 31, 2017 and 201 6 , and consolidated statements of changes in shareholders' equity and consolidated statements of cash flows for the three months ended March 31, 2017 and 201 6 present fairly the financial condition and results of operations of the Company.  All material adjustments required for a fair presentation have been made.  These adjustments are of a normal recurring nature.  Certain reclassifications have been made to the 201 6 financial statements to conform to the 201 7 presentation. 

In preparing these consolidated financial statements, the Company evaluated the events and transactions that occurred after March 31, 2017 through the date these consolidated financial statements were issued.

This Quarterly Report on Form 10-Q should be read in conjunction with the Company's audited financial statements for the year ended December 31, 201 6 , and the notes included therein, included within the Company's Annual Report filed on Form 10-K.

Critical accounting policies

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported periods.  Actual results could differ from those estimates.

A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for loan losses.  Management believes that the allowance for loan losses at March 31, 2017 is adequate and reasonable.  Given the subjective nature of identifying and estimating loan losses, it is likely that well-informed individuals could make different assumptions and could, therefore, calculate a materially different allowance amount.  While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in the future.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses.  Such agencies may require the Company to recognize adjustments to the allowance based on their judgment of information available to them at the time of their examination.

Another material estimate is the calculation of fair values of the Company's investment securities.  Fair values of investment securities are determined by pricing provided by a third-party vendor, who is a provider of financial market data, analytics and related services to financial institutions.  Based on experience, management is aware that estimated fair values of investment securities tend to vary among valuation services.  Accordingly, when selling investment securities, price quotes may be obtained from more than one source.  All of the Company's investment securities are classified as available-for-sale (AFS).  AFS securities are carried at fair value on the

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consolidated balance sheets, with unrealized gains and losses, net of income tax, reported separately within shareholders' equity as a component of accumulated other comprehensive income (AOCI).

The fair value of residential mortgage loans, classified as held-for-sale (HFS), is obtained from the Federal National Mortgage Association (FNMA) or the Federal Home Loan Bank (FHLB).  Generally, the market to which the Company sells residential mortgages it originates for sale is restricted and price quotes from other sources are not typically obtained.  On occasion, the Company may transfer loans from the loan portfolio to loans HFS.  Under these circumstances, pricing may be obtained from other entities and the residential mortgage loans are transferred at the lower of cost or market value and simultaneously sold.  For other loans transferred to HFS, pricing may be obtained from other entities or modeled and the other loans are transferred at the lower of cost or market value and then sold.  As of March 31, 2017 and December 31, 201 6 , loans classified as HFS consisted of residential mortgage loans.

Financing of automobiles, provided to customers under lease arrangements of varying terms, are accounted for as direct finance leases.  Interest income on automobile direct finance leasing is determined using the interest method to arrive at a level effective yield over the life of the lease.

Foreclosed assets held-for-sale includes other real estate acquired through foreclosure (ORE) and may, from time-to-time, include repossessed assets such as automobiles.  ORE is carried at the lower of cost (principal balance at date of foreclosure) or fair value less estimated cost to sell.  Any write-downs at the date of foreclosure are charged to the allowance for loan losses.  Expenses incurred to maintain ORE properties, subsequent write downs to the asset's fair value, any rental income received and gains or losses on disposal are included as components of other real estate owned expense in the consolidated statements of income.   

Goodwill is recorded on the consolidated balance sheet s as the excess of liabilities assumed over identifiable assets acquired on the acquisition date.  Goodwill is recorded at its net carrying value which represents estimated fair value.  The goodwill is deductible for tax purposes over a 15 year period.

The Company maintains bank owned life insurance policies (BOLI) for a selected group of employees ,   namely its officers where the Company is the owner and sole beneficiary of the policies .  The earnings from the BOLI are recognized as a component of other income in the consolidated statements of income.  The BOLI is an asset that can be liquidated, if necessary, with tax consequences.  However, the Company intends to hold these policies and accordingly, the Company has not provided for deferred taxes on the earnings from the increase in the cash surrender value.

The Company holds separate supplemental executive retirement (SERP) agreements for certain officers and an amount is credited to each participant's SERP account monthly while they are actively employed by the bank until retirement. A deferred tax asset is provided for the non-deductible SERP expense.  The Company also entered into separate split dollar life insu rance arrangements with three executives providing post-retirement benefits and accrues monthly expense for this benefit .  Monthly expenses for the SERP and post-retirement split dollar life benefit are recorded as components of salaries and employee benefit expense on the consolidated statements of income.

For purposes of the consolidated statements of cash flows, cash and cash equivalents includes cash on hand, amounts due from banks and interest-bearing deposits with financial institutions. Expenditures for construction in process, a component of other assets in the consolidated balance sheets, are included in acquisition of premises and equipment.

2.  New accounting pronouncements

In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2016-13, Financial Instruments – Credit Losses (Topic 326) Measurement of Credit Losses on Financial Instruments .  The amendments in this update require financial assets measured at amortized cost basis to be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis.  Previously, when credit losses were measured under GAAP, an entity only considered past events and current conditions when measuring the incurred loss.  The amendments in this update broaden the information that an entity must consider in developing its expected credit loss estimate for assets measured either collectively or individually.  The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount.  An entity must use judgement in determining the relevant information and estimation methods that are appropriate under the circumstances.  The amendments in this update also require that credit losses on available-for-sale debt securities be presented as an allowance for credit losses rather than a writedown.  The amendments in this update are effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2019 for public companies.  Early adoption is permitted beginning after December 15, 2018, including interim periods within those fiscal years.  An entity will apply the amendments in this update through a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption (modified-retrospective approach).  Upon adoption, the change in this accounting guidance could result in an increase in the Company's allowance for loan losses and require the Company to record loan losses more rapidly.  The Company is currently evaluating the impact of ASU 2016-13 on its consolidated financial statements.

In March 2016, the FASB issued ASU 2016-09, Compensation – Stock Compensation (Topic 718) Improvements to Employee Share-Based Payment Accounting .  The areas for simplification in the update involve several aspects of accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the

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statement of cash flows.  The amendments in this update are effective for annual reporting periods, including interim periods within those annual periods, beginning after December 15, 2016.  Early adoption is permitted.  Amendments should be applied using either a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted, retrospectively, prospectively, or using either a prospective transition method or a retrospective transition method.  The Company adopted this accounting standard during the first quarter of 2017 and does not expect this amendment to have a material impact on its consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers , which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services.  ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP:  identify the contract(s) with a customer; identify the performance obligations in the contract; determine the transaction price; allocate the transaction price to the performance obligations in the contract; recognize revenue when (or as) the entity satisfies a performance obligation.  The standard is effective for annual periods beginning after December 15, 2017, and interim periods therein, using either of the following transition methods: a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures).  The Company is evaluating the impact of the adoption of ASU 2014-09 on its consolidated financial statements and has not yet determined the method by which it will adopt the standard effective in the first quarter of 2018.

Subsequently, the FASB issued additional guidance to clarify certain implementation issues. Specifically, the FASB issued Principal versus Agent Considerations, Identifying Performance Obligations and Licensing, Narrow-Scope Improvements and Practical Expedients and Technical Corrections and Improvements in March, April, May and December 2016, respectively. These amendments do not change the core principle in Revenue from Contracts with Customers (Topic 606) and the effective date and transition requirements are consistent with those in Topic 606.

In January 2016, the FASB issued ASU 2016-01 related to F inancial Instruments - Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities .  The update applies to all entities that hold financial assets or owe financial liabilities.  The amendments in this update make targeted improvements to U.S. GAAP as follows:

·

Require equity investments to be measured at fair value with changes in fair value recognized in net income;

·

Simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment;

·

Require public business entities to use the exit price notion when measuring fair value of financial instruments for disclosure purposes;

·

Require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset;

·

Clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities.

The amendments are effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years.  The Company is evaluating the impact of the adoption of ASU 2016-01 on its consolidated financial statements, but does not expect it to have a significant impact.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements.  ASU 2016-02 requires the recognition of a right-of-use asset and related lease liability by lessees for leases classified as operating leases under GAAP.  The amendments in this update are effective for the Company for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  Early adoption of the amendments in this update are permitted.  A modified retroactive approach must be applied for leases existing at, or entered into after, the beginning of the earliest comparative period.  Upon adoption, this change in accounting guidance could have a significant impact on the consolidated balance sheets and could potentially impact debt covenant agreements with our customers.  The Company is currently evaluating the amount of the impact of ASU 2016-02 on its consolidated financial statements.

In August 2016, the FASB released ASU 2016-15, Statement of Cash Flows (Topic 230) to clarify the presentation of certain cash receipts and payments on the statement of cash flows.  The update addressed eight specific cash flow issues with the objective of reducing the existing diversity in practice.  The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years.  Early adoption is permitted, including adoption in an interim period.  The amendments in this update should be applied using a retrospective transition method to each period presented.  The Company is currently evaluating the impact of the adoption of ASU 2016-15 on its consolidated financial statements, but does not expect it to have a significant impact.

In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350) to simplify the test for goodwill impairment.  To simplify the subsequent measurement of goodwill, the Board eliminated Step 2 from the goodwill impairment test.  Under the amendments in this update, an entity should perform its annual goodwill impairment test by comparing the fair value of a

11

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reporting unit with its carrying amount.  An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting units fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit.  An entity should apply the amendments in his update on a prospective basis.  The amendments in this update are effective for the Company for its annual goodwill impairment tests in fiscal years beginning after December 15, 2019.  Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017.  The Company will early adopt this standard and it will not have an impact on its consolidated financial statements.

In March 2017, the FASB issued ASU 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20) Premium Amortization on Purchased Callable Debt Securities to amend the amortization period for certain purchased callable debt securities held at a premium.  The amendments in this update shorten the amortization period for the premium to the earliest call date.  The amendments in this update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018.  Early adoption is permitted, including adoption in an interim period.  An entity should apply the amendments in this update on a modified retrospective basis through a cumulative effect adjustment directly to retained earnings as of the beginning of the period of adoption.  The Company has adopted this standard and it will not have an effect on its consolidated financial statements.

3.  Accumulated other comprehensive income

The following tables illustrate the changes in accumulated other comprehensive income by component and the details about the components of accumulated other comprehensive income as of and for the periods indicated:







As of and for the three months ended March 31, 2017



Unrealized gains



(losses) on



available-for-sale

(dollars in thousands)

securities

Total

Beginning balance

$

1,381 

$

1,381 



Other comprehensive income before reclassifications, net of tax

18 

18 

Amounts reclassified from accumulated other comprehensive income, net of tax

 -

 -

Net current-period other comprehensive income

18 

18 

Ending balance

$

1,399 

$

1,399 









As of and for the three months ended March 31, 2016



Unrealized gains



(losses) on



available-for-sale

(dollars in thousands)

securities

Total

Beginning balance

$

2,188 

$

2,188 



Other comprehensive income before reclassifications, net of tax

715 

715 

Amounts reclassified from accumulated other comprehensive income, net of tax

 -

 -

Net current-period other comprehensive income

715 

715 

Ending balance

$

2,903 

$

2,903 







4. Investment securities

Agency – Government-sponsored enterprise (GSE) and MBS - GSE residential

Agency – GSE and MBS – GSE residential securities consist of short- to long-term notes issued by Federal Home Loan Mortgage Corporation (FHLMC), Federal National Mortgage Association (FNMA), Federal Home Loan Bank (FHLB) and Government National Mortgage Association (GNMA).  These securities have interest rates that are fixed and adjustable, have varying short- to long-term maturity dates and have contractual cash flows guaranteed by the U.S. government or agencies of the U.S. government.

Obligations of states and political subdivisions

The municipal securities are bank qualified or bank eligible, general obligation and revenue bonds rated as investment grade by various credit rating agencies and have fixed rates of interest with mid- to long-term maturities.  Fair values of these securities are highly driven by interest rates.  Management performs ongoing credit quality reviews on these issues.

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The amortized cost and fair value of investment securities at March 31, 2017 and December 31, 201 6 are summarized as follows:









Gross

Gross



Amortized

unrealized

unrealized

Fair

(dollars in thousands)

cost

gains

losses

value

March 31, 2017

Available-for-sale securities:

Agency - GSE

$

17,330 

$

43 

$

(117)

$

17,256 

Obligations of states and political subdivisions

42,142 

1,920 

(271)

43,791 

MBS - GSE residential

92,336 

793 

(650)

92,479 



Total debt securities

151,808 

2,756 

(1,038)

153,526 



Equity securities - financial services

294 

403 

 -

697 



Total available-for-sale securities

$

152,102 

$

3,159 

$

(1,038)

$

154,223 











Gross

Gross



Amortized

unrealized

unrealized

Fair

(dollars in thousands)

cost

gains

losses

value

December 31, 2016

Available-for-sale securities:

Agency - GSE

$

18,362 

$

58 

$

(144)

$

18,276 

Obligations of states and political subdivisions

38,648 

1,803 

(260)

40,191 

MBS - GSE residential

70,639 

851 

(553)

70,937 



Total debt securities

127,649 

2,712 

(957)

129,404 



Equity securities - financial services

294 

339 

 -

633 



Total available-for-sale securities

$

127,943 

$

3,051 

$

(957)

$

130,037 



The amortized cost and fair value of debt securities at March 31, 2017 by contractual maturity are summarized below:







Amortized

Fair

(dollars in thousands)

cost

value

Available-for-sale securities:

Debt securities:

Due in one year or less

$

4,006 

$

4,011 

Due after one year through five years

14,124 

14,149 

Due after five years through ten years

1,663 

1,741 

Due after ten years

39,679 

41,146 



Total debt securities

59,472 

61,047 



MBS - GSE residential

92,336 

92,479 



Total available-for-sale debt securities

$

151,808 

$

153,526 



Actual maturities will differ from contractual maturities because issuers and borrowers may have the right to call or repay obligations with or without call or prepayment penalty.  Agency – GSE and municipal securities are included based on their original stated maturity.  MBS – GSE residential, which are based on weighted-average lives and subject to monthly principal pay-downs, are listed in total.  Most of the securities have fixed rates or have predetermined scheduled rate changes and many have call features that allow the issuer to call the security at par before its stated maturity without penalty.

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The following table presents the fair value and gross unrealized losses of investment securities aggregated by investment type, the length of time and the number of securities that have been in a continuous unrealized loss position as of March 31, 2017 and December 31, 201 6 :  









Less than 12 months

More than 12 months

Total



Fair

Unrealized

Fair

Unrealized

Fair

Unrealized

(dollars in thousands)

value

losses

value

losses

value

losses



March 31, 2017

Agency - GSE

$

6,048 

$

(117)

$

 -

$

 -

$

6,048 

$

(117)

Obligations of states and political subdivisions

11,051 

(271)

 -

 -

11,051 

(271)

MBS - GSE residential

61,193 

(650)

 -

 -

61,193 

(650)

Total

$

78,292 

$

(1,038)

$

 -

$

 -

$

78,292 

$

(1,038)

Number of securities

61 

 -

61 



December 31, 2016

Agency - GSE

$

6,032 

$

(144)

$

 -

$

 -

$

6,032 

$

(144)

Obligations of states and political subdivisions

8,690 

(260)

 -

 -

8,690 

(260)

MBS - GSE residential

41,111 

(553)

 -

 -

41,111 

(553)

Total

$

55,833 

$

(957)

$

 -

$

 -

$

55,833 

$

(957)

Number of securities

48 

 -

48 





The Company had sixty-one securities in an unrealized loss position at March 31, 2017 , including six agency securities, thirty-three mortgage-backed securities and twenty-two municipal securities. The severity of these unrealized losses based on their underlying cost basis was as follows at March 31, 2017 :   1.90 % for agencies; 1. 05 % for total MBS-GSE; and 2. 39 % for municipals. In addition, none of these securities had been in an unrealized loss position in excess of 12 months. The changes in the prices on these securities are the result of interest rate movement and management believes they are temporary in nature.

Management believes the cause of the unrealized losses is related to changes in interest rates, instability in the capital markets or the limited trading activity due to illiquid conditions in the debt market and is not directly related to credit quality.  Quarterly, management conducts a formal review of investment securities for the presence of other-than-temporary impairment (OTTI).  The accounting guidance related to OTTI requires the Company to assess whether OTTI is present when the fair value of a debt security is less than its amortized cost as of the balance sheet date.  Under those circumstances, OTTI is considered to have occurred if: (1) the entity has intent to sell the security; (2) more likely than not the entity will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of expected cash flows is not sufficient to recover the entire amortized cost.  The accounting guidance requires that credit-related OTTI be recognized in earnings while non-credit-related OTTI on securities not expected to be sold be recognized in other comprehensive income (OCI).  Non-credit-related OTTI is based on other factors affecting market value, including illiquidity.

The Company's OTTI evaluation process also follows the guidance set forth in topics related to debt and equity securities.  The guidance set forth in the pronouncements require the Company to take into consideration current market conditions, fair value in relationship to cost, extent and nature of changes in fair value, issuer rating changes and trends, volatility of earnings, current analysts' evaluations, all available information relevant to the collectability of debt securities, the ability and intent to hold investments until a recovery of fair value which may be to maturity and other factors when evaluating for the existence of OTTI.  The guidance requires that credit-related OTTI be recognized as a realized loss through earnings when there has been an adverse change in the holder's expected cash flows such that the full amount (principal and interest) will probably not be received.  This requirement is consistent with the impairment model in the guidance for accounting for debt and equity securities.

For all security types, as of March 31, 2017 , the Company applied the criteria provided in the recognition and presentation guidance related to OTTI. That is, management has no intent to sell the securities and no conditions were identified by management that more likely than not would require the Company to sell the securities before recovery of their amortized cost basis. The results indicated there was no presence of OTTI in the Company's security portfolio. In addition, management believes the change in fair value is attributable to changes in interest rates.

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5.  Loans and leases

The classifications of loans and leases at March 31, 2017 and December 31, 201 6 are summarized as follows:







(dollars in thousands)

March 31, 2017

December 31, 2016



Commercial and industrial

$

118,003 

$

98,477 

Commercial real estate:

Non-owner occupied

105,103 

93,364 

Owner occupied

99,209 

106,960 

Construction

3,789 

3,987 

Consumer:

Home equity installment

27,725 

28,466 

Home equity line of credit

52,398 

51,609 

Auto loans and leases

63,446 

56,841 

Other

6,250 

13,301 

Residential:

Real estate

138,102 

134,475 

Construction

7,657 

10,496 

Total

621,682 

597,976 

Less:

Allowance for loan losses

(9,548)

(9,364)

Unearned lease revenue

(513)

(482)



Loans and leases, net

$

611,621 

$

588,130 



Net deferred loan costs of $1. 8 million have been included in the carrying values of loans at both March 31, 2017 and December 31, 201 6 , respectively.

Unearned lease revenue represents the difference between the lessor's investment in the property and the gross investment in the lease.  Unearned revenue is accrued over the life of the lease using the effective interest method.

The Company services real estate loans for investors in the secondary mortgage market which are not included in the accompanying consolidated balance sheets.  The approximate unpaid principal balance of mortgages serviced amounted to $2 87.0 million as of March 31, 2 01 7 and $ 285.2 million as of December 31, 201 6 .  Mortgage servicing rights amounted to $1. 3 million both as of March 31, 2017 and December 31, 201 6 , respectively.

Management is responsible for conducting the Company's credit risk evaluation process, which includes credit risk grading of individual commercial and industrial and commercial real estate loans. Commercial and industrial and commercial real estate loans are assigned credit risk grades based on the Company's assessment of conditions that affect the borrower's ability to meet its contractual obligations under the loan agreement. That process includes reviewing borrowers' current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower. Upon review, the commercial loan credit risk grade is revised or reaffirmed as the case may be. The credit risk grades may be changed at any time management feels an upgrade or downgrade may be warranted.  The Company utilizes an external independent loan review firm that reviews and validates the credit risk program on at least an annual basis. Results of these reviews are presented to management and the board of directors. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Company's policies and procedures.

Non-accrual loans

The decision to place loans on non-accrual status is made on an individual basis after considering factors pertaining to each specific loan.  Commercial and industrial (C&I) and commercial real estate (CRE) loans are placed on non-accrual status when management has determined that payment of all contractual principal and interest is in doubt or the loan is past due 90 days or more as to principal and interest, unless well-secured and in the process of collection.  Consumer loans secured by real estate and residential mortgage loans are placed on non-accrual status at 120 days past due as to principal and interest and unsecured consumer loans are charged-off when the loan is 90 days or more past due as to principal and interest. The Company considers all non-accrual loans to be impaired loans.

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Table Of Contents

Non-accrual loans, segregated by class, at March 31, 2017 and December 31, 201 6 , were as follows:







(dollars in thousands)

March 31, 2017

December 31, 2016



Commercial and industrial

$

$

11 

Commercial real estate:

Non-owner occupied

1,357 

1,407 

Owner occupied

3,903 

3,078 

Construction

182 

193 

Consumer:

Home equity installment

 -

31 

Home equity line of credit

798 

737 

Auto loans and leases

42 

25 

Other

 -

Residential:

Real estate

1,565 

1,882 

Total

$

7,851 

$

7,370 



Troubled Debt Restructuring

A modification of a loan constitutes a troubled debt restructuring (TDR) when a borrower is experiencing financial difficulty and the modification constitutes a concession.  The Company considers all TDRs to be impaired loans.  The Company offers various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted.  C&I loans modified in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans.  Additional collateral, a co-borrower, or a guarantor is often requested.  CRE loans modified in a TDR can involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor.  Commercial real estate construction loans modified in a TDR may also involve extending the interest-only payment period.  Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers' financial needs for an extended period of time.  After the lowered monthly payment period ends, the borrower would revert back to paying principal and interest pursuant to the original terms with the maturity date adjusted accordingly.  Consumer loan modifications are typically not granted and therefore standard modification terms do not exist for loans of this type.

Loans modified in a TDR may or may not be placed on non-accrual status.  As of March 31, 2017 , total TDRs amounted to $4.2 million, consisting of 14 loans ( 11 CRE loans, 1 C&I loan, 1 HELOC and 1 residential mortgage to 9 unrelated borrowers), of which two CRE loans, totaling $ 1.0 million ,   one HELOC, totaling $0.6 million, and one residential mortgage, totaling $0.9 million, were on non-accrual status.  The March 31, 2017 balance represented a $ 0. 9 million increase over the December 31, 201 6 balance, which amounted to $ 3. 3 million (consisting of 6 CRE loans, 1 C&I loan, 1 HELOC and 1 residential mortgage to 6 unrelated borrowers), of which the HELOC, totaling $0.6 million, and the residential mortgage, totaling $0.9 million, were on non-accrual status.  This increase in TDRs was attributed to the addition of the f ive accruing TDRs in the category of commercial real estate, totaling $0. 9 million .  Of the TDRs outstanding as of March 31, 2017 and December 31, 2016, when modified, the concessions granted consisted of temporary interest-only payments, extensions of maturity date, or a reduction in the rate of interest to a below-market rate for a contractual period of time.  Other than the TDRs that were placed on non-accrual status, the TDRs were performing in accordance with their modified terms.

16

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The following presents by class, information related to loans modified in a TDR:







Loans modified as TDRs for the three months ended:

(dollars in thousands)

March 31, 2017

March 31, 2016





Recorded

Increase in

Recorded

Increase in



Number

investment

allowance

Number

investment

allowance



of

(as of

(as of

of

(as of

(as of



contracts

period end)

period end)

contracts

period end)

period end)

Commercial real estate - non-owner occupied

 1

$

119 

$

 -

$

 -

$

 -

Commercial real estate - owner occupied

 4

779 

150 

 -

 -

 -

Consumer home equity line of credit

 -

 -

 -

 1

650 

128 

Total

 5

$

898 

$

152 

 1

$

650 

$

128 



In the above table , the period end balances are inclusive of all partial pay downs and charge-offs since the modification date.

The following presents by class, loans modified as a TDR that subsequently defaulted (i.e. 90 days or more past due following a modification) during the periods indicated:





Loans modified as a TDR within the previous twelve months that subsequently defaulted during the:

(dollars in thousands)

Three months ended March 31, 2017

Three months ended March 31, 2016





Number of

Recorded

Number of

Recorded



contracts

investment

contracts

investment

Consumer home equity line of credit

 -

$

 -

2

$

156 



In the above table, the period end balances are inclusive of all partial pay downs and charge-offs since the modification date.

Loans modified in a TDR are closely monitored for delinquency as an early indicator of possible future default.  If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. 

The allowance for loan losses (allowance) may be increased, adjustments may be made in the allocation of the allowance or partial charge-offs may be taken to further write-down the carrying value of the loan.  An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the loan's observable market price.  If the loan is collateral dependent, the estimated fair value of the collateral is used to establish the allowance.  As of March 31, 2017 and 2016, respectively, the allowance for impaired loans that have been modified in a TDR was $0. 9 million and $0. 8 million, respectively.

Past due loans

Loans are considered past due when the contractual principal and/or interest is not received by the due date.  An aging analysis of past due loans, segregated by class of loans, as of the period indicated is as follows (dollars in thousands):









Recorded



Past due

investment past



30 - 59 Days

60 - 89 Days

90 days

Total

Total

due ≥ 90 days

March 31, 2017

past due

past due

 or more (1)

past due

Current

loans (3)

and accruing



Commercial and industrial

$

191 

$

12 

$

$

207 

$

117,796 

$

118,003 

$

 -

Commercial real estate:

Non-owner occupied

139 

130 

1,357 

1,626 

103,477 

105,103 

 -

Owner occupied

 -

 -

3,903 

3,903 

95,306 

99,209 

 -

Construction

 -

 -

182 

182 

3,607 

3,789 

 -

Consumer:

Home equity installment

99 

78 

 -

177 

27,548 

27,725 

 -

Home equity line of credit

33 

39 

798 

870 

51,528 

52,398 

 -

Auto loans and leases

311 

101 

79 

491 

62,442 

62,933 

(2)

37 

Other

38 

11 

21 

70 

6,180 

6,250 

21 

Residential:

Real estate

252 

 -

1,565 

1,817 

136,285 

138,102 

 -

Construction

 -

 -

 -

 -

7,657 

7,657 

 -

Total

$

1,063 

$

371 

$

7,909 

$

9,343 

$

611,826 

$

621,169 

$

58 

(1) Includes $ 7 .9 million of non -accrual loans.  (2) Net of unearned lease revenue of $0.5 million. (3 ) Includes net deferred loan costs of $1. 8 million.



17

Table Of Contents







Recorded



Past due

investment past



30 - 59 Days

60 - 89 Days

90 days

Total

Total

due ≥ 90 days

December 31, 2016

past due

past due

 or more (1)

past due

Current

loans (3)

and accruing



Commercial and industrial

$

208 

$

 -

$

11 

$

219 

$

98,258 

$

98,477 

$

 -

Commercial real estate:

Non-owner occupied

180 

 -

1,407 

1,587 

91,777 

93,364 

 -

Owner occupied

13 

776 

3,078 

3,867 

103,093 

106,960 

 -

Construction

 -

 -

193 

193 

3,794 

3,987 

 -

Consumer:

Home equity installment

213 

25 

31 

269 

28,197 

28,466 

 -

Home equity line of credit

 -

 -

737 

737 

50,872 

51,609 

 -

Auto loans and leases

293 

59 

44 

396 

55,963 

56,359 

(2)

19 

Other

37 

45 

13,256 

13,301 

 -

Residential:

Real estate

14 

421 

1,882 

2,317 

132,158 

134,475 

 -

Construction

 -

 -

 -

 -

10,496 

10,496 

 -

Total

$

958 

$

1,283 

$

7,389 

$

9,630 

$

587,864 

$

597,494 

$

19 

(1) Includes $ 7.4 million of non-accrual loans.  (2) Net of unearned lease revenue of $0. 5 million .   (3) Includes net deferred loan costs of $1. 8 million .

Impaired loans

A loan is considered impaired when, based on current information and events; it is probable that the Company will be unable to collect the scheduled payments in accordance with the contractual terms of the loan.  Factors considered in determining impairment include payment status, collateral value and the probability of collecting payments when due.  The significance of payment delays and/or shortfalls is determined on a case-by-case basis.  All circumstances surrounding the loan are taken into account.  Such factors include the length of the delinquency, the underlying reasons and the borrower's prior payment record.  Impairment is measured on these loans on a loan-by-loan basis.  Impaired loans include non-accrual loans, TDRs and other loans deemed to be impaired based on the aforementioned factors.

At March 31, 2017, impaired loans consisted of accruing TDRs of $1.7 million, $7.9 million in non-accrual loans and $1.6 million in accruing loans.  At December 31, 2016, impaired loans consisted of accruing TDRs of $1.8 million, $7.4 million in non-accrual loans and $2.2 million in accruing loans.  As of March 31, 2017, the non-accrual loans included four TDRs to three unrelated borrowers, totaling $2.5 million compared with two TDRs totaling $1.5 million as of December 31, 2016.

Impaired loans, segregated by class, as of the perio d indicated are detailed below:







Recorded

Recorded



Unpaid

investment

investment

Total



principal

with

with no

recorded

Related

(dollars in thousands)

balance

allowance

allowance

investment

allowance

March 31, 2017

Commercial and industrial

$

224 

$

195 

$

29 

$

224 

$

183 

Commercial real estate:

Non-owner occupied

3,197 

2,651 

425 

3,076 

1,114 

Owner occupied

5,387 

5,013 

310 

5,323 

1,395 

Construction

405 

 -

182 

182 

 -

Consumer:

Home equity installment

33 

 -

 -

 -

 -

Home equity line of credit

837 

718 

80 

798 

202 

Auto loans and leases

42 

41 

42 

12 

Other

 -

 -

 -

 -

 -

Residential:

Real estate

1,584 

1,249 

316 

1,565 

217 

Construction

 -

 -

 -

 -

 -

Total

$

11,709 

$

9,867 

$

1,343 

$

11,210 

$

3,123 





18

Table Of Contents







Recorded

Recorded



Unpaid

investment

investment

Total



principal

with

with no

recorded

Related

(dollars in thousands)

balance

allowance

allowance

investment

allowance

December 31, 2016

Commercial and industrial

$

235 

$

206 

$

29 

$

235 

$

193 

Commercial real estate:

Non-owner occupied

3,346 

2,611 

405 

3,016 

993 

Owner occupied

5,363 

4,351 

876 

5,227 

1,389 

Construction

416 

 -

193 

193 

 -

Consumer:

Home equity installment

64 

 -

31 

31 

 -

Home equity line of credit

778 

650 

87 

737 

167 

Auto

25 

25 

 -

25 

Other

 -

Residential:

Real estate

1,949 

1,466 

416 

1,882 

315 

Construction

 -

 -

 -

 -

 -

Total

$

12,182 

$

9,315 

$

2,037 

$

11,352 

$

3,061 



The following table presents the average recorded investments in impaired loans and related amount of interest income recognized during the periods indicated below.  The average balances are calculated based on the quarter-end balances of impaired loans.  Payments received from non-accruing impaired loans are first applied against the outstanding principal balance, then to the recovery of any charged-off amounts.  Any excess is treated as a recovery of interest income.  Payments received from accruing impaired loans are applied to principal and interest, as contractually agreed upon.









March 31, 2017

March 31, 2016



Cash basis

Cash basis



Average

Interest

interest

Average

Interest

interest



recorded

income

income

recorded

income

income

(dollars in thousands)

investment

recognized

recognized

investment

recognized

recognized

Commercial and industrial

$

367 

$

 -

$

 -

$

675 

$

$

 -

Commercial real estate:

Non-owner occupied

4,302 

35 

 -

3,859 

24 

 -

Owner occupied

4,527 

30 

 -

2,825 

38 

 -

Construction

200 

 -

 -

234 

 -

 -

Consumer:

Home equity installment

45 

 -

 -

195 

 -

Home equity line of credit

873 

 -

 -

606 

11 

 -

Auto

30 

 -

 -

29 

 -

 -

Other

 -

 -

 -

Residential:

Real estate

1,150 

 -

671 

 -

Construction

 -

 -

 -

 -

 -

 -

Total

$

11,499 

$

74 

$

 -

$

9,103 

$

83 

$

 -





Credit Quality Indicators

Commercial and industrial and commercial real estate

The Company utilizes a loan grading system and assigns a credit risk grade to its loans in the C&I and CRE portfolios.  The grading system provides a means to measure portfolio quality and aids in the monitoring of the credit quality of the overall loan portfolio.  The credit risk grades are arrived at using a risk rating matrix to assign a grade to each of the loans in the C&I and CRE portfolios.

The following is a description of each risk rating category the Company uses to classify each of its C&I and CRE loans:

Pass

Loans in this category have an acceptable level of risk and are graded in a range of one to five.  Secured loans generally have good collateral coverage.  Current financial statements reflect acceptable balance sheet ratios, sales and earnings trends.  Management is considered to be competent, and a reasonable succession plan is evident.  Payment experience on the loans has been good with minor or no delinquency experience.  Loans with a grade of one are of the highest quality in the range.  Those graded five are of marginally acceptable quality.

19

Table Of Contents

Special Mention

Loans in this category are graded a six and may be protected but are potentially weak.  They constitute a credit risk to the Company, but have not yet reached the point of adverse classification.  Some of the following conditions may exist: little or no collateral coverage; lack of current financial information; delinquency problems; highly leveraged; available financial information reflects poor balance sheet ratios and profit and loss statements reflect uncertain trends; and document exceptions.  Cash flow may not be sufficient to support total debt service requirements.

Substandard

Loans in this category are graded a seven and have a well-defined weakness which may jeopardize the ultimate collectability of the debt.  The collateral pledged may be lacking in quality or quantity.  Financial statements may indicate insufficient cash flow to service the debt; and/or do not reflect a sound net worth.  The payment history indicates chronic delinquency problems.  Management is considered to be weak.  There is a distinct possibility that the Company may sustain a loss.  All loans on non-accrual are rated substandard.  Other loans that are included in the substandard category can be accruing, as well as loans that are current or past due.  Loans 90 days or more past due, unless otherwise fully supported, are classified substandard. Also, borrowers that are bankrupt or have loans categorized as TDRs can be graded substandard.

Doubtful

Loans in this category are graded an eight and have a better than 50% possibility of the Company sustaining a loss, but the loss cannot be determined because of specific reasonable factors which may strengthen credit in the near-term.  Many of the weaknesses present in a substandard loan exist.  Liquidation of collateral, if any, is likely.  Any loan graded lower than an eight is considered to be uncollectible and charged-off.

Consumer and residential

The consumer and residential loan segments are regarded as homogeneous loan pools and as such are not risk rated.  For these portfolios, the Company utilizes payment activity, history and recency of payment in assessing performance.  Non-performing loans are considered to be loans past due 90 days or more and accruing and non-accrual loans.  All loans not classified as non-performing are considered performing.

The following table presents loans including $1. 8 million and $1.8 million of deferred costs, segregated by class, categorized into the appropriate credit quality indicator category as of March 31, 2017 and December 31, 201 6 , respectively:

Commercial credit exposure

Credit risk profile by creditworthiness category











March 31, 2017

(dollars in thousands)

Pass

Special mention

Substandard

Doubtful

Total



Commercial and industrial

$

116,782 

$

461 

$

760 

$

 -

$

118,003 

Commercial real estate - non-owner occupied

96,838 

679 

7,586 

 -

105,103 

Commercial real estate - owner occupied

91,794 

1,317 

6,098 

 -

99,209 

Commercial real estate - construction

3,607 

 -

182 

 -

3,789 

Total commercial

$

309,021 

$

2,457 

$

14,626 

$

 -

$

326,104 



Consumer & Mortgage lending credit exposure

Credit risk profile based on payment activity









March 31, 2017

(dollars in thousands)

Performing

Non-performing

Total



Consumer

Home equity installment

$

27,725 

$

 -

$

27,725 

Home equity line of credit

51,600 

798 

52,398 

Auto loans and leases (1)

62,854 

79 

62,933 

Other

6,229 

21 

6,250 

Total consumer

$

148,408 

$

898 

$

149,306 

Residential

Real estate

$

136,537 

$

1,565 

138,102 

Construction

7,657 

 -

7,657 

Total residential

$

144,194 

$

1,565 

$

145,759 

Total consumer & residential

$

292,602 

$

2,463 

$

295,065 

(1) Net of unearned lease revenue of $0.5 million.



20

Table Of Contents

Commercial credit exposure

Credit risk profile by creditworthiness category









December 31, 2016

(dollars in thousands)

Pass

Special mention

Substandard

Doubtful

Total



Commercial and industrial

$

97,308 

$

479 

$

690 

$

 -

$

98,477 

Commercial real estate - non-owner occupied

83,962 

1,811 

7,591 

 -

93,364 

Commercial real estate - owner occupied

99,981 

1,075 

5,904 

 -

106,960 

Commercial real estate - construction

3,794 

 -

193 

 -

3,987 

Total commercial

$

285,045 

$

3,365 

$

14,378 

$

 -

$

302,788 



Consumer & Mortgage lending credit exposure

Credit risk profile based on payment activity









December 31, 2016

(dollars in thousands)

Performing

Non-performing

Total



Consumer

Home equity installment

$

28,435 

$

31 

$

28,466 

Home equity line of credit

50,872 

737 

51,609 

Auto loans and leases (2)

56,315 

44 

56,359 

Other

13,295 

13,301 

Total consumer

$

148,917 

$

818 

$

149,735 

Residential

Real estate

$

132,593 

$

1,882 

$

134,475 

Construction

10,496 

 -

10,496 

Total residential

$

143,089 

$

1,882 

$

144,971 

Total consumer & residential

$

292,006 

$

2,700 

$

294,706 

(2) Net of unearned lease revenue of $0.5 million.

Allowance for loan losses

Management continually evaluates the credit quality of the Company's loan portfolio and performs a formal review of the adequacy of the allowance on a quarterly basis.  The allowance reflects management's best estimate of the amount of credit losses in the loan portfolio.  Management's judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans.  Those estimates may be susceptible to significant change.  Loan losses are charged directly against the allowance when loans are deemed to be uncollectible.  Recoveries from previously charged-off loans are added to the allowance when received.

Management applies two primary components during the loan review process to determine proper allowance levels.  The two components are a specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated.  The methodology to analyze the adequacy of the allowance for loan losses is as follows:

§

identification of specific impaired loans by loan category;

§

identification of specific loans that are not impaired, but have an identified potential for loss;

§

calculation of specific allowances where required for the impaired loans based on collateral and other objective and quantifiable evidence;

§

determination of loans with similar credit characteristics within each class of the loan portfolio segment and eliminating the impaired loans;

§

application of historical loss percentages (t railing twelve-quarter average) to pools to determine the allowance allocation;

§

application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio.

§

Qualitative factor adjustments include:

o

levels of and trends in delinquencies and non-accrual loans;

o

levels of and trends in charge-offs and recoveries;

o

trends in volume and terms of loans;

o

changes in risk selection and underwriting standards;

o

changes in lending policies, procedures and practices;

o

experience, ability and depth of lending management;

o

national and local economic trends and conditions; and

o

changes in credit concentrations.

Allocation of the allowance for different categories of loans is based on the methodology as explained above.  A key element of the methodology to determine the allowance is the Company's credit risk evaluation process, which includes credit risk grading of individual C&I and CRE loans.  C&I and CRE loans are assigned credit risk grades based on the Company's assessment of conditions

21

Table Of Contents

that affect the borrower's ability to meet its contractual obligations under the loan agreement.  That process includes reviewing borrowers' current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower.  Upon review, the commercial loan credit risk grade is revised or reaffirmed as the case may be.  The credit risk grades may be changed at any time management feels an upgrade or downgrade may be warranted.  The credit risk grades for the C&I and CRE loan portfolios are taken into account in the reserve methodology and loss factors are applied based upon the credit risk grades.  The loss factors applied are based upon the Company's historical experience as well as what we believe to be best practices and common industry standards.  Historical experience reveals there is a direct correlation between the credit risk grades and loan charge-offs.  The changes in allocations in the C&I and CRE loan portfolio from period to period are based upon the credit risk grading system and from periodic reviews of the loan portfolio.  An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses.  The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies.

Each quarter, management performs an assessment of the allowance.  The Company's Special Assets Committee meets monthly and the applicable lenders discuss each relationship under review and reach a consensus on the appropriate estimated loss amount, if applicable, based on current accounting guidance.  The Special Assets Committee's focus is on ensuring the pertinent facts are considered regarding not only loans considered for specific reserves, but also the collectability of loans that may be past due in payment.  The assessment process also includes the review of all loans on a non-accruing basis as well as a review of certain loans to which the lenders or the Company's Credit Administration function have assigned a criticized or classified risk rating.

The Company's policy is to charge-off unsecured consumer loans when they become 90 days or more past due as to principal and interest.  In the other portfolio segments, amounts are charged-off at the point in time when the Company deems the balance, or a portion thereof, to be uncollectible.

Information related to the change in the allowance and the Company's recorded investment in loans by portfolio segment as of the period indicated is as follows: 





As of and for the three months ended March 31, 2017



Commercial &

Commercial

Residential

(dollars in thousands)

industrial

real estate

Consumer

real estate

Unallocated

Total

Allowance for Loan Losses:

Beginning balance

$

1,075 

$

4,706 

$

1,834 

$

1,622 

$

127 

$

9,364 

Charge-offs

 -

(67)

(76)

(38)

 -

(181)

Recoveries

10 

28 

 -

 -

40 

Provision

186 

273 

(55)

(65)

(14)

325 

Ending balance

$

1,263 

$

4,922 

$

1,731 

$

1,519 

$

113 

$

9,548 

Ending balance: individually evaluated for impairment

$

183 

$

2,509 

$

214 

$

217 

$

 -

$

3,123 

Ending balance: collectively evaluated for impairment

$

1,080 

$

2,413 

$

1,517 

$

1,302 

$

113 

$

6,425 

Loans Receivables:

Ending balance (2)

$

118,003 

$

208,101 

$

149,306 

(1)

$

145,759 

$

 -

$

621,169 

Ending balance: individually evaluated for impairment

$

224 

$

8,581 

$

840 

$

1,565 

$

 -

$

11,210 

Ending balance: collectively evaluated for impairment

$

117,779 

$

199,520 

$

148,466 

$

144,194 

$

 -

$

609,959 

( 1) Net of unearned lease revenue of $0.5 million. (2) Includes $1. 8 million of net deferred loan costs.

22

Table Of Contents





As of and for the year ended December 31, 2016



Commercial &

Commercial

Residential

(dollars in thousands)

industrial

real estate

Consumer

real estate

Unallocated

Total

Allowance for Loan Losses:

Beginning balance

$

1,336 

$

5,014 

$

1,533 

$

1,407 

$

237 

$

9,527 

Charge-offs

(224)

(592)

(504)

(60)

 -

(1,380)

Recoveries

55 

37 

100 

 -

 -

192 

Provision

(92)

247 

705 

275 

(110)

1,025 

Ending balance

$

1,075 

$

4,706 

$

1,834 

$

1,622 

$

127 

$

9,364 

Ending balance: individually evaluated for impairment

$

193 

$

2,382 

$

171 

$

315 

$

 -

$

3,061 

Ending balance: collectively evaluated for impairment

$

882 

$

2,324 

$

1,663 

$

1,307 

$

127 

$

6,303 

Loans Receivables:

Ending balance (2)

$

98,477 

$

204,311 

$

149,735 

(1)

$

144,971 

$

 -

$

597,494 

Ending balance: individually evaluated for impairment

$

235 

$

8,436 

$

799 

$

1,882 

$

 -

$

11,352 

Ending balance: collectively evaluated for impairment

$

98,242 

$

195,875 

$

148,936 

$

143,089 

$

 -

$

586,142 

(1) Net of unearned lease revenue of $0. 5 million .  (2) Includes $1. 8 million of net deferred loan costs.







As of and for the three months ended March 31, 2016



Commercial &

Commercial

Residential

(dollars in thousands)

industrial

real estate

Consumer

real estate

Unallocated

Total

Allowance for Loan Losses:

Beginning balance

$

1,336 

$

5,014 

$

1,533 

$

1,407 

$

237 

$

9,527 

Charge-offs

(14)

(85)

(175)

(60)

 -

(334)

Recoveries

28 

 -

 -

41 

Provision

309 

(350)

292 

32 

(133)

150 

Ending balance

$

1,640 

$

4,583 

$

1,678 

$

1,379 

$

104 

$

9,384 







6.  Earnings per share

Basic earnings per share (EPS) is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding for the period.  Diluted EPS is computed in the same manner as basic EPS but also reflects the potential dilution that could occur from the grant of stock-based compensation awards.  The Company maintains two active share-based compensation plans that may generate additional potentially dilutive common shares.  For granted and unexercised stock options and stock-settled stock appreciation rights (SSARs), dilution would occur if Company-issued stock options or SSARs were exercised a nd converted into common stock.  As of the three months ended March 31, 2017 and 2016 , there were 5,784 and 1,638 potentially dilutive shares related to issued and unexercised stock options and SSARs .  For restricted stock, dilution would occur from the Company's previously granted but unvested shares.  There were 2,9 79 and 4,983 potentially dilutive shares related to unvested restricted share grants as of the three months ended March 31, 2017 and 2016, respectively.

In the computation of diluted EPS, the Company uses the treasury stock method to determine the dilutive effect of its granted but unexercised stock options and SSARs and unvested restricted stock.  Under the treasury stock method, the assumed proceeds, as defined, received from shares issued in a hypothetical stock option exercise or restricted stock grant, are assumed to be used to purchase treasury stock.  Proceeds include: amounts received from the exerci se of outstanding stock options and compensation cost for future service that the Company has not yet recognized in earnings .  The Company does not consider awards from share-based grants in the computation of basic EPS.

23

Table Of Contents

The following table illustrates the data used in computing basic and diluted EPS for the periods indicated:







Three months ended March 31,



2017

2016

(dollars in thousands except per share data)

Basic EPS:

Net income available to common shareholders

$

1,980 

$

1,701 

Weighted-average common shares outstanding

2,464,384 

2,450,771 

Basic EPS

$

0.80 

$

0.69 



Diluted EPS:

Net income available to common shareholders

$

1,980 

$

1,701 

Weighted-average common shares outstanding

2,464,384 

2,450,771 

Potentially dilutive common shares

8,763 

6,621 

Weighted-average common and potentially dilutive shares outstanding

2,473,147 

2,457,392 

Diluted EPS

$

0.80 

$

0.69 







7.  Stock plans

The Company has two stock-based compensation plans (the stock compensation plans) from which it can grant stock-based compensation awards, and applies the fair value method of accounting for stock-based compensation provided under current accounting guidance.  The guidelines require the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements.  The Company's stock compensation plans were shareholder-approved and permit the grant of share-based compensation awards to its employees and directors.  The Company believes that the stock-based compensation plans will advance the development, growth and financial condition of the Company by providing incentives through participation in the appreciation in the value of the Company's common stock.  In return, the Company hopes to secure, retain and motivate the employees and directors who are responsible for the operation and the management of the affairs of the Company by aligning the interest of its employees and directors with the interest of its shareholders.  In the stock compensation plans, employees and directors are eligible to be awarded stock-based compensation grants which can consist of stock options (qualified and non-qualified), stock appreciation rights (SARs) and restricted stock.

At the 2012 annual shareholders' meeting, the Company's shareholders approved and the Company adopted the 2012 Omnibus Stock Incentive Plan and the 2012 Director Stock Incentive Plan (collectively, the 2012 stock incentive plans).  The 2012 stock incentive plans replaced both the expired 2000 Independent Directors Stock Option Plan and the 2000 Stock Incentive Plan (collectively, the 2000 stock incentive plans).  Unless terminated by the Company's board of directors, the 2012 stock incentive plans will expire on, and no stock-based awards shall be granted after the year 2022.

In each of the 2012 stock incentive plans, the Company has reserved 500,000 shares of its no-par common stock for future issuance.  The Company recognizes share-based compensation expense over the requisite service or vesting period.  During 2015, the Company created a Long-Term Incentive Plan (LTIP) that awards restricted stock and stock-settled stock appreciation rights (SSARs) to senior officers based on the attainment of performance goals.  The service requirement is the participant's continued employment throughout the LTIP with a three -year vesting period.  The restricted stock has a two -year post vesting holding period requirement. The SSAR awards have a ten year term from the date of each grant.  The Company granted restricted stock and SSARs in February 2016 based on 2015 performance and in February 2017 based on 2016 performance .

The following table summarizes the weighted-average fair value and vesting of restricted stock grants awarded during the periods ended March 31, 2017 and 2016 under the 2012 stock incentive plans:











March 31, 2017

March 31, 2016



Weighted-

Weighted-



average

average



Shares

grant date

Shares

grant date



granted

fair value

granted

fair value



Director plan

5,600 

(2)

$

39.25 

5,600 

(1)

$

32.40 

Omnibus plan

3,165 

(3)

35.90 

3,155 

(3)

29.22 

Omnibus plan

50 

(1)

39.25 

50 

(1)

31.50 

Total

8,815 

$

38.05 

8,805 

$

31.26 

(1) Vest after 1 year  (2 ) Vest after 2 years – 50 % each year (3) Vest after 3 years – 33% each year

24

Table Of Contents

The fair value of the 3,1 6 5 shares granted on February 7 , 201 7 was calculated using the grant date stock price with a discount valuation.  The Chaffe model was used to calculate the discount. Since the shares vest over three years and then have a further two -year holding period, the historical volatility of the five years prior to the issue date was used to estimate volatility.  The five year treasury yield was used as the interest rate. The Company does pay a dividend, but since the shareholder will receive the dividends during vesting and the post-vest restriction period, no dividend yield was used in the calculation as not to inflate the discount.  The g rant date stock price was $39.25 and the discount of 8.548% was calculated using an interest rate of 1. 841 % and a 5 year historical volatility of 18.556 % .

A summary of the status of the Company's non-vested restricted stock as of and changes during the period indicated are presented in the following table:











2012 Stock incentive plans



Director

Omnibus

Total

Weighted- average grant date fair value

Non-vested balance at December 31, 2016

5,600 

9,040 

14,640 

$

30.47 

Granted

5,600 

3,215 

8,815 

38.05 

Forfeited

 -

 -

 -

Vested

(5,600)

(3,707)

(9,307)

30.57 

Non-vested balance at March 31, 2017

5,600 

8,548 

14,148 

$

35.36 





The Company granted 16,229 SSARs under the Omnibus Plan on February 7, 2017 .  The Company estimated the fair value of SSARs using the Black-Scholes-Merton valuation model on the grant date.  The Company used the following assumptions: the risk-free interest rate is the rate equivalent to the expected term of the option interpolated from the U.S. Treasury Yield Curve on the valuation date and historical volatility is calculated by taking the standard deviation of historical returns using weekly and monthly data.  The fai r value of these SSARs was $7.58 per share, based on a risk-free interest rate of 2.386 % , a dividend yield of 3. 110 % and a volatility of 23.4 34 % using an expected term of ten years .

A summary of the status of the Company's SSARs as of and changes during the period indicated are presented in the following table:











Awards

Weighted-average grant date fair value

Weighted-average remaining contractual term (years)

Outstanding December 31, 2016

19,341 

$

5.21 

9.1 

Granted

16,229 

7.58 

10.0 

Exercised

 -

 -

Forfeited

 -

 -

Outstanding March 31, 2017

35,570 

$

6.29 

9.3 



Of  t he SSARs outstanding at March 31, 2017, 6,447 vested and were exercisable . SSARs vest over a three year period – 33% per year.

Share-based compensation expense is included as a component of salaries and employee benefits in the consolidated statements of income.  The following tables illustrate stock-based compensation expense recognized on non-vested equity awards during the three months ended March 31, 2017 and 2016 and the unrecognized stock-based compensation expense as of March 31, 2017 :









Three months ended March 31,

(dollars in thousands)

2017

2016

Stock-based compensation expense:

Director stock incentive plan

$

34 

$

39 

Omnibus stock incentive plan

45 

31 

Employee stock purchase plan

23 

15 

Total stock-based compensation expense

$

102 

$

85 

In addition, during the first quarter of 2017 the Company accrued $ 55 thousand in stock-based compensation expense for restricted stock and SSARs to be awarded under the Omnibus Plan.  The Company accrue d $34 thousand in stock-based compensation expense during the first quarter of 2016 .

25

Table Of Contents







As of

(dollars in thousands)

March 31, 2017

Unrecognized stock-based compensation expense:

Director plan

$

201 

Omnibus plan

429 

Total unrecognized stock-based compensation expense

$

630 

The unrecognized stock-based compensation expense as of March 31, 2017 will be recognized ratably over the periods ended January 201 9 and January 2020 for the Director Plan and the Omnibus Plan, respectively.

Transactions under the Com pany's stock option plan for the three months ended March 31, 201 7 are presented in the following table:











Options

Weighted-average exercise price

Weighted-average remaining contractual term (years)

Outstanding and exercisable, December 31, 2016

15,000 

$

28.67 

1.0 

Granted

 -

 -

Exercised

(519)

28.90 

Forfeited

 -

 -

Outstanding and exercisable, March 31, 2017

14,481 

$

28.66 

0.8 





During the first quarter of 201 7 , there were 5 19 stock options exercised at a price of $ 28.90 per share.  The intrinsic value of these stock options was $2, 891 .  The tax deduction realized from the exercise of these options was $ 1,959 .  During the first quarter of 2016, there were 500 stock options exercised at a price of $27.75 per share.  The intrinsic value of these stock options was $2 , 585 and the tax deduction realized from the exercise of these options was $808 .  The Company has not issued stock options since 2008.

In addition to the 2012 stock incentive plans, the Company established the 2002 Employee Stock Purchase Plan (the ESPP) and reserved 110,000 shares of its un-issued capital stock for issuance under the plan.  The ESPP was designed to promote broad-based employee ownership of the Company's stock and to motivate employees to improve job performance and enhance the financial results of the Company.  Under the ESPP, participation is voluntary whereby employees use automatic payroll withholdings to purchase the Company's capital stock at a discounted price based on the fair market value of the capital stock as measured on either the commencement or termination dates, as defined.  As of March 31, 2017 ,   4 6 , 467 shares have been issued under the ESPP.  The ESPP is considered a compensatory plan and is required to comply with the provisions of current accounting guidance.  The Company recognizes compensation expense on its ESPP on the date the shares are purchased and it is included as a component of salaries and employee benefits in the co nsolidated statements of income .

8.  Fair value measurements

The accounting guidelines establish a framework for measuring and disclosing information about fair value measurements.  The guidelines of fair value reporting instituted a valuation hierarchy for disclosure of the inputs used to measure fair value.  This hierarchy prioritizes the inputs into three broad levels as follows:

Level 1 - inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities; 

Level 2 - inputs are quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument;

Level 3 - inputs are unobservable and are based on the Company's own assumptions to measure assets and liabilities at fair value.  Level 3 pricing for securities may also include unobservable inputs based upon broker-traded transactions.

A financial asset or liability's classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

The Company uses fair value to measure certain assets and, if necessary, liabilities on a recurring basis when fair value is the primary measure for accounting.  Thus, the Company uses fair value for AFS securities.  Fair value is used on a non-recurring basis to measure certain assets when adjusting carrying values to market values, such as impaired loans, other real estate owned (ORE) and other repossessed assets.

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The following table represents the carrying amount and estimated fair value of the Company's financial instrumen ts as of the periods indicated:





March 31, 2017



Quoted prices

Significant

Significant



in active

other

other



Carrying

Estimated

markets

observable inputs

unobservable inputs

(dollars in thousands)

amount

fair value

(Level 1)

(Level 2)

(Level 3)



Financial assets:

Cash and cash equivalents

$

29,116 

$

29,116 

$

29,116 

$

 -

$

 -

Available-for-sale securities

154,223 

154,223 

697 

153,526 

 -

FHLB stock

2,467 

2,467 

 -

2,467 

 -

Loans and leases, net

611,621 

616,689 

 -

 -

616,689 

Loans held-for-sale

1,961 

1,999 

 -

1,999 

 -

Accrued interest receivable

2,284 

2,284 

 -

2,284 

 -

Financial liabilities:

Deposits with no stated maturities

631,806 

631,806 

 -

631,806 

 -

Time deposits

102,120 

101,241 

 -

101,241 

 -

Short-term borrowings

14,699 

14,699 

 -

14,699 

 -

Long-term debt

17,000 

16,931 

 -

16,931 

 -

Accrued interest payable

295 

295 

 -

295 

 -









December 31, 2016



Quoted prices

Significant

Significant



in active

other

other



Carrying

Estimated

markets

observable inputs

unobservable inputs

(dollars in thousands)

amount

fair value

(Level 1)

(Level 2)

(Level 3)



Financial assets:

Cash and cash equivalents

$

25,843 

$

25,843 

$

25,843 

$

 -

$

 -

Available-for-sale securities

130,037 

130,037 

633 

129,404 

 -

FHLB stock

2,606 

2,606 

 -

2,606 

 -

Loans and leases, net

588,130 

590,688 

 -

 -

590,688 

Loans held-for-sale

2,854 

2,907 

 -

2,907 

 -

Accrued interest receivable

2,246 

2,246 

 -

2,246 

 -

Financial liabilities:

Deposits with no stated maturities

610,706 

610,706 

 -

610,706 

 -

Time deposits

92,753 

91,969 

 -

91,969 

 -

Short-term borrowings

4,223 

4,223 

 -

4,223 

 -

Accrued interest payable

181 

181 

 -

181 

 -





The carrying value of short-term financial instruments, as listed below, approximates their fair value.  These instruments generally have limited credit exposure, no stated or short-term maturities, carry interest rates that approximate market and generally are recorded at amounts that are payable on demand :

·

Cash and cash equivalents;

·

Non-interest bearing deposit accounts;

·

Savings, interest-bearing checking and money market accounts and

·

Short-term borrowings.

Securities:  Fair values on investment securities are determined by prices provided by a third-party vendor, who is a provider of financial market data, analytics and related servic es to financial institutions. 

Loans and leases:  The fair value of loans is estimated by the net present value of the future expected cash flows discounted at current offering rates for similar loans.  Current offering rates consider, among other things, credit risk.  The carrying value that fair value is compared to is net of the allowance for loan losses and since there is significant judgment included in evaluating credit quality, loans

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are classified within Level 3 of the fair value hierarchy.  The $1.6 million net carrying value of loans acquired through the Wayne Bank branch acquisition approximates the fair value of the loans.

Loans held-for-sale:  The fair value of loans held-for-sale is estimated using rates currently offered for similar loans and is typically obtained from the Federal National Mortgage Association (FNMA) or the Federal Home Loan Bank of Pittsburgh (FHLB).

Certificates of deposit:  The fair value of certificates of deposit is based on discounted cash flows using rates which approximate market rates for deposits of similar matu rities. The fair value of $11.5 million in certificates of deposit acquired through the Wayne Bank branch acquisition represents the estimated fair value of these deposits.

Long-term debt:  Fair value is estimated using the rates currently offered for similar borrowings.

The following tables illustrate the financial instruments measured at fair value on a recurring basis segregated by hierarchy fair value levels as of the period s indicated:









Quoted prices



in active

Significant other

Significant other



Total carrying value

markets

observable inputs

unobservable inputs

(dollars in thousands)

March 31, 2017

(Level 1)

(Level 2)

(Level 3)

Available-for-sale securities:

Agency - GSE

$

17,256 

$

 -

$

17,256 

$

 -

Obligations of states and political subdivisions

43,791 

 -

43,791 

 -

MBS - GSE residential

92,479 

 -

92,479 

 -

Equity securities - financial services

697 

697 

 -

 -

Total available-for-sale securities

$

154,223 

$

697 

$

153,526 

$

 -









Quoted prices



in active

Significant other

Significant other



Total carrying value

markets

observable inputs

unobservable inputs

(dollars in thousands)

December 31, 2016

(Level 1)

(Level 2)

(Level 3)

Available-for-sale securities:

Agency - GSE

$

18,276 

$

 -

$

18,276 

$

 -

Obligations of states and political subdivisions

40,191 

 -

40,191 

 -

MBS - GSE residential

70,937 

 -

70,937 

 -

Equity securities - financial services

633 

633 

 -

 -

Total available-for-sale securities

$

130,037 

$

633 

$

129,404 

$

 -



Equity securities in the AFS portfolio are measured at fair value using quoted market prices for identical assets and are classified within Level 1 of the valuation hierarchy.  Debt securities in the AFS portfolio are measured at fair value using market quotations provided by a third-party vendor, who is a provider of financial market data, analytics and related services to financial institutions.  Assets classified as Level 2 use valuation techniques that are common to bond valuations.  That is, in active markets whereby bonds of similar characteristics frequently trade, quotes for similar assets are obtained.  For the periods ending March 31, 2017 and December 31, 2016 , there were no transfers to or from Level 1 and Level 2 fair value measurements for financial assets measured on a recurring basis .

There were no changes in Level 3 financial instruments measured at fair value on a recurring basis as of and for the periods ending March 31, 2017 and December 31, 2016 , respectively .

The following table illustrates the financial instruments newly measured at fair value on a non-recurring basis segregated by hierarchy fair value lev els as of the periods indicated:







Quoted prices in

Significant other

Significant other



Total carrying value

active markets

observable inputs

unobservable inputs

(dollars in thousands)

at March 31, 2017

(Level 1)

(Level 2)

(Level 3)



Impaired loans

$

6,744 

$

 -

$

 -

$

6,744 

Other real estate owned

812 

 -

 -

812 

Total

$

7,556 

$

 -

$

 -

$

7,556 

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Quoted prices in

Significant other

Significant other



Total carrying value

active markets

observable inputs

unobservable inputs

(dollars in thousands)

at December 31, 2016

(Level 1)

(Level 2)

(Level 3)



Impaired loans

$

6,254 

$

 -

$

 -

$

6,254 

Other real estate owned

872 

 -

 -

872 

Total

$

7,126 

$

 -

$

 -

$

7,126 



From time-to-time, the Company may be required to record at fair value financial instruments on a non-recurring basis, such as impaired loans, ORE and other repossessed assets.  These non-recurring fair value adjustments involve the application of lower-of-cost-or-market accounting on write downs of individual assets.

The following describes valuation methodologies used for financial instruments measured at fair value on a non-recurring basis.

Impaired loans that are collateral dependent are written down to fair value through the establishment of specific reserves, a component of the allowance for loan losses, and as such are carried at the lower of net recorded investment or the estimated fair value.

Estimates of fair value of the collateral are determined based on a variety of information, including available valuations from certified appraisers for similar assets, present value of discounted cash flows and inputs that are estimated based on commonly used and generally accepted industry liquidation advance rates and estimates and assum ptions developed by management.

Valuation techniques for impaired loans are typically determined through independent appraisals of the underlying collateral or may be determined through present value of discounted cash flows.  Both techniques include various Level 3 inputs which are not identifiable.  The valuation technique may be adjusted by management for estimated liquidation expenses and qualitative factors such as economic conditions.  If real estate is not the primary source of repayment, present value of discounted cash flows and estimates using generally accepted industry liquidation advance rates and other factors may be utilized to determine fair value.

At March 31, 2017 and  December 31, 2016, the range of liquidation expenses and other valuation adjustments applied to impaired loans ranged from -18.03% to - 56.1 0% and from -22.72% to -57.49% respectively.  The weighted-average of liquidation expenses and other valuation adjustments applied to impaired loans amounted to - 26.35 % and -32.47% as of March 31, 2017 and December 31, 2016, respectively.  Due to the multitude of assumptions, many of which are subjective in nature, and the varying inputs and techniques used to determine fair value, the Company recognizes that valuations could differ across a wide spectrum of techniques employed.  Accordingly, fair value estimates for impaired loans are classified as Level 3.

For ORE, fair value is generally determined through independent appraisals of the underlying properties which generally include various Level 3 inputs which are not identifiable.  Appraisals form the basis for determining the net realizable value from these properties.  Net realizable value is the result of the appraised value less certain costs or discounts associated with liquidation which occurs in the normal course of business.  Management's assumptions may include consideration of the location and occupancy of the property, along with current economic conditions.  Subsequently, as these properties are actively marketed, the estimated fair values may be periodically adjusted through incremental subsequent write-downs.  These write-downs usually reflect decreases in estimated values resulting from sales price observations as well as changing economic and market conditions.  At March 31, 2017 and December 31, 2016, the discounts applied to the appraised values of ORE ranged from -21.74% to - 99.00 % and -21.74% to -99.00% , respectiv ely.  As of March 31, 2017 and December 31, 2016, the weighted-average of discount to the apprais al values of ORE amounted to -31.60 % and -32.38% , respectively.

As of March 31, 2017, the Company had one automobile in other repossessed assets with a balance of $1 thousand and as of December 31, 2016 , the Company had another automobile in other repossessed assets with a balance of $8 thousand.  There were no adjustments to the carrying value of these automobiles.

9.  Acquisition

On March 17, 2017, the Company completed the acquisition of the West Scranton branch of Wayne Bank, the wholly owned banking subsidiary of Norwood Financial Corp., pursuant to the terms of the Branch Purchase and Deposit Assumption Agreement dated September 29, 2016.  The Company purchased all of the deposit liabilities associated with the branch, certain loans, and the branch real estate, and immediately closed the branch and consolidated the acquired deposits and loans into its nearby West Scranton branch office.  The Company expects this transaction to expand its customer base in West Scranton.

The transaction has been accounted for using the acquisition method of accounting.  The acquired assets and assumed liabilities were recorded at book value which also represented estimated fair value at the date of acquisition.  Management made significant estimates and exercised significant judgement in estimating fair value, but the fair value adjustments were deemed immaterial to the financial statements . 

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The Company recognized $ 34 thousand of acquisition-related costs during the first quarter of 2017.  These costs are being expensed as incurred and are presented in non-interest expenses on the consolidated statements of income.  Costs incurred in 2017 consist principally of legal fees and professional fees .

The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition :







(dollars in thousands)

March 17, 2017



Cash and cash equivalents

$

11,817 

Loans

1,574 

Bank premises and equipment

264 

Goodwill

209 

Accrued interest receivable and other assets

Total assets acquired

$

13,868 



Deposits

$

13,809 

Accrued interest payable and other liabilities

59 

Total liabilities assumed

$

13,868 



The Company acquired $1.6 million in residential and consumer loans.  None of the loans that were acquired had evidence of credit quality deterioration.

The Company recorded goodwill associated with the acquisition of the West Scranton branch of Wayne bank totaling $0.2 million.  Goodwill is not amortized, but is periodically evaluated for impairment.  The Company did not recognize any impairment during the three months ended March 31, 2017.  For income tax purposes, goodwill will be deducted over a 15 year period.

10.  Employee Benefits

Bank-Owned Life Insurance (BOLI)

The Company has purchased single premium BOLI policies on certain officers.  The policies are recorded at their cash surrender values.  Increases in cash surrender values are included in non-interest income in the consolidated statements of income.  In March 2017, the Company purchased an additional $8.0 million of BOLI.  The policies' cash surrender value totaled $19.5 million and $11.4 million, respectively, as of March 31, 2017 and December 31, 2016 and is reflected as an asset on the consolidated balance sheets.  As of March 31, 2017 and 2016, the Company has recorded income of $107 thousand and $87 thousand, respectively.

Officer Life Insurance

In 2017, the Bank entered into separate split dollar life insurance arrangements (Split Dollar Agreements) with eleven officers.  This plan provides each officer a specified death benefit should the officer die while in the Bank's employ.  The Bank paid the insurance premiums in March 2017 and the arrangements were effective in March 2017.  The Bank owns the policies and all cash values thereunder.  Upon death of the covered employee, the agreed-upon amount of death proceeds from the policies will be paid directly to the insured's beneficiary.  As of March 31, 2017, the policies had total death benefits of $20.3 million of which $3.9 million would have been paid to the officer's beneficiaries and the remaining $16.4 million would have been paid to the Bank.  In addition, three executive officers have the opportunity to retain a split dollar benefit equal to two times their highest base salary after separation from service if the vesting requirements are met.  As of March 31, 2017, the Company has accrued expenses of $3 thousand for the split dollar benefit.

Supplemental Executive Retirement plan (SERP)

On March 29, 2017, the Bank entered into separate supplemental executive retirement agreements (individually the "SERP Agreement") with five officers , pursuant to which the Bank will credit an amount to a SERP account established on each participant's behalf while they are actively employed by the Bank for each calendar month from March 1, 2017 until retirement.  As of March 31, 2017, the Company has accrued expenses of $38 thousand in connection with the SERP.

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Item 2:  Management 's Discussion and Analysis of Financial Condition and Results of Operations

The following is management's discussion and analysis of the significant changes in the consolidated financial condition of the Company as of March 31, 2017 compared to December 31, 2016 and a comparison of the results of operations for the three months ended March 31, 2017 and 2016.  Current performance may not be indicative of future results.  This discussion should be read in conjunction with the Company's 2016 Annual Report filed on Form 10-K.

Forward-looking statements

Certain of the matters discussed in this Quarterly Report on Form 10-Q may constitute forward-looking statements for purposes of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.  The words "expect," "anticipate," "intend," "plan," "believe," "estimate," and similar expressions are intended to identify such forward-looking statements.

The Company's actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors, including, without limitation:

§

the effects of economic conditions on current customers, specifically the effect of the economy on loan customers' ability to repay loans;

§

the costs and effects of litigation and of unexpected or adverse outcomes in such litigation;

§

the impact of new or changes in existing laws and regulations, including the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the regulations promulgated there under;

§

impacts of the capital and liquidity requirements of the Basel III standards and other regulatory pronouncements, regulations and rules;

§

governmental monetary and fiscal policies, as well as legislative and regulatory changes;

§

effects of short- and long-term federal budget and tax negotiations and their effect on economic and business conditions;

§

the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Financial Accounting Standards Board and other accounting standard setters;

§

the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities and interest rate protection agreements, as well as interest rate risks;

§

the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in our market area and elsewhere, including institutions operating locally, regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the internet;

§

technological changes;

§

the interruption or breach in security of our information systems and other technological risks and attacks resulting in failures or disruptions in customer account management, general ledger processing and loan or deposit updates and potential impacts resulting therefrom including additional costs, reputational damage, regulatory penalties, and financial losses;

§

acquisitions and integration of acquired businesses;

§

the failure of assumptions underlying the establishment of reserves for loan losses and estimations of values of collateral and various financial assets and liabilities;

§

volatilities in the securities markets;

§

acts of war or terrorism;

§

disruption of credit and equity markets; and

§

the risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.

The Company cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this document.  The Company has no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document.

Readers should review the risk factors described in other documents that we file or furnish, from time to time, with the Securities and Exchange Commission, including Annual Reports to Shareholders, Annual Reports filed on Form 10-K and other current reports filed or furnished on Form 8-K.

Executive Summary

The Company is a Pennsylvania corporation and a bank holding company, whose wholly-owned state chartered commercial bank is The Fidelity Deposit and Discount Bank.  The Company is headquartered in Dunmore, Pennsylvania.  We consider Lackawanna and Luzerne Counties our primary marketplace.

As a leading Northeastern Pennsylvania community bank, our goals are to enhance shareholder value while continuing to build a full-service community bank.  We focus on growing our core business of retail and business lending and deposit gathering while

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maintaining strong asset quality and controlling operating expenses.  We continue to implement strategies to diversify earning assets and to increase low cost core deposits.  These strategies include a greater level of commercial lending and the ancillary business products and services supporting our commercial customers' needs as well as residential lending strategies and an array of consumer products.  We focus on developing a full banking relationship with existing, as well as new, small- and middle-sized business prospects.  In addition, we explore opportunities to selectively expand our franchise footprint, consisting presently of our 10-branch network.  The Company is constructing a new branch in Dallas, PA in order to expand our presence in Luzerne County.

We are impacted by both national and regional economic factors, with commercial, commercial real estate and residential mortgage loans concentrated in Northeastern Pennsylvania, primarily in Lackawanna and Luzerne counties.  Although the U.S. economy has shown signs of modest improvement, the general operating environment and our local market area continue to remain challenging.  For the near-term, we expect to continue to operate in a low, but slowly-rising interest rate environment.  A rising rate environment positions the Company to improve its net interest income performance .   The Federal Open Market Committee (FOMC) adjusted the short-term federal funds rate up 25 basis points during March 2017.  Expectations are for short-term rates to rise twice more this year, potentially pressuring deposit rate pricing.  The national unemployment rate for March 2017 was 4.5%, down from 4.7% at December 2016 .  However ,   the unemployment rate in Scranton - Wilkes-Barre Metropolitan Statistical Area (local) increased during the first quarter of 2017 and continued to lag behind the unemployment rates of the state and nation.  According to the U.S. Bureau of Labor Statistics, the local unemployment rate at March 31, 2017 was 6.1 %, an increase of 0.7 percentage points f rom 5. 4 % at December 31, 2016 .   During the first quarter of 2017, there was an increase in the number of people that were unemployed which caused the unemployment rate to rise .  Seasonal fluctuations in unemployment are expected.  On the upside, the local unemployment rate decreased year-over-year from 6.6% as of March 31, 2016. The median home values in the region have gone up 2.2 % over the past year, and according to Zillow, an online database advertising firm providing access to its real estate search engines to various media outlets, values are expected to rise 2.4 % within the next year.  In light of these expectations, we will continue to monitor the economic climate in our region and scrutinize growth prospects with credit quality as a principal consideration.

In addition to the challenging economic environment in which we compete, the regulation and oversight of our business has changed significantly in recent years.  As described more fully in Part I, Item 1A, "Risk Factors," and in the "Supervisory and Regulation" section of management's discussion and analysis of financial condition and results of operations in our 201 6 Annual Report filed on Form 10-K, certain aspects of the Dodd-Frank Wall Street Reform Act (Dodd-Frank Act) continue to have a significant impact on us.  In addition, final rules to implement Basel III regulatory capital reform, approved by the federal bank regulatory agencies in 2013, subject many banks including the Company, to capital requirements which will be phased in.  The initial provisions effective for us beg a n on January 1, 2015.  The rules also revise the minimum risk-based and leverage capital ratio requirements applicable to the Company and revise the calculation of risk-weighted assets to enhance their risk sensitivity.  We will continue to prepare for the impacts that the Dodd-Frank Act and the Basel III capital standards, and related rulemaking will have on our business, financial condition and results of operations.

General

The Company's earnings depend primarily on net interest income.  Net interest income is the difference between interest income and interest expense.  Interest income is generated from yields earned on interest-earning assets, which consist principally of loans and investment securities.  Interest expense is incurred from rates paid on interest-bearing liabilities, which consist of deposits and borrowings.  Net interest income is determined by the Company's interest rate spread (the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.  Interest rate spread is significantly impacted by: changes in interest rates and market yield curves and their related impact on cash flows; the composition and characteristics of interest-earning assets and interest-bearing liabilities; differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them and by the competition in the marketplace.

The Company's earnings are also affected by the level of its non-interest income and expenses and by the provisions for loan losses and income taxes.  Non-interest income consists of: service charges on the Company's loan and deposit products; interchange fees; trust and asset management service fees; increases in the cash surrender value of the bank owned life insurance and from net gains or losses from sales of loans and securities.  Non-interest expense consists of: compensation and related employee benefit costs; occupancy; equipment; data processing; advertising and marketing; FDIC insurance premiums; professional fees; loan collection; net other real estate owned (ORE) expenses; supplies and other operating overhead.

Comparison of the results of operations

Three months ended March 31, 2017 and 2016

Overview

During the first quarter of 2017, the Company generated net income of $2.0 million, or $0.80 per diluted share, an increase of $0 .3 million , or 16%, over the $1. 7 million, or $0. 69 per diluted share, generated during the first quarter of 2016.  The increase was due to higher net interest income and non-interest income partially offset by additional non-interest expenses and a higher provision for loan losses.

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Return on average assets (ROA) was 0.99% and 0.92% for the first quarters of 2017 and 2016, respectively.  Return on average shareholders' equity (ROE) was 9.85 % and 8.83 % for the first quarters of 2017 and 2016, respectively .  ROA and ROE both increased because of net income growth. 

Net interest income and interest sensitive assets / liabilities

Net interest income increased $ 0.5 million, or 9%, to $6.6 million for the quarter ended March 31, 2017 from $6.1 million for the quarter ended March 31, 2016 ,   due to higher interest income produced by the addition of $63.9 million in t otal average interest-earning assets .  The loan portfolio experienced average balance growth of $54.9 million which had the effect of producing $0.4 million more interest income despite the negative impact of a n eleven basis point lower yield earned thereon.  All of the loan portfolios contributed to the increase.  Higher average balances of higher-yielding securities produced $0.3 million in additional interest income from investments.  On the liability side, an increase of $37.0 million in average borrowings bumped up interest expense $0.1 million.  Total interest-bearing deposits grew $6.7 million on average but interest expense on deposits was relatively unchanged.

The fully-taxable equivalent (FTE) net interest rate spread was 3.58% for both the first quarter of 2017 and the first quarter of 2016.  The spread remained steady because higher yielding securities caused the total yield on interest-earning assets to increase by four basis points while an increase in borrowings caused rate paid on interest-bearing liabilities to increase by the same amount .   The fully-taxable equivalent (FTE) net interest rate margin in creased by two basis points for the first quarter of 201 7 compared to the first quarter of 201 6 .  Margin growth resulted from a higher-yielding larger average portfolio of interest-earning assets.  The overall cost of funds, which includes the impact of non-interest bearing deposits, increased two basis points for the first quarter of 2017 compared to the first quarter of 2016.  The main reason for the increase was an increase in average borrowings .

During 2017 , the Company expects to operate in a gradually increasing interest rate environment.  A rate environment with rising interest rates positions the Company to improve its interest income performance from new and maturing earning assets.  Until there is a sustained period of yield curve steepening, with rates rising more sharply at the long en d, the interest rate margin may experience compression.  However for 2017, the Company anticipates net interest income to improve as growth in interest-earning assets would help mitigate an adverse impact of rate movements on cost of funds .  The Federal Open Market Committee (FOMC )   increased the short-term federal funds rate in both 2015 and 2016 and again in March 2017, but it had a minimal effect on rates paid on funding sources.  The focus for 2017 is to manage net interest income after years of a sustained low interest rate environment by maintaining a reasonable spread.  Interest expense is projected to increase for 2017 from growth in deposits and borrowings and an increase in rates paid on both .  Continued growth in the loan portfolios complemented with investment security growth is expected to boost interest income , and when coupled with a proactive relationship approach to deposit cost setting strategies should help c ontain the interest rate margin at acceptable levels.

The Company's cost of interest-bearing liabilities was 50 basis points for the three months ended March 31, 2017 and 46 basis points for the three months ended March 31, 2016, respectively.  The four basis point increase was due to an increase of $37.0 million in average borrowings .  Other than retaining maturing long-term CDs, further reductions in deposit rates from the current historic low levels would have an insignificant cost-savings impact and it is unlikely in the short-term .  Interest rates along the treasury yield curve have been volatile with s horter-term rates rising faster than long-term rates producing a flatter yield curve during 2017 .  Competition could pressure banks to increase deposit rates.  On the asset side, the prime interest rate, the benchmark rate that banks use as a base rate for adjustable rate loans, rose 25 basis points in March 2017.  I f   rates continue to rise in 2017 , the effect could pressure net interest income if short-term rates rise more rapidly than longer-term interest rates, thereby compressing the interest rate spread .  To help mitigate the impact of the imminent change to the economic landscape, the Company has successfully developed and will continue to strengthen its association with existing customers, develop new business relationships, generate new loan volumes, and retain and generate higher levels of average non-interest bearing deposit balances.  Strategically deploying no- and low-cost deposits into interest earning-assets is an effective margin-preserving strategy that the Company expects to continue to pursue and expand to help stabilize net interest margin.

The Company's Asset Liability Management (ALM) team meets regularly to discuss among other things, interest rate risk and when deemed necessary adjusts interest rates.  ALM also discusses revenue enhancing strategies to help combat the potential for a decline in net interest income. The Company's marketing department, together with ALM, lenders and deposit gatherers, continue to develop prudent strategies that will grow the loan portfolio and accumulate low-cost deposits to improve net interest income performance.

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Table Of Contents

The table that follows sets forth a comparison of average balances of assets and liabilities and their related net tax equivalent yields and rates for the periods indicated.  Within the table, interest income was adjusted to a tax-equivalent basis (FTE), using the corporate federal tax rate of 34% to recognize the income from tax-exempt interest-earning assets as if the interest was taxable.  This treatment allows a uniform comparison among yields on interest-earning assets.  Loans include loans HFS and non-accrual loans but exclude the allowance for loan losses.  Net deferred loan cost amortization of $ 108 thousand and $113 thousand for the first quarters of 201 7 and 201 6 , respectively, are included in interest income from loans.  Average balances are based on amortized cost and do not reflect net unrealized gains or losses.  Net interest margin is calculated by dividing annualized net interest income - FTE by total average interest-earning assets.  Cost of funds includes the effect of average non-interest bearing deposits as a funding source:









Three months ended

(dollars in thousands)

March 31, 2017

March 31, 2016



Average

Yield /

Average

Yield /

Assets

balance

Interest

rate

balance

Interest

rate



Interest-earning assets

Interest-bearing deposits

$

2,070 

$

1.14 

%

$

16,740 

$

22 

0.53 

%

Investments:

Agency - GSE

18,291 

63 

1.41 

18,450 

53 

1.15 

MBS - GSE residential

85,541 

556 

2.63 

68,661 

317 

1.86 

State and municipal (nontaxable)

40,171 

545 

5.50 

34,979 

496 

5.70 

Other

3,512 

26 

3.06 

1,707 

23 

5.46 

Total investments

147,515 

1,190 

3.27 

123,797 

889 

2.89 

Loans and leases:

Commercial and commercial real estate (taxable)

291,997 

3,213 

4.46 

278,003 

3,068 

4.44 

Commercial and commercial real estate (nontaxable)

29,031 

319 

4.45 

27,200 

290 

4.28 

Consumer

94,037 

1,002 

4.32 

65,603 

911 

5.58 

Residential real estate

197,517 

1,945 

3.99 

186,905 

1,836 

3.95 

Total loans and leases

612,582 

6,479 

4.29 

557,711 

6,105 

4.40 

Federal funds sold

 -

   -

 -

 -

 -

 -

Total interest-earning assets

762,167 

7,675 

4.08 

%

698,248 

7,016 

4.04 

%

Non-interest earning assets

51,916 

48,581 

Total assets

$

814,083 

$

746,829 



Liabilities and shareholders' equity



Interest-bearing liabilities

Deposits:

Interest-bearing checking

$

177,161 

$

165 

0.38 

%

$

154,628 

$

102 

0.26 

%

Savings and clubs

122,849 

38 

0.13 

117,256 

37 

0.13 

MMDA

115,928 

179 

0.63 

127,635 

217 

0.68 

Certificates of deposit

93,650 

204 

0.88 

103,399 

224 

0.87 

Total interest-bearing deposits

509,588 

586 

0.47 

502,918 

580 

0.46 

Repurchase agreements

13,674 

0.22 

14,710 

0.22 

Borrowed funds

39,471 

95 

0.97 

2,434 

10 

1.55 

Total interest-bearing liabilities

562,733 

688 

0.50 

%

520,062 

598 

0.46 

%

Non-interest bearing deposits

164,340 

144,890 

Non-interest bearing liabilities

5,501 

4,396 

Total liabilities

732,574 

669,348 

Shareholders' equity

81,509 

77,481 

Total liabilities and shareholders' equity

$

814,083 

$

746,829 

Net interest income - FTE

$

6,987 

$

6,418 



Net interest spread

3.58 

%

3.58 

%

Net interest margin

3.72 

%

3.70 

%

Cost of funds

0.38 

%

0.36 

%





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Changes in net interest income are a function of both changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities.  The following table presents the extent to which changes in interest rates and changes in volumes of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and interest expense during the periods indicated.  Information is provided in each category with respect to (1) the changes attributable to changes in volume (changes in volume multiplied by the prior period rate), (2) the changes attributable to changes in interest rates (changes in rates multiplied by prior period volume) and (3) the net change.  The combined effect of changes in both volume and rate has been allocated proportionately to the change due to volume and the change due to rate.  Tax-exempt income was not converted to a tax-equivalent basis on the rate/volume analysis:







Three months ended March 31,

(dollars in thousands)

2017 compared to 2016

2016 compared to 2015



Increase (decrease) due to



Volume

Rate

Total

Volume

Rate

Total

Interest income:

Interest-bearing deposits

$

(29)

$

13 

$

(16)

$

(6)

$

12 

$

Investments:

Agency - GSE

-

11 

11 

(5)

MBS - GSE residential

88 

150 

238 

69 

38 

107 

State and municipal

43 

(14)

29 

 -

Other

15 

(11)

(61)

(56)

Total investments

146 

136 

282 

86 

(28)

58 

Loans and leases:

Residential real estate

91 

18 

109 

133 

(24)

109 

Commercial and CRE

136 

28 

164 

342 

(83)

259 

Consumer

326 

(235)

91 

(13)

13 

 -

Total loans and leases

553 

(189)

364 

462 

(94)

368 

Federal funds sold

-

 -

 -

 -

 -

 -

Total interest income

670 

(40)

630 

542 

(110)

432 



Interest expense:

Deposits:

Interest-bearing checking

15 

48 

63 

17 

12 

29 

Savings and clubs

(1)

(16)

(14)

Money market

(21)

(17)

(38)

16 

24 

Certificates of deposit

(23)

(20)

(20)

(16)

Total deposits

(27)

33 

39 

(16)

23 

Repurchase agreements

(1)

-

(1)

(1)

 -

Borrowed funds

90 

(5)

85 

(63)

(59)

(122)

Total interest expense

62 

28 

90 

(25)

(74)

(99)

Net interest income

$

608 

$

(68)

$

540 

$

567 

$

(36)

$

531 



Provision for loan losses

The provision for loan losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for loan losses (the allowance) to a level that represents management's best estimate of known and inherent losses in the Company's loan portfolio.  Loans determined to be uncollectible are charged off against the allowance. The required amount of the provision for loan losses, based upon the adequate level of the allowance, is subject to the ongoing analysis of the loan portfolio.  The Company's Special Assets Committee meets periodically to review problem loans.  The committee is comprised of management, including credit administration officers, loan officers, loan workout officers and collection personnel.  The committee reports quarterly to the Credit Administration Committee of the board of directors.

Management continuously reviews the risks inherent in the loan portfolio.  Specific factors used to evaluate the adequacy of the loan loss provision during the formal process include:

• specific loans that could have loss potential;

• levels of and trends in delinquencies and non-accrual loans;

• levels of and trends in charge-offs and recoveries;

• trends in volume and terms of loans;

• changes in risk selection and underwriting standards;

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Table Of Contents

• changes in lending policies, procedures and practices;

• experience, ability and depth of lending management;

• national and local economic trends and conditions; and

• changes in credit concentrations.

For the three months ended March 31, 2017 and 2016, the Company recorded a provision for loan losses of $0.3 million and $0. 1 million, respectively.  The provision increased $0. 2 million during comparable periods because of approximately $66 million growth in gross loans, combined with increased environmental factors and specific reserves held for impaired loans.  At the same time, non-performing loans as a percentage of total loans fell 33 basis points to 1.27% at March 31, 2017 from 1.60% at March 31, 2016, indicating improvement in year-over-year asset quality.  For a discussion on the allowance for loan losses, see "Allowance for loan losses," located in the comparison of financial condition section of management's discussion and analysis contained herein.

Other income

For the first quarter of 2017, non-interest income amounted to $2.1 million, an increase of $0.4 million from the $1.7 million recorded for the first quarter of 2016 .  The increase was primarily due to $0.2 million more gains on the sale of loans from a higher number of loans sold and a large gain recognized on a sold commercial loan.  Increases in service charges on deposit accounts, interchange fees, fees from financial services and service charges on loans added another $0.2 million combined to non-interest income.

Other operating expenses

For the three months ended March 31, 2017, non-interest expenses increased $0.4 million, or 8%, compared to the three months ended March 31, 2016, from $5.4 million to $5.8 million .  Salaries and employee benefits increased $0. 2 million, from $ 2.9 million for the first quarter of 2016 to $ 3.1 million for the same 201 7 period.  The increase stems from select staff additions or replacements to previously vacant positions, annual merit increases, one-time salary increases awarded to certain employees in the normal course of performance management, higher share-based compensation expense and additional expenses for a retirement benefit plan that was implemented in the first quarter of 2017 .  Data processing and communications increased $0.1 million d ue to additional costs related to a new integrated dealer lending program and higher data center costs incurred during 2017.  Premises and equipment increased $67 thousand, or 7%, due to additional expenses for snow removal during the first quarter of 2017 and building maintenance.  Automated transaction processing also increased $47 thousand for the quarter ended March 31, 2017 compared to the 201 6 like period due to expenses incurred related to updating customer debit cards with the new chip technology and more ATM activity during the first quarter of 2017.  Partially offsetting these increases was a $60 thousand decrease in the FDIC assessment. 

The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, at March 31, 2017 and 2016 were 1.88 % and 1 .99 %, r espectively.  The expense ratio decreased due to higher average assets which were able to absorb the higher non-interest expenses .  The efficiency ratio also decreased from 66.49 % at March 31, 2016 to 64.33 % at March 31, 2017 due to higher income.

Comparison of financial condition at

March 31, 2017 and December 31, 201 6

Overview

Consolidated assets increased $ 59.7 million, or 8 %, to $ 852.6 million as of March 31, 2017 from $ 792.9 million at December 31, 201 6 .  The increase in assets occurred in the loan and investment portfolio s and bank owned life insurance utilizing growth in deposits of $ 30.5 million , borrowings of $27.5 million and $ 1.2 million in retained earnings, net of dividends declared. 

Funds Deployed:

Investment securities

At the time of purchase, management classifies investment securities into one of three categories: trading, available-for-sale (AFS) or held-to-maturity (HTM).  To date, management has not purchased any securities for trading purposes.  All of the securities the Company purchases are classified as AFS even though there is no immediate intent to sell them.  The AFS designation affords management the flexibility to sell securities and position the balance sheet in response to capital levels, liquidity needs or changes in market conditions.  Securities AFS are carried at fair value on the consolidated balance sheets with unrealized gains and losses, net of deferred income taxes, reported separately within shareholders' equity as a component of accumulated other comprehensive income (AOCI).  Securities designated as HTM are carried at amortized cost and represent debt securities that the Company has the ability and intent to hold until maturity.

As of March 31, 2017 , the carrying value of investment securities amounted to $ 154.2 million, or 18 % of total assets, compared to $ 130.0 million, or 1 6 % of total assets, at December 31, 201 6 .  On March 31 , 2017, 60% of the carrying value of the investment portfolio was comprised of U.S. Government Sponsored Enterprise residential mortgage-backed securities (MBS – GSE residential or mortgage-backed securities) that amortize and provide monthly cash flow that the Company can use for reinvestment, loan demand, unexpected deposit outflow, facility expansion or operations.

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Table Of Contents

Investment securities were comprised of AFS securities as of March 31, 2017 .  The AFS securities were recorded with a net unrealized gain of $2.1 million both as of March 31, 2017 and December 31, 201 6 , or a net gain of $ 27 thousand during the first three months of 2017 .  The direction and magnitude of the change in value of the Company's investment portfolio is attributable to the direction and magnitude of the change in interest rates along the treasury yield curve.  Generally, the values of debt securities move in the opposite direction of the changes in interest rates.  As interest rates along the treasury yield curve decline, especially at the intermediate and long end, the values of debt securities tend to rise.  Whether or not the value of the Company's investment portfolio will continue to exceed its amortized cost will be largely dependent on the direction and magnitude of interest rate movements and the duration of the debt securities within the Company's investment portfolio.  When interest rates rise, the market values of the Company's debt securities portfolio could be subject to market value declines.

As of March 31, 2017, the Company had $155.6 million in public deposits, or 21% of total deposits.  These public deposits require the Company to maintain pledged securities.  As of March 31, 2017, the balance of pledged securities required for deposit and repurchase agreement accounts was $139.1 million.

Quarterly, management performs a review of the investment portfolio to determine the causes of declines in the fair value of each security.  The Company uses inputs provided by independent third parties to determine the fair value of its investment securities portfolio.  Inputs provided by the third parties are reviewed and corroborated by management.  Evaluations of the causes of the unrealized losses are performed to determine whether impairment exists and whether the impairment is temporary or other-than-temporary.  Considerations such as the Company's intent and ability to hold the securities to maturity, recoverability of the invested amounts over the intended holding period, the length of time and the severity in pricing decline below cost, the interest rate environment, the receipt of amounts contractually due and whether or not there is an active market for the securities, for example, are applied, along with an analysis of the financial condition of the issuer for management to make a realistic judgment of the probability that the Company will be unable to collect all amounts (principal and interest) due in determining whether a security is other-than-temporarily impaired.  If a decline in value is deemed to be other-than-temporary, the amortized cost of the security is reduced by the credit impairment amount and a corresponding charge to current earnings is recognized.  During the three months ended March 31, 2017 , the Company did not incur other-than-temporary impairment charges from its investment securities portfolio.

During the first quarter of 2017 , the carrying value of total investments increased $ 24.2 million, or 19 %.  The Company attempts to maintain a well-diversified and proportionate investment portfolio that is structured to complement the strategic direction of the Company.  Its growth typically supplements the lending activities but also considers the current and forecasted economic conditions, the Company's liquidity needs and interest rate risk profile.  The Company expects to grow the portfolio and increase its relative size with a preference toward mortgage-backed securities.  If rates rise, the strategy will provide a good source of cash flow to reinvest into higher yielding interest-sensitive assets.  During the first quarter of 2017, the Company purchased approximately $20 million of securities, primarily MBS - GSE residential, funded by $10 million in debt maturing in two years and another $10 million in borrowings laddered out from six months to one year matching a spread expected to produce a suitable after-tax return.

A comparison of investment securities at March 31, 2017 and December 31, 2016 is as follows:









March 31, 2017

December 31, 2016

(dollars in thousands)

Amount

%

Amount

%



MBS - GSE residential

$

92,479 

60.0 

%

$

70,937 

54.5 

%

State & municipal subdivisions

43,791 

28.4 

40,191 

30.9 

Agency - GSE

17,256 

11.2 

18,276 

14.1 

Equity securities - financial services

697 

0.4 

633 

0.5 

Total

$

154,223 

100.0 

%

$

130,037 

100.0 

%



As of March 31, 2017, there were no investments from any one issuer with an aggregate book value that exceeded 10% of the Company's shareholders' equity.

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Table Of Contents

The distribution of debt securities by stated maturity and tax-equivalent yield at March 31, 2017 are as follows:









More than

More than

More than



One year or less

one year to five years

five years to ten years

ten years

Total

(dollars in thousands)

$  

%

$  

%

$  

%

$  

%

$  

%



MBS - GSE residential

$

 -

 -

%

$

2,110  3.84 

%

$

4,870  3.59 

%

$

85,499  3.30 

%

$

92,479  3.33 

%

State & municipal subdivisions

 -

 -

903  6.44 

1,741  5.68 

41,147  5.09 

43,791  5.14 

Agency - GSE

4,011  1.21 

13,245  1.48 

 -

 -

 -

 -

17,256  1.42 

Total debt securities

$

4,011  1.21 

%

$

16,258  2.02 

%

$

6,611  4.14 

%

$

126,646  3.87 

%

$

153,526  3.61 

%



In the above table, the book yields on state & municipal subdivisions were adjusted to a tax-equivalent basis using the corporate federal tax rate of 34%.  In addition, average yields on securities AFS are based on amortized cost and do not reflect unrealized gains or losses.

Federal Home Loan Bank Stock

Investment in Federal Home Loan Bank (FHLB) stock is required for membership in the organization and is carried at cost since there is no market value available.  The amount the Company is required to invest is dependent upon the relative size of outstanding borrowings the Company has with the FHLB of Pittsburgh.  Excess stock is repurchased from the Company at par if the amount of borrowings decline to a predetermined level.  In addition, the Company earns a return or dividend based on the amount invested.  T he balance in FHLB stock was $2. 5 million and $2. 6 million as of March 31, 2017 and December 31, 201 6 , respectively.  During 2017, the balance of FHLB stock is expected to increase to support anticipated borrowing activities .

Loans held-for-sale (HFS)

Upon origination, most residential mortgages and certain Small Business Administration (SBA) guaranteed loans may be classified as held-for-sale (HFS).  In the event of market rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market.  In low interest rate environments, the Company would be exposed to prepayment risk and, as rates on adjustable-rate loans decrease, interest income would be negatively affected.  Consideration is given to the Company's current liquidity position and projected future liquidity needs.  To better manage prepayment and interest rate risk, loans that meet these conditions may be classified as HFS.  Occasionally, residential mortgage and/or other nonmortgage loans may be transferred from the loan portfolio to HFS.  The carrying value of loans HFS is based on the lower of cost or estimated fair value.  If the fair values of these loans decline below their original cost, the difference is written down and charged to current earnings.  Subsequent appreciation in the portfolio is credited to current earnings but only to the extent of previous write-downs.

As of March 31, 2017 and December 31, 2016, loans HFS consisted of residential mortgages with carrying amounts of $2.0 million and $2.9 million, respectively, which approximated their fair values.  During the three months ended March 31, 2017, residential mortgage loans with principal balances of $8.5 million were sold into the secondary market and the Company recognized net gains of $0.2 million, compared to $6.5 million and $0.1 million, respectively during the three months ended March 31, 2016.  During 2017, the Company also sold one SBA guaranteed loan with a principal balance of $2.4 million and recognized a net gain on the sale of $0.1 million.  The Company did not sell any SBA guaranteed loans in 2016. 

The Company retains mortgage servicing rights (MSRs) on loans sold into the secondary market.  MSRs are retained so that the Company can foster personal relationships with its loyal customer base.  At March 31, 2017 and December 31, 2016, the servicing portfolio balance of sold residential mortgage loans was $287.0 million and $285.2 million, respectively.  At March 31, 2017 and December 31, 2016, the servicing portfolio balance of sold SBA loans was $6.3 million and $4.1 million, respectively.

Loans and leases

For the quarter ended March 31, 2017, the overall loan portfolio had growth of $23.7 million, or 4%.  This growth was primarily attributed to commercial and industrial loans ($19.5 million) ,   auto loans and leases ($6.6 million) and residential real estate loans ($3.6 million ) .  Management continue s to anticipate growth, but at a slower pace than the first quarter of 2017 .  The Company expect s overall portfolio growth for 2017 , after an anticipated pay-off of a large CRE credit and the expected selling of loan participations .

Growth will occur from a continuation of the partnership between credit and the relationship managers as well as utilizing the team approach between branch personnel, business services and relationship managers who have the common goal of becoming trusted financial advisors and exceeding customer expectations.

Commercial and industrial and commercial real estate

Compared to year-end 2016, the commercial and industrial (C&I) loan portfolio increased $19.5 million, or 20%, in the first quarter of 2017.  The major contributors to this growth were credit facilities to several municipalities .  The commercial real estate (CRE) loan portfolio was up $3.8 million, or 2%, from $204.3 million at December 31, 2016 to $208.1 million at March 31, 2017 which was attributable to the normal course of business.  Our original estimate for anticipated growth in the commercial portfolio remains at 4 %. 

Consumer

The consumer loan portfolio remained relatively flat at approximately $150.0 million in total as continued growth of $6.6 million in auto loans and leases was offset by a $7.1 million decrease in other loans.  T he decrease in other loans was due to a temporary

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Table Of Contents

overdraft at the end of 2016 funded by a C&I loan in January 2017 .  Additionally, a slight reduction in home equity installment loans outstanding was offset by growth in home equity lines of credit.  

Residential

The residential loan portfolio grew $0.8 million, or 1%, from $145.0 million at December 31, 2016 to $145.8 million at March 31, 2017.  The allocation of the portfolio shifted as noted by a $2.8 million reduction in construction mortgages and an increase of $3.6 million in real estate mortgages which make up approximately 95 % of this category.

The composition of the loan portfolio at March 31, 2017 and December 31, 2016 is summarized as follows:









March 31, 2017

December 31, 2016

(dollars in thousands)

Amount

%

Amount

%



Commercial and industrial

$

118,003 

19.0 

%

$

98,477 

16.5 

%

Commercial real estate:

Non-owner occupied

105,103 

16.9 

93,364 

15.6 

Owner occupied

99,209 

16.0 

106,960 

17.8 

Construction

3,789 

0.6 

3,987 

0.7 

Consumer:

Home equity installment

27,725 

4.5 

28,466 

4.8 

Home equity line of credit

52,398 

8.4 

51,609 

8.6 

Auto and leases

63,446 

10.2 

56,841 

9.5 

Other

6,250 

1.0 

13,301 

2.2 

Residential:

Real estate

138,102 

22.2 

134,475 

22.5 

Construction

7,657 

1.2 

10,496 

1.8 

Gross loans

621,682 

100.0 

%

597,976 

100.0 

%

Less:

Allowance for loan losses

(9,548)

(9,364)

Unearned lease revenue

(513)

(482)

Net loans

$

611,621 

$

588,130 



Loans held-for-sale

$

1,961 

$

2,854 



Allowance for loan losses

Management evaluates the credit quality of the Company's loan portfolio and performs a formal review of the adequacy of the allowance for loan losses (the allowance) on a quarterly basis.  The allowance reflects management's best estimate of the amount of credit losses in the loan portfolio.  Management's judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans.  Those estimates may be susceptible to significant change.  The provision for loan losses represents the amount necessary to maintain an appropriate allowance.  Loan losses are charged directly against the allowance when loans are deemed to be uncollectible.  Recoveries from previously charged-off loans are added to the allowance when received.

Management applies two primary components during the loan review process to determine proper allowance levels.  The two components are a specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated.  The methodology to analyze the adequacy of the allowance for loan losses is as follows:

• identification of specific impaired loans by loan category;

• calculation of specific allowances where required for the impaired loans based on collateral and other objective and quantifiable evidence;

• determination of loans with similar credit characteristics within each class of the loan portfolio segment and eliminating the impaired loans;

• application of historical loss percentages (trailing twelve-quarter average) to pools to determine the allowance allocation;

• application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio, and/or current economic conditions.

Through March 31, 2017, allocation of the allowance for different categories of loans is based on the methodology as explained above.  A key element of the methodology to determine the allowance is the Company's credit risk evaluation process, which includes credit risk grading of individual commercial loans.  Commercial loans are assigned credit risk grades based on the Company's assessment of conditions that affect the borrower's ability to meet its contractual obligations under the loan agreement.  That process

39

Table Of Contents

includes reviewing borrowers' current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower.  Upon review, the commercial loan credit risk grade is revised or reaffirmed.  The credit risk grades may be changed at any time management determines an upgrade or downgrade may be warranted.  The credit risk grades for the commercial loan portfolio are taken into account in the reserve methodology and loss factors are applied based upon the credit risk grades.  The loss factors applied are based upon the Company's historical experience as well as what management believes to be best practices and within common industry standards.  Historical experience reveals there is a direct correlation between the credit risk grades and loan charge-offs.  The changes in allocations in the commercial loan portfolio from period-to-period are based upon the credit risk grading system and from periodic reviews of the loan portfolio.

Each quarter, management performs an assessment of the allowance for loan losses.  The Company's Special Assets Committee meets monthly and the applicable lenders discuss each relationship under review and reach a consensus on the appropriate estimated loss amount, if applicable, based on current accounting guidance.  The Special Assets Committee's focus is on ensuring the pertinent facts are considered regarding not only loans considered for specific reserves, but also the collectability of loans that may be past due.  The assessment process also includes the review of all loans on non-accrual status as well as a review of certain loans to which the lenders or the Credit Administration function have assigned a criticized or classified risk rating.

Net charge-offs were $0.1 million as of March 31, 2017, $1.2 million for the year ended December 31, 2016 and $0.3 million as of March 31, 2016.  During the period ended March 31, 2017, no specific loan class significantly underperformed as charge-offs were taken across a variety of consumer, commercial and residential loans.  For a discussion on the provision for loan losses, see the "Provision for loan losses," located in the results of operations section of management's discussion and analysis contained herein.

The allowance for loan losses was $9.5 million as of March 31, 2017, and $9.4 million both as of December 31, 2016 and March 31, 2016 .   Management believes that the current balance in the allowance for loan losses is sufficient to withstand the identified potential credit quality issues that may arise and others unidentified but inherent to the portfolio.  Potential problem loans are those where there is known information that leads management to believe repayment of principal and/or interest is in jeopardy and the loans are currently neither on non-accrual status nor past due 90 days or more.  There could be additional instances which become identified in future periods that may require additional charge-offs and/or increases to the allowance due to continued sluggishness in the economy and pressure on property values. In contrast, an abrupt significant increase in the U.S. Prime lending rate could adversely impact the debt service capacity of existing borrowers' ability to repay.

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The following tables set forth the activity in the allowance for loan losses and certain key ratios for the period indicated:







As of and for the

As of and for the

As of and for the



three months ended

twelve months ended

three months ended

(dollars in thousands)

March 31, 2017

December 31, 2016

March 31, 2016



Balance at beginning of period

$

9,364 

$

9,527 

$

9,527 



Charge-offs:

Commercial and industrial

 -

(224)

(14)

Commercial real estate

(67)

(592)

(85)

Consumer

(76)

(504)

(175)

Residential

(38)

(60)

(60)

Total

(181)

(1,380)

(334)



Recoveries:

Commercial and industrial

55 

Commercial real estate

10 

37 

Consumer

28 

100 

28 

Residential

 -

 -

 -

Total

40 

192 

41 

Net charge-offs

(141)

(1,188)

(293)

Provision for loan losses

325 

1,025 

150 

Balance at end of period

$

9,548 

$

9,364 

$

9,384 



Allowance for loan losses to total loans

1.54 

%

1.57 

%

1.69 

%

Net charge-offs to average total loans outstanding

0.09 

%

0.21 

%

0.21 

%

Average total loans

$

612,582 

$

568,953 

$

557,711 

Loans 30 - 89 days past due and accruing

$

1,434 

$

2,241 

$

2,390 

Loans 90 days or more past due and accruing

$

58 

$

19 

$

619 

Non-accrual loans

$

7,851 

$

7,370 

$

8,306 

Allowance for loan losses to loans 90 days or more past due and accruing

164.62 

x

492.84 

x

15.16 

Allowance for loan losses to non-accrual loans

1.22 

x

1.27 

x

1.13 

x

Allowance for loan losses to non-performing loans

1.21 

x

1.27 

x

1.05 

x



The allowance for loan losses can generally absorb losses throughout the loan portfolio.  However, in some instances an allocation is made for specific loans or groups of loans.  Allocation of the allowance for loan losses for different categories of loans is based on the methodology used by the Company, as previously explained.  The changes in the allocations from period-to-period are based upon quarter-end reviews of the loan portfolio.

Allocation of the allowance among major categories of loans for the periods indicated, as well as the percentage of loans in each category to total loans, is summarized in the following table.  This table should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or proportions, or that the allocation indicates future charge-off trends.  When present, the portion of the allowance designated as unallocated is within the Company's guidelines:









March 31, 2017

December 31, 2016

March 31, 2016



Category

Category

Category



% of

% of

% of

(dollars in thousands)

Allowance

Loans

Allowance

Loans

Allowance

Loans

Category

Commercial real estate

$

4,922 

34 

%

$

4,706 

34 

%

$

4,583 

36 

%

Commercial and industrial

1,263 

19 

1,075 

17 

1,640 

19 

Consumer

1,731 

24 

1,834 

25 

1,678 

20 

Residential real estate

1,519 

23 

1,622 

24 

1,379 

25 

Unallocated

113 

 -

127 

 -

104 

 -

Total

$

9,548 

100 

%

$

9,364 

100 

%

$

9,384 

100 

%

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Table Of Contents



Non-performing assets

The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, troubled debt restructured loans (TDRs), other real estate owned (ORE) and repossessed assets.  At March 31, 2017, non-performing assets represented 1.28% of total assets compared with 1.33% as of December 31, 2016 and 1.77% as of March 31, 2016, as a result of a reduction in accruing TDRs by $1. 1 million and ORE by $0. 5 million over the twelve month p eriod ending March 31, 2017.  There was also a net reduction in non-accrual loans over the same twelve month period, from $8.3 million as of March 31, 2016 to $7.9 million as of March 31, 2017.  The net reduction in non-accrual loans occurred in the second quarter of 2016 and was primarily the result of the payoff of one large commercial real estate loan for $5.0 million and the addition of two other commercial real estat e loans totaling $3.1 million. Most of the non-performing loans are collateralized, thereby mitigating the Company's potential for loss.

The following table sets forth non-performing assets data as of the period indicated:









(dollars in thousands)

March 31, 2017

December 31 2016

March 31, 2016



Loans past due 90 days or more and accruing

$

58 

$

19 

$

619 

Non-accrual loans *

7,851 

7,370 

8,306 

Total non-performing loans

7,909 

7,389 

8,925 

Troubled debt restructurings

1,745 

1,823 

2,857 

Other real estate owned and repossessed assets

1,239 

1,306 

1,766 

Total non-performing assets

$

10,893 

$

10,518 

$

13,548 



Total loans, including loans held-for-sale

$

623,130 

$

600,348 

$

557,293 

Total assets

$

852,686 

$

792,944 

$

763,382 

Non-accrual loans to total loans

1.26% 

1.23% 

1.49% 

Non-performing loans to total loans

1.27% 

1.23% 

1.60% 

Non-performing assets to total assets

1.28% 

1.33% 

1.77% 

* In the table above, the amount includes non- accrual TDRs of $2.5 million as of March 31, 2017, $1.5 million as of December 31, 2016 and $ 0.2 million as of March 31, 2016 .

In the review of loans for both delinquency and collateral sufficiency, management concluded that there were a number of loans that lacked the ability to repay in accordance with contractual terms.  The decision to place loans on non-accrual status is made on an individual basis after considering factors pertaining to each specific loan.  Generally, commercial loans are placed on non-accrual status when management has determined that payment of all contractual principal and interest is in doubt or the loan is past due 90 days or more as to principal and interest, unless well-secured and in the process of collection.  Consumer loans secured by residential real estate and residential mortgage loans are placed on non-accrual status at 120 days past due as to principal and interest, and unsecured consumer loans are charged-off when the loan is 90 days or more past due as to principal and interest.  Uncollected interest income accrued on all loans placed on non-accrual is reversed and charged to interest income.

Non-performing loans, which consists of accruing loans that are over 90 days past due as well as all non-accrual loans, decreased $1. 0 million, or 1 1 %, from $8.9 million at March 31, 201 6   to $7. 9 million at March 31, 2017 .  This decrease is attributed to the payoff of one large non-accrual loan in the commercial real estate portfolio and reduction of over 90 day delinquent loans by $0.6 million.  Compared to December 31, 2016 ,   non-performing loans increased $0.5 million to $7.9 million as of March 31, 2017 as a result of the addition of two commercial real estate loans into non - accrual status.  At March 31, 2017, the portion of accruing loans that was over 90 days past due totaled $58 thousand and consisted of 7 loans to 7 unrelated borrowers ranging from $1 thousand to $20 thousand.  At December 31, 2016, the portion of accruing loans that was over 90 days past due totaled $19 thousand and consisted of 4 auto loans with recourse to four unrelated borrowers, ranging from $1 thousand to $9 thousand.  At March 31, 2016, the portion of accruing loans that was over 90 days past due totaled $0.6 million and consisted of nine loans to nine unrelated borrowers ranging from less than $6 thousand to $0.2 million.  The Company seeks payments from all past due customers through an aggressive customer communication process.  A past due loan will be placed on non-accrual at the 90 day point when it is deemed that a customer is non-responsive and uncooperative to collection efforts .

At March 31, 2017, there were 41 loans to 31 unrelated borrowers ranging from less than $1 thousand to $2.3 million in the non-accrual category.  At December 31, 2016, there were 46 loans to 39 unrelated borrowers ranging from less than $1 thousand to $2.3 million in the non-accrual category.  Non-accrual loans in creased during the period ending March 31, 2017 for the following reasons:  $1.1 million in new non-accrual loans plus capitalized expenditures on these loans were added; $0.2 million were paid down or paid off; $0. 1 million were charged off; $ 0.2 million were transferred to ORE, and $ 0.1 million was moved back to accrual status.

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The composition of non-performing loans as of March 31, 2017 is as follows:













Past due



Gross

90 days or

Non-

Total non-

% of



loan

more and

accrual

performing

gross

(dollars in thousands)

balances

still accruing

loans

loans

loans

Commercial and industrial

$

118,003 

$

 -

$

$

0.00% 

Commercial real estate:

Non-owner occupied

105,103 

 -

1,357 

1,357 

1.29% 

Owner occupied

99,209 

 -

3,903 

3,903 

3.93% 

Construction

3,789 

 -

182 

182 

4.80% 

Consumer:

Home equity installment

27,725 

 -

 -

 -

0.00% 

Home equity line of credit

52,398 

 -

798 

798 

1.52% 

Auto loans and leases *

62,933 

37 

42 

79 

0.13% 

Other

6,250 

21 

 -

21 

0.34% 

Residential:

Real estate

138,102 

 -

1,565 

1,565 

1.13% 

Construction

7,657 

 -

 -

 -

 -

Loans held-for-sale

1,961 

 -

 -

 -

 -



Total

$

623,130 

$

58 

$

7,851 

$

7,909 

1.27% 



*Net of unearned lease revenue of $0.5 million.

Payments received from non-accrual loans are recognized on a cost recovery method.  Payments are first applied to the outstanding principal balance, then to the recovery of any charged-off loan amounts.  Any excess is treated as a recovery of interest income.  If the non-accrual loans that were outstanding as of March 31, 2017 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $11 thousand.

The Company, on a regular basis, reviews changes to loans to determine if they meet the definition of a TDR.  TDRs arise when a borrower experiences financial difficulty and the Company grants a concession that it would not otherwise grant based on current underwriting standards in order to maximize the Company's recovery.  TDRs aggregated $4.2 million at March 31, 2017, a net increase of $0. 9 million, from $3. 3 million at December 31, 2016, due to the addition of five commercial real estate loans (4 owner-occupied and 1 non owner-occupied) during the period.  The $4.2 million in TDRs as of March 31, 2017, consisted of twelve commercial loans (11 CRE and 1 C&I), one residential mortgage and one consumer loan (HELOC) to nine unrelated borrowers.  As of March 31, 2017, four TDRs, two commercial real estate loans, the residential mortgage and the HELOC, were on non-accrual.

The following tables set forth the activity in TDRs as and for the periods indicated:







As of and for the three months ended March 31, 2017



Accruing

Non-accruing



Commercial &

Commercial

Consumer

Commercial

Residential

(dollars in thousands)

industrial

real estate

HELOC

real estate

real estate

Total



Troubled Debt Restructures:

Beginning balance

$

25 

$

1,798 

$

650 

$

 -

$

881 

$

3,354 

Additions

 -

900 

 -

 -

 -

900 

Transfers

 -

(970)

 -

970 

 -

 -

Pay downs / payoffs

 -

(8)

 -

(1)

(9)

(18)

Charge offs

 -

 -

 -

 -

 -

 -

Ending balance

$

25 

$

1,720 

$

650 

$

969 

$

872 

$

4,236 



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Table Of Contents









As of and for the year ended December 31, 2016



Accruing

Non-accruing



Commercial &

Commercial

Consumer

Commercial

Residential

(dollars in thousands)

industrial

real estate

HELOC

real estate

real estate

Total



Troubled Debt Restructures:

Beginning balance

$

525 

$

1,898 

$

 -

$

 -

$

 -

$

2,423 

Additions

 -

650 

 -

881 

1,535 

Transfers

 -

(20)

 -

20 

 -

 -

Pay downs / payoffs

(500)

(84)

 -

 -

 -

(584)

Charge offs

 -

 -

 -

(20)

 -

(20)

Ending balance

$

25 

$

1,798 

$

650 

$

 -

$

881 

$

3,354 



If applicable, a TDR loan classified as non-accrual would require a minimum of six months of payments before consideration for a return to accrual status.  The concessions granted consisted of temporary interest-only payments or a reduction in the rate of interest to a below-market rate for a contractual period of time.  The Company believes concessions have been made in the best interests of the borrower and the Company.  If loans characterized as a TDR perform according to the restructured terms for a satisfactory period of time, the TDR designation may be removed in a new calendar year if the loan yields a market rate of interest.

Foreclosed assets held-for-sale

Foreclosed assets held-for-sale aggregated $1.2 million at March 31, 2017 and $1.3 million at December 31, 2016. The following table sets forth the activity in the ORE component of foreclosed assets held-for-sale :









March 31, 2017

December 31, 2016

(dollars in thousands)

Amount

#

Amount

#



Balance at beginning of period

$

1,298  13 

$

1,074  14 



Additions

166 

1,056  11 

Pay downs

 -

(18)

Write downs

(14)

(80)

Sold

(212) (1)

(734) (12)

Balance at end of period

$

1,238  14 

$

1,298  13 



As of March 31, 2017, ORE consisted of fourteen properties from thirteen unrelated borrowers totaling $1.2 million.  Two of these properties ($0.2 million) were added in 2017; four were added in 2016 ($0.6 million); three were added in 2015 ($0. 2 million); two were added in 2014 ($0.1 million); one was added in 2013 ($0.1 million); one was added in 2012 ($100); and one was added in 2011 ($0. 2 million).  In addition, of the fourteen properties, one ($0.1 million) had a signed sales agreement, eight ($0.9 million) were listed for sale, while the remaining properties (five totaling $0.2 million) are either in litigation, being prepared for disposition, in the process of eviction or disposal, or being prepared to be listed for sale.

As of March 31, 2017, the Company acquired one other repossessed assets held-for-sale, with a balance of $1 thousand. There was one other repossessed assets held-for-sale at December 31, 2016, with a balance of $8 thousand.

Cash surrender value of bank owned life insurance

The Company maintains bank owned life insurance (BOLI) for a chosen group of employees at the time of purchase, namely its officers, where the Company is the owner and sole beneficiary of the policies.  BOLI is classified as a non-interest earning asset.  Increases in the cash surrender value are recorded as components of non-interest income.  The BOLI is profitable from the appreciation of the cash surrender values of the pool of insurance and its tax-free advantage to the Company.  This profitability is used to offset a portion of current and future employee benefit costs.  In March 2017, the Company invested in $8.0 million in additional BOLI as a source of funding for additional life insurance benefits for officers and employee benefit expenses related to the Company's non-qualified Supplemental Executive Retirement Plan (SERP) implemented for certain executive officers that provides for payments upon death.  As of March 31, 2017, the bank has accrued expenses of $38 thousand, in connection with the SERP.  The BOLI can be liquidated if necessary with associated tax costs.  However, the Company intends to hold this pool of insurance, because it provides income that enhances the Company's capital position.  Therefore, the Company has not provided for deferred income taxes on the earnings from the increase in cash surrender value.

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Table Of Contents

Other assets

The $ 1.7 million increase in oth er assets was due mostly to $0.5 million in higher residual values associated with recording new automobile leases, net of lease disposals , $0.7 million higher prepaid expenses, $0.3 million more in construction in process and a $0. 1 million higher prepaid dealer reserve.

Funds Provided:

Deposits

The Company is a community based commercial depository financial institution, member FDIC, which offers a variety of deposit products with varying ranges of interest rates and terms.  Generally, deposits are obtained from consumers, businesses and public entities within the communities that surround the Company's 10 branch offices and all deposits are insured by the FDIC up to the full extent permitted by law.  Deposit products consist of transaction accounts including: savings; clubs; interest-bearing checking; money market and non-interest bearing checking (DDA).  The Company also offers short- and long-term time deposits or certificates of deposit (CDs).  CDs are deposits with stated maturities which can range from seven days to ten years.  Cash flow from deposits is influenced by economic conditions, changes in the interest rate environment, pricing and competition.  To determine interest rates on its deposit products, the Company considers local competition, spreads to earning-asset yields, liquidity position and rates charged for alternative sources of funding such as short-term borrowings and long-term FHLB advances.

The following table represents the components of deposits as of the date indicated:









March 31, 2017

December 31, 2016

(dollars in thousands)

Amount

%

Amount

%



Interest-bearing checking

$

196,074 

26.7 

%

$

161,563 

23.0 

%

Savings and clubs

127,526 

17.4 

120,512 

17.1 

Money market

117,724 

16.0 

117,478 

16.7 

Certificates of deposit

102,120 

13.9 

92,753 

13.2 

Total interest-bearing

543,444 

74.0 

492,306 

70.0 

Non-interest bearing

190,482 

26.0 

211,153 

30.0 

Total deposits

$

733,926 

100.0 

%

$

703,459 

100.0 

%



Total deposits increased $ 30.5 million, or 4 %, from $ 703.4 million at December 31, 201 6 to $ 733.9 million at March 31, 201 7. A majority of the increase came from growth in interest-bearing checking accounts of $34.5 million.  CDs and savings and clubs added another $9.4 million and $7.0 million, respectively, to deposit growth .  Non-interest bearing deposits decreased due to a temporary deposit of $48.7 million received at the end of 2016 that was transferred to a trust escrow account in January.  Excluding this temporary deposit, the Company experienced growth in non-interest-bearing deposits. During the first quarter, the Company typically experiences deposit growth due to the seasonal timing of public tax deposits.  Tax deposits are usually received mid-quarter and retained for a short period of time with disbursements occurring shortly after they are received.  During the first quarter of 2017, the Company also completed the acquisition of Wayne Bank's West Scranton branch which increased deposits by $13.9 million.  The Company will continue to execute on its relationship development strategy, explore the demographics within its marketplace and develop deposit gathering programs for its customers.  The Company expects asset growth for 2017 funded primarily by growth in deposits plus utilization of available borrowing capacity.  Transactional deposit and CD growth is projected as a result of our relationship strategy.  Seasonal public deposit fluctuations are expected to remain volatile and at times may partially offset this deposit growth.

Customers' interest in long-term time deposit products continues to be weak with a sustaining preference for non-maturing transaction deposits.  The Company's portfolio of CDs would have decreased ;   if not for $11.5 million in CDs acquired from the West Scranton branch of Wayne Bank during the first quarter of 2017 .  The Company expects CDs to increase 14% in 2017 mostly as a result of this acquisition .  If rates continue to rise, demand for CDs may also increase thereby possibly increasing funding costs.  The Company will continue to pursue strategies to grow and retain retail and business customers with an emphasis on deepening and broadening existing and creating new relationships.

The Company uses the Certificate of Deposit Account Registry Service (CDARS) reciprocal program to obtain FDIC insurance protection for customers who have large deposits that at times may exceed the FDIC maximum amount of $250,000 per person.  In the CDARS program, deposits with varying terms and interest rates, originated in the Company's own markets, are exchanged for deposits of other financial institutions that are members in the CDARS network.  By placing the deposits in other participating institutions, the deposits of our customers are fully insured by the FDIC.  In return for deposits placed with network institutions, the Company receives from network institutions deposits that are approximately equal in amount and are comprised of terms similar to those placed for our customers.  Deposits the Company receives from other institutions are considered reciprocal deposits by regulatory definitions.  As of March 31, 2017 and December 31, 2016, CDARS represented $1.1 million, or less than 1%, of total deposits.

45

Table Of Contents

The maturity distribution of certificates of deposit at March 31, 2017 is as follows:







More than

More than

More



Three months

three months

six months to

than twelve

(dollars in thousands)

or less

to six months

twelve months

months

Total

CDs of $100,000 or more

$

5,184 

$

13,027 

$

11,183 

$

20,653 

$

50,047 

CDARS

 -

 -

1,133 

 -

1,133 

Total CDs of $100,000 or more

5,184 

13,027 

12,316 

20,653 

51,180 

CDs of less than $100,000

6,649 

7,435 

10,069 

26,787 

50,940 

Total CDs

$

11,833 

$

20,462 

$

22,385 

$

47,440 

$

102,120 



Certificates of deposit of $ 250,000 or more amounted to $26.0 million and $ 25 .7 million as of March 31, 2017 and December 31, 201 6 , respectively.

Including CDARS, approximately 44 % of the CDs, with a weighted-average interest rate of 0.6 8 %, are scheduled to mature in 2017 and an additional 23 %, with a weighted-average interest rate of 0.9 3 %, are scheduled to mature in 2018.  Renewing CDs may re-price to lower or higher market rates depending on the rate on the maturing CD, the pace and direction of interest rate movements, the shape of the yield curve, competition, the rate profile of the maturing accounts and depositor preference for alternative, non-term products.  As noted, the widespread preference continues for customers with maturing CDs to hold their deposits in readily available transaction accounts.  The Company does not expect significant CD growth other than from the branch purchase during 2017, but will develop CD promotional programs when the Company deems that it is economically feasible to do so or when demand exists.  As with all promotions, the Company will consider the needs of the customers and simultaneously be mindful of the liquidity levels and the interest rate sensitivity exposure of the Company.

Borrowings

Borrowings are used as a complement to deposit generation as an alternative funding source whereby the Company will borrow under customer repurchase agreements in the local market, advances from the FHLB and other correspondent banks for asset growth and liquidity needs.

Repurchase agreements are non-insured interest-bearing liabilities that have a perfected security interest in qualified investments of the Company as required by the FDIC Depositor Protection Act of 2009.  Repurchase agreements are offered through a sweep product.  A sweep account is designed to ensure that on a daily basis, an attached DDA is adequately funded and excess funds are transferred, or swept, into an interest-bearing overnight repurchase agreement account.  Due to the constant inflow and outflow of funds of the sweep product, their balances tend to be somewhat volatile, similar to a DDA.  Customer liquidity is the typical cause for variances in repurchase agreements , which during the first quarter of 2017 increased $10.5 million from the end of 2016 .  In addition, short-term borrowings may include overnight balances which the Company may require to fund daily liquidity needs such as deposit and repurchase agreement cash outflow, loan demand and operations.  The Company did not have a balance in overnight borrowings at March 31, 2017 and December 31, 2016.  A $48.7 million temporary deposit at the end of 2016 prevented the Company from having to use overnight borrowings at year-end.  Short-term borrowings are expected to increase in 2017 to fund asset growth above deposit balance growth.

During the first quarter of 2017, the Company borrowed $17 million from the FHLB to purchase securities.  The borrowings were laddered out with maturities ranging from July 2017 to January 2019 and interest rates ranging from 0.64% to 1.34%.

The following table represents the components of borrowings as of the date indicated:







March 31, 2017

December 31, 2016

(dollars in thousands)

Amount

%

Amount

%



Securities sold under repurchase agreements

$

14,699 

46.4 

%

$

4,223 

100.0 

%

Long-term FHLB advances

17,000 

53.6 

 -

 -

Total

$

31,699 

100.0 

%

$

4,223 

100.0 

%







Item 3.  Quantitative and Qualitative Disclosure About Market Risk

Management of interest rate risk and market risk analysis.

The adequacy and effectiveness of an institution's interest rate risk management process and the level of its exposures are critical factors in the regulatory evaluation of an institution's sensitivity to changes in interest rates and capital adequacy.  Management believes the Company's interest rate risk measurement framework is sound and provides an effective means to measure, monitor, analyze, identify and control interest rate risk in the balance sheet.

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The Company is subject to the interest rate risks inherent in its lending, investing and financing activities.  Fluctuations of interest rates will impact interest income and interest expense along with affecting market values of all interest-earning assets and interest-bearing liabilities, except for those assets or liabilities with a short term remaining to maturity.  Interest rate risk management is an integral part of the asset/liability management process.  The Company has instituted certain procedures and policy guidelines to manage the interest rate risk position.  Those internal policies enable the Company to react to changes in market rates to protect net interest income from significant fluctuations.  The primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on net interest income along with creating an asset/liability structure that maximizes earnings.

Asset/Liability Management.  One major objective of the Company when managing the rate sensitivity of its assets and liabilities is to stabilize net interest income.  The management of and authority to assume interest rate risk is the responsibility of the Company's Asset/Liability Committee (ALCO), which is comprised of senior management and members of the board of directors.  ALCO meets quarterly to monitor the relationship of interest sensitive assets to interest sensitive liabilities.  The process to review interest rate risk is a regular part of managing the Company.  Consistent policies and practices of measuring and reporting interest rate risk exposure, particularly regarding the treatment of non-contractual assets and liabilities, are in effect.  In addition, there is an annual process to review the interest rate risk policy with the board of directors which includes limits on the impact to earnings from shifts in interest rates.

Interest Rate Risk Measurement. Interest rate risk is monitored through the use of three complementary measures: static gap analysis, earnings at risk simulation and economic value at risk simulation.  While each of the interest rate risk measurements has limitations, collectively, they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company and the distribution of risk along the yield curve, the level of risk through time and the amount of exposure to changes in certain interest rate relationships.

Static Gap .  The ratio between assets and liabilities re-pricing in specific time intervals is referred to as an interest rate sensitivity gap.  Interest rate sensitivity gaps can be managed to take advantage of the slope of the yield curve as well as forecasted changes in the level of interest rate changes.

To manage this interest rate sensitivity gap position, an asset/liability model commonly known as cumulative gap analysis is used to monitor the difference in the volume of the Company's interest sensitive assets and liabilities that mature or re-price within given time intervals.  A positive gap (asset sensitive) indicates that more assets will re-price during a given period compared to liabilities, while a negative gap (liability sensitive) indicates the opposite effect.  The Company employs computerized net interest income simulation modeling to assist in quantifying interest rate risk exposure.  This process measures and quantifies the impact on net interest income through varying interest rate changes and balance sheet compositions.  The use of this model assists the ALCO to gauge the effects of the interest rate changes on interest-sensitive assets and liabilities in order to determine what impact these rate changes will have upon the net interest spread.  At March 31, 2017, the Company maintained a one-year cumulative gap of positive (asset sensitive) $59.1 million, or 7%, of total assets.  The effect of this positive gap position provided a mismatch of assets and liabilities which may expose the Company to interest rate risk during periods of falling interest rates.  Conversely, in an increasing interest rate environment, net interest income could be positively impacted because more assets than liabilities will re-price upward during the one-year period.

Certain shortcomings are inherent in the method of analysis discussed above and presented in the next table.  Although certain assets and liabilities may have similar maturities or periods of re-pricing, they may react in different degrees to changes in market interest rates.  The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates.  Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset.  In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table amounts.  The ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.

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The following table illustrates the Company's interest sensitivity gap position at March 31, 2017 :









More than three

More than



Three months

months to

one year

More than

(dollars in thousands)

or less

twelve months

to three years

three years

Total



Cash and cash equivalents

$

16,059 

$

 -

$

 -

$

13,057 

$

29,116 

Investment securities (1)(2)

3,632 

15,347 

48,919 

88,792 

156,690 

Loans and leases (2)

197,972 

106,607 

160,712 

148,291 

613,582 

Fixed and other assets

 -

19,542 

 -

33,756 

53,298 

Total assets

$

217,663 

$

141,496 

$

209,631 

$

283,896 

$

852,686 

Total cumulative assets

$

217,663 

$

359,159 

$

568,790 

$

852,686 



Non-interest-bearing transaction deposits (3)

$

 -

$

19,067 

$

52,344 

$

119,071 

$

190,482 

Interest-bearing transaction deposits (3)

182,202 

22,458 

158,946 

77,718 

441,324 

Certificates of deposit

11,833 

42,847 

35,053 

12,387 

102,120 

Repurchase agreements

14,699 

 -

 -

 -

14,699 

Long-term debt

 -

7,000 

10,000 

 -

17,000 

Other liabilities

 -

 -

 -

4,868 

4,868 

Total liabilities

$

208,734 

$

91,372 

$

256,343 

$

214,044 

$

770,493 

Total cumulative liabilities

$

208,734 

$

300,106 

$

556,449 

$

770,493 



Interest sensitivity gap

$

8,929 

$

50,124 

$

(46,712)

$

69,852 

Cumulative gap

$

8,929 

$

59,053 

$

12,341 

$

82,193 



Cumulative gap to total assets

1.0% 

6.9% 

1.4% 

9.6% 

(1)   Includes FHLB stock and the net unrealized gains/losses on available-for-sale securities.

(2)   Investments and loans are included in the earlier of the period in which interest rates were next scheduled to adjust or the period in which they are due.  In addition, loans were included in the periods in which they are scheduled to be repaid based on scheduled amortization.  For amortizing loans and MBS – GSE residential, annual prepayment rates are assumed reflecting historical experience as well as management's knowledge and experience of its loan products.

(3)  The Company's demand and savings accounts were generally subject to immediate withdrawal.  However, management considers a certain amount of such accounts to be core accounts having significantly longer effective maturities based on the retention experiences of such deposits in changing interest rate environments.  The effective maturities presented are the recommended maturity distribution limits for non-maturing deposits based on historical deposit studies.

Earnings at Risk and Economic Value at Risk Simulations .  The Company recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet that extend beyond static re-pricing gap analysis.  Although it will continue to measure its re-pricing gap position, the Company utilizes additional modeling for identifying and measuring the interest rate risk in the overall balance sheet.  The ALCO is responsible for focusing on "earnings at risk" and "economic value at risk", and how both relate to the risk-based capital position when analyzing the interest rate risk.

Earnings at Risk .  An earnings at risk simulation measures the change in net interest income and net income should interest rates rise and fall.  The simulation recognizes that not all assets and liabilities re-price one-for-one with market rates (e.g., savings rate).  The ALCO looks at "earnings at risk" to determine income changes from a base case scenario under an increase and decrease of 200 basis points in interest rate simulation models.

Economic Value at Risk. An earnings at risk simulation measures the short-term risk in the balance sheet.  Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the Company's existing assets and liabilities.  The ALCO examines this ratio quarterly utilizing an increase and decrease of 200 basis points in interest rate simulation models.  The ALCO recognizes that, in some instances, this ratio may contradict the "earnings at risk" ratio.

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Table Of Contents

The following table illustrates the simulated impact of an immediate 200 basis points upward or downward movement in interest rates on net interest income, net income and the change in the economic value (portfolio equity).  This analysis assumed that the adjusted interest-earning asset and interest-bearing liability levels at March 31, 2017 remained constant.  The impact of the rate movements was developed by simulating the effect of the rate change over a twelve-month period from the March 31, 2017 levels:









% change



Rates +200

Rates -200

Earnings at risk:

Net interest income

5.8 

%

(6.7)

%

Net income

13.9 

(14.9)

Economic value at risk:

Economic value of equity

(1.4)

(27.8)

Economic value of equity as a percent of total assets

(0.2)

(4.2)



Economic value has the most meaning when viewed within the context of risk-based capital.  Therefore, the economic value may normally change beyond the Company's policy guideline for a short period of time as long as the risk-based capital ratio (after adjusting for the excess equity exposure) is greater than 10%.  At March 31, 2017 , the Company's risk-based capital ratio was 14. 4 %.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning April 1, 2017 , under alternate interest rate scenarios using the income simulation model described above:









Net interest

$

%

(dollars in thousands)

income

variance

variance

Simulated change in interest rates

+200 basis points

$

29,761 

$

1,639 

5.8 

%

+100 basis points

28,941 

819 

2.9 

 Flat rate

28,122 

 -

 -

-100 basis points

26,820 

(1,302)

(4.6)

-200 basis points

26,237 

(1,885)

(6.7)



Simulation models require assumptions about certain categories of assets and liabilities.  The models schedule existing assets and liabilities by their contractual maturity, estimated likely call date or earliest re-pricing opportunity.  MBS – GSE residential securities and amortizing loans are scheduled based on their anticipated cash flow including estimated prepayments.  For investment securities, the Company uses a third-party service to provide cash flow estimates in the various rate environments.  Savings, money market and interest-bearing checking accounts do not have stated maturities or re-pricing terms and can be withdrawn or re-price at any time.  This may impact the margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff.  Management projects the re-pricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity.  The model reinvests all maturities, repayments and prepayments for each type of asset or liability into the same product for a new like term at current product interest rates.  As a result, the mix of interest-earning assets and interest bearing-liabilities is held constant.

Liquidity

Liquidity management ensures that adequate funds will be available to meet customers' needs for borrowings, deposit withdrawals and maturities, facility expansion and normal operating expenses.  Sources of liquidity are cash and cash equivalents, asset maturities and pay-downs within one year, loans HFS, investments AFS, growth of core deposits and repurchase agreements, utilization of borrowing capacities from the FHLB, correspondent banks, CDARs, the Discount Window of the Federal Reserve Bank of Philadelphia (FRB) and proceeds from the issuance of capital stock.  Though regularly scheduled investment and loan payments are dependable sources of daily liquidity, sales of both loans HFS and investments AFS, deposit activity and investment and loan prepayments are significantly influenced by general economic conditions including the interest rate environment.  During low and declining interest rate environments, prepayments from interest-sensitive assets tend to accelerate and provide significant liquidity that can be used to invest in other interest-earning assets but at lower market rates.  Conversely, in periods of high or rising interest rates, prepayments from interest-sensitive assets tend to decelerate causing prepayment cash flows from mortgage loans and mortgage-backed securities to decrease.  Rising interest rates may also cause deposit inflow but priced at higher market interest rates or could also cause deposit outflow due to higher rates offered by the Company's competition for similar products.  The Company closely monitors activity in the capital markets and takes appropriate action to ensure that the liquidity levels are adequate for funding, investing and operating activities.

The Company's contingency funding plan (CFP) sets a framework for handling liquidity issues in the event circumstances arise which the Company deems to be less than normal.  The Company established guidelines for identifying, measuring, monitoring and managing the resolution of potentially serious liquidity crises.  The CFP outlines required monitoring tools, acceptable alternative

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Table Of Contents

funding sources and required actions during various liquidity scenarios.  Thus, the Company has implemented a proactive means for the measurement and resolution for handling potentially significant adverse liquidity conditions.  At least quarterly, the CFP monitoring tools, current liquidity position and monthly projected liquidity sources and uses are presented and reviewed by the Company's Asset/Liability Committee.  As of March 31, 2017 , the Company had not experienced any adverse issues that would give rise to its inability to raise liquidity in an emergency situation.

During the quarter ended March 31, 2017 , the Company accumulated $ 3.3 million of cash.  During the period, the Company's operations provided approximately $ 4.8 million mostly from $ 7.0 million of net cash inflow from the components of net interest income and $ 3.3 million in proceeds of loans HFS over originations; partially offset by net non-interest expense/income related payments of $ 4.4 million and a $ 0.5 million increase in the residual value from the Company's automobile leasing activities.  Cash inflow from interest-earning assets , borrowings, the acquisition of a bank branch and growth in deposits were used to purchase investment securities and replace maturing and cash runoff of securities, purchase bank owned life insurance, fund the loan portfolio and make net dividend payments.  The Company received a large amount of public deposits over the past two years.  The seasonal nature of deposits from municipalities and other public funding sources requires the Company to be prepared for the inherent volatility and the unpredictable timing of cash outflow from this customer base, including maintaining the requirements to pledge investment securities.  Accordingly, the use of short-term overnight borrowings could be used to fulfill funding gap needs.  The CFP is a tool to help the Company ensure that alternative funding sources are available to meet its liquidity needs.

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers and in connection with the overall interest rate management strategy.  These instruments involve, to a varying degree, elements of credit, interest rate and liquidity risk.  In accordance with GAAP, these instruments are either not recorded in the consolidated financial statements or are recorded in amounts that differ from the notional amounts.  Such instruments primarily include lending commitments and lease obligations. 

Lending commitments include commitments to originate loans and commitments to fund unused lines of credit.  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

In addition to lending commitments, the Company has contractual obligations related to operating lease commitments.  Operating lease commitments are obligations under various non-cancelable operating leases on buildings and land used for office space and banking purposes.  The Company's position with respect to lending commitments and significant contractual lease obligations, both on a short- and long-term basis has not changed materially from December 31, 201 6 .  

During the third quarter of 2016, the Company entered into an agreement to acquire all the deposits, certain loans and fixed assets of a bank branch.  The transaction was completed during the first quarter of 2017 .  As a result of this transaction , the Company experienced an increase of $13.9 million in deposits during the first quarter of 2017.

As of March 31, 2017, the Company maintained $2 9 . 1 million in cash and cash equivalents and $156.2 million of investments AFS and loans HFS.  Also as of March 31, 2017, the Company had approximately $1 83 . 2 million available to borrow from the FHLB, $21.0 million from correspondent banks, $57.6 million from the FRB and $39.7 million from the CDARS program.  The combined total of $ 486.8 million represented 5 7 % of total assets at March 31, 2017.  Management believes this level of liquidity to be strong and adequate to support current operations.

Capital

During the quarter ended March 31, 2017 , total shareholders' equity increased $ 1.6 million, or 2 %, due principally from the $ 2.0 million in net income added into retained earnings.  Capital was further enhanced by $0.1 million from investments in the Company's common stock via the Employee Stock Purchase (ESPP) , $0.1 million from issuance of common stock through the dividend reinvestment plan and $0. 1 million from stock-based compensation expense from the ESPP and unvested restricted stock.  These items were partially offset by $0.8 million of cash dividends declared on the Company's common stock.  The Company's dividend payout ratio, defined as the rate at which current earnings ar e paid to shareholders, was 38.9 % for the quarter ended March 31, 2017 .  The balance of earnings is retained to further strengthen the Company's capital position.

As of March 31, 2017 , the Company reported a net unrealized gain position of $1.4 million, net of tax, from the securities AFS portfolio compared to a net unrealized gain of $ 1.4 million as of December 31, 201 6.  Management believes that changes in fair value of the Company's securities are due to changes in interest rates and not in the creditworthiness of the issuers.  Generally, when U.S. Treasury rates rise, investment securities' pricing declines and fair values of investment securities also decline.  While volatility has existed in the yield curve within the past twelve months, a rising rate environment is inevitable and during the period of rising rates, the Company expects pricing in the bond portfolio to decline.  There is no assurance that future realized and unrealized losses will not be recognized from the Company's portfolio of investment securities.  To help maintain a healthy capital position, the Company can issue stock to participants in the DRP and ESPP plans.  The DRP affords the Company the option to acquire shares in open market purchases and/or issue shares directly from the Compan y to plan participants.  Both the DRP and the ESPP plans have been a consistent source of capital from the Company's loyal employees and shareholders and their participation in these plans will continue

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to help strengthen the Company's balance sheet.  Beginning in 2009, the Company's board of directors had allowed a benefit to its loyal shareholders as a discount on the purchase price for shares issued directly from the Company through the DRP and voluntary cash feature.  During the first quarter of 2014, the DRP was amended to discontinue a portion of the discount on the voluntary cash feature as the board of directors had determined that the Company's capital position achieved sufficient levels.

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's and the Bank's financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices.  The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings and other factors.  Prompt corrective action provisions are not applicable to bank holding companies.

Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with appropriate weights.  The resulting ratios represent capital as a percentage of total risk-weighted assets and certain off-balance sheet items.  The guidelines require all banks and bank holding companies to maintain a minimum ratio of total risk-based capital to total risk-weighted assets (Total Risk Adjusted Capital) of 8%, including Tier I common equity to total risk-weighted assets (Tier I Common Equity) of 4.5%, Tier I capital to total risk-weighted assets (Tier I Capital) of 6% and Tier I capital to average total assets (Leverage Ratio) of at least 4%.  A capital conservation buffer, comprised of common equity Tier I capital, is also established above the regulatory minimum capital requirements rising up to 2.50% by 2019.  As of March 31, 2017 and December 31, 2016 , the Company and the Bank exceeded all capital adequacy requir ements to which it was subject.

The Company continues to closely monitor and evaluate alternatives to enhance its capital ratios as the regulatory and economic environments change.  The following table depicts the capital amounts and ratios of the Company , on a combined basis, and the Bank as of March 31, 2017 and December 31, 2016 :













To be well capitalized



For capital

under prompt corrective



Actual

adequacy purposes

action provisions

(dollars in thousands)

Amount

Ratio

Amount

Ratio

Amount

Ratio

As of March 31, 2017:



Total capital (to risk-weighted assets)

Consolidated

$

88,018 

14.4% 

≥  

$

52,413 

≥  

9.3% 

(1)

N/A

N/A

Bank

$

87,639 

14.4% 

≥  

$

52,398 

≥  

9.3% 

(1)

≥  

$

60,928 

10.0% 



Tier 1 common equity (to risk-weighted assets)

Consolidated

$

80,584 

13.2% 

≥  

$

31,082 

≥  

5.8% 

(1)

N/A

N/A

Bank

$

80,207 

13.2% 

≥  

$

31,073 

≥  

5.8% 

(1)

$

39,603 

6.5% 



Tier I capital (to risk-weighted assets)

Consolidated

$

80,375 

13.2% 

≥  

$

39,127 

≥  

7.3% 

(1)

N/A

N/A

Bank

$

79,998 

13.2% 

≥  

$

39,106 

≥  

7.3% 

(1)

$

48,742 

8.0% 



Tier I capital (to average assets)

Consolidated

$

80,375 

9.9% 

$

32,650 

4.0% 

N/A

N/A

Bank

$

79,998 

9.8% 

$

32,621 

4.0% 

$

40,776 

5.0% 



(1) Includes 1.25% capital conservation buffer.

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As of December 31, 2016:



Total capital (to risk-weighted assets)

Consolidated

$

86,702 

14.9% 

≥  

$

46,550 

≥  

8.6% 

(2)

N/A

N/A

Bank

$

86,332 

14.8% 

≥  

$

46,538 

≥  

8.6% 

(2)

≥  

$

58,172 

10.0% 



Tier 1 common equity (to risk-weighted assets)

Consolidated

$

79,250 

13.6% 

≥  

$

26,184 

≥  

5.1% 

(2)

N/A

N/A

Bank

$

79,033 

13.6% 

≥  

$

26,178 

≥  

5.1% 

(2)

$

37,812 

6.5% 



Tier I capital (to risk-weighted assets)

Consolidated

$

79,250 

13.6% 

≥  

$

34,912 

≥  

6.6% 

(2)

N/A

N/A

Bank

$

79,033 

13.6% 

≥  

$

34,903 

≥  

6.6% 

(2)

$

46,538 

8.0% 



Tier I capital (to average assets)

Consolidated

$

79,250 

10.3% 

$

30,717 

4.0% 

N/A

N/A

Bank

$

79,033 

10.3% 

$

30,650 

4.0% 

$

38,313 

5.0% 



(2) Includes a 0.625% capital conservation buffer.

The Company advises readers to refer to the Supervision and Regulation section of Management's Discussion and Analysis of Financial Condition and Results of Operation, of its 201 6 Form 10-K for a discussion on the regulatory environment and recent legislation and rulemaking.

Item 4.  Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out by the Company's management, with the participation of its President and Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company's disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934.  Based on such evaluation, the President and Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or furnishes under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and regulations, and are effective.  The Company made no changes in its internal controls over financial reporting or in other factors that materially affected, or are reasonably likely to materially affect, these controls during the last fiscal quarter ended March 31, 2017 .

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PART II - Other Information

Item 1.  Legal Proceedings

The nature of the Company's business generates some litigation involving matters arising in the ordinary course of business.  However, in the opinion of the Company after consultation with legal counsel, no legal proceedings are pending, which, if determined adversely to the Company or the Bank, would have a material adverse effect on the Company's undivided profits or financial condition.  No legal proceedings are pending other than ordinary routine litigation incidental to the business of the Company and the Bank.  In addition, to management's knowledge, no governmental authorities have initiated or contemplated any material legal actions against the Company or the Bank.

Item 1A.  Risk Factors

Management of the Company does not believe there have been any material changes to the risk factors that were disclosed in the 2016 Form 10-K filed with the Securities and Exchange Commission on March 10, 2017.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3.  Default Upon Senior Securities

None                                                                                               

Item 4.  Mine Safety Disclosures

Not applicable                                                                                               

Item 5.  Other Information

None                                                                                               

Item 6.  Exhibits

The following exhibits are filed herewith or incorporated by reference as a part of this Form 10-Q:

3(i) Amended and Restated Articles of Incorporation of Registrant. Incorporated by reference to Annex B of the Proxy Statement/Prospectus included in Registrant's Amendment 4 to its Registration Statement No. 333-90273 on Form S-4, filed with the SEC on April 6, 2000.

3(ii) Amended and Restated Bylaws of Registrant. Incorporated by reference to Exhibit 3(ii) to Registrant's Form 8-K filed with the SEC on November 21, 2007.

* 10.1 Registrant's 2012 Dividend Reinvestment and Stock Repurchase Plan .  Incorporated by reference to Exhibit 4.1 to Registrant's Registration Statement No. 333-183216 on Form S-3 filed with the SEC on August 10, 2012 as amended February 3, 2014.

* 10.2 Registrant's 2000 Independent Directors Stock Option Plan.  Incorporated by reference to Exhibit 4.3 to Registrant's Registration Statement No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.

* 10.3 Amendment, dated October 2, 2007, to the Registrant's 2000 Independent Directors Stock Option Plan.  Incorporated by reference to Exhibit 10.2 to Registrant's Form 8-K filed with the SEC on October 4, 2007.

* 10.4 Registrant's 2000 Stock Incentive Plan.  Incorporated by reference to Exhibit 4.4 to Registrant's Registration Statement No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.

* 10.5 Amendment, dated October 2, 2007, to the Registrant's 2000 Stock Incentive Plan.  Incorporated by reference to Exhibit 10.1 to Registrant's Form 8-K filed with the SEC on October 4, 2007.

* 10.6 Registrant's 2002 Employee Stock Purchase Plan.  Incorporated by reference to Appendix A to Definitive proxy Statement filed with the SEC on March 28, 2002.

* 10. 7 Amended and Restated Executive Employment Agreement between Fidelity D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and Daniel J. Santaniello, dated March 23, 2011.  Incorporated by reference to Exhibit 99.1 to Registrant's Current Report on Form 8-K filed with the SEC on March 29, 2011.

* 10. 8 Amended and Restated Executive Employment Agreement between Fidelity D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and Timothy P. O'Brien, dated March 23, 2011.  Incorporated by reference to Exhibit 99.2 to Registrant's Current Report on Form 8-K filed with the SEC on March 29, 2011.

*10. 9 2012 Omnibus Stock Incentive Plan.  Incorporated by reference to Appendix A to Registrant's Definitive Proxy Statement filed with the SEC on March 30, 2012.

*10.1 0 2012 Director Stock Incentive Plan.  Incorporated by reference to Appendix B to Registrant's Definitive Proxy Statement filed with the SEC on March 30, 2012.

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*10. 1 1 Employment Agreement between Fidelity D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and Salvatore R. DeFrancesco, Jr. dated as of March 17, 2016 Incorporated by reference to Exhibit 99.1 to Registrant' s Current Report on Form 8-K filed with the SEC on March 18, 2016.

* 10.1 2 Change in Control and Severance Agreement between the Registrant, The Fidelity Deposit and Discount Bank and Michael J. Pacyna dated as of March 29, 2017.  Incorporated by reference to Exhibit 99.1 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

* 10.13 Employment Agreement between Fidelity D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and Eugene J. Walsh dated as of March 29, 2017.  Incorporated by reference to Exhibit 99.1 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*10.14 Form of Supplemental Executive Retirement Plan – Applicable to Daniel J. Santaniello and Salvatore R. DeFrancesco, Jr. Incorporated by reference to Exhibit 99.1 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*10.15 Form of Supplemental Executive Retirement Plan – Applicable to Eugene J. Walsh and Timothy P O'Brien. Incorporated by reference to Exhibit 99.2 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*10.16 Form of Split Dollar Life Insurance Agreement – Applicable to Daniel J. Santaniello, Salvatore R. DeFrancesco, Jr. and Eugene J. Walsh. Incorporated by reference to Exhibit 99.3 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*10.17 Form of Split Dollar Life Insurance Agreement – Applicable to Timothy P O'Brien and Michael Pacyna. Incorporated by reference to Exhibit 99.4 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

11 Statement regarding computation of earnings per share.  Included herein in Note No. 6, "Earnings per share," contained within the Notes to Consolidated Financial Statements, and incorporated herein by reference.

31.1 Rule 13a-14(a) Certification of Principal Executive Officer, filed herewith.

31.2 Rule 13a-14(a) Certification of Principal Financial Officer, filed herewith.

32.1 Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350,

  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.

32.2 Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350,

  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 , filed herewith.

101 Interactive data files: The following, from Fidelity D&D Bancorp, Inc.'s. Quarterly Report on Form 10-Q for the quarter ended March 31, 2017 , is formatted in XBRL (eXtensible Business Reporting Language): Consolidated Balance Sheets as of March 31, 2017 and December 31, 201 6 ;  Consolidated Statements of Income for the three months ended March 31, 2017 and 2016; Consolidated Statements of Comprehen sive Income for the three months ended March 31, 2017 and 2016; Consolidated Statements of Changes in Shareholders' Equity for the three months ended March 31. 2017 and 2016; Consolidated Statements of Cash Flows for the three months ended March 31, 2017 and 2016 and the Notes to the Consolidated Financial Statements.

________________________________________________

 *   Management contract or compensatory plan or arrangement.

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Signatures





FIDELITY D & D BANCORP, INC.



Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.









Fidelity D & D Bancorp, Inc.



Date: May 8 , 2017

/s/Daniel J. Santaniello



    Daniel J. Santaniello,

    President and Chief Executive Officer





Fidelity D & D Bancorp, Inc.



Date: May 8 , 2017

/s/Salvatore R. DeFrancesco, Jr.



     Salvatore R. DeFrancesco, Jr.,

     Treasurer and Chief Financial Officer





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EXHIBIT INDEX





3(i) Amended and Restated Articles of Incorporation of Registrant. Incorporated by reference to Annex B of the Proxy Statement/Prospectus included in Registrant's Amendment 4 to its Registration Statement No. 333-90273 on Form S-4, filed with the SEC on April 6, 2000.

*



3(ii) Amended and Restated Bylaws of Registrant. Incorporated by reference to Exhibit 3(ii) to Registrant's Form 8-K filed with the SEC on November 21, 2007.

*



10.1 Registrant's Dividend Reinvestment and Stock Purchase Plan .  Incorporated by reference to Exhibit 4.1 to Registrant's Registration Statement No. 333-183216 on Form S-3 filed with the SEC on August 10, 2012 as amended February 3, 2014.

*



10.2 Registrant's 2000 Independent Directors Stock Option Plan.  Incorporated by reference to Exhibit 4.3 to Registrant's Registration Statement No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.

*



10.3 Amendment, dated October 2, 2007, to the Registrant's 2000 Independent Directors Stock Option Plan.  Incorporated by reference to Exhibit 10.2 to Registrant's Form 8-K filed with the SEC on October 4, 2007.

*



10.4 Registrant's 2000 Stock Incentive Plan.  Incorporated by reference to Exhibit 4.4 to Registrant's Registration Statement No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.

*



10.5 Amendment, dated October 2, 2007, to the Registrant's 2000 Stock Incentive Plan.  Incorporated by reference to Exhibit 10.1 to Registrant's Form 8-K filed with the SEC on October 4, 2007.

*



10.6 Registrant's 2002 Employee Stock Purchase Plan. Incorporated by reference to Appendix A to Registrant's Definitive Proxy Statement filed with the SEC on March 28, 2002.

*



10. 7 Amended and Restated Executive Employment Agreement between Fidelity D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and Daniel J. Santaniello, dated March 23, 2011.  Incorporated by reference to Exhibit 99.1 to Registrant's Current Report on Form 8-K filed with the SEC on March 29, 2011.

*



10. 8 Amended and Restated Executive Employment Agreement between Fidelity D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and Timothy P. O'Brien, dated March 23, 2011.  Incorporated by reference to Exhibit 99.2 to Registrant's Current Report on Form 8-K filed with the SEC on March 29, 2011.

*



10.9 2012 Omnibus Stock Incentive Plan.  Incorporated by reference to Appendix A to Registrant's Definitive Proxy Statement filed with the SEC on March 30, 2012.

*



10.10 2012 Director Stock Incentive Plan.  Incorporated by reference to Appendix B to Registrant's Definitive Proxy Statement filed with the SEC on March 30, 2012.

*



10.1 1 Employment Agreement between Fidelity D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and Salvatore R. DeFrancesco, Jr. dated as of March 17, 2016.  Incorporated by reference to Exhibit 99.1 to Registrant's Current Report on Form 8-K filed with the SEC on March 18, 2016.

*



10.1 2 Change in Control and Severance Agreement between the Registrant, The Fidelity Deposit and Discount Bank and Michael J. Pacyna dated as of March 29, 2017.  Incorporated by reference to Exhibit 99.1 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*



10.13 Employment Agreement between Fidelity D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and Eugene J. Walsh dated as of March 29, 2017.  Incorporated by reference to Exhibit 99.1 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*



10.14 Form of Supplemental Executive Retirement Plan – Applicable to Daniel J. Santaniello and Salvatore R. DeFrancesco, Jr. Incorporated by reference to Exhibit 99.1 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*



10.15 Form of Supplemental Executive Retirement Plan – Applicable to Eugene J. Walsh and Timothy P O'Brien. Incorporated by reference to Exhibit 99.2 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*



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10.16 Form of Split Dollar Life Insurance Agreement – Applicable to Daniel J. Santaniello, Salvatore R. DeFrancesco, Jr. and Eugene J. Walsh. Incorporated by reference to Exhibit 99.3 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*



10.17 Form of Split Dollar Life Insurance Agreement – Applicable to Timothy P O'Brien and Michael Pacyna. Incorporated by reference to Exhibit 99.4 to Registrant's Current Report on Form 8-K filed with the SEC on April 4, 2017.

*



11 Statement regarding computation of earnings per share.

2 2



31.1 Rule 13a-14(a) Certification of Principal Executive Officer , filed herewith .



31.2 Rule 13a-14(a) Certification of Principal Financial Officer, filed herewith.



32.1 Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith .



32.2 Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.





101 Interactive data files: The following, from the Registrant's Quarterly Rep ort on Form 10- Q for the quarter ended March 31, 2017 , is formatted in XBRL (eXtensible Business Reporting Language): Consolidated Balance Sheets as of March 31, 2017 and December 31, 201 6 ;  Consolidated Statements of Income for the three months ended March 31, 2017 and 2016 ; Consolidated Statements of Comprehensive Income for the three months ended March 31, 2017 and 2016 ; Consolidated Statements of Changes in Shareholders' Equity for the three months ended March 31, 2017 and 2016; Consolidated Statements of Cash Flows for the three months ended March 31, 2017 and 2016 and the Notes to the Consolidated Financial Statements. **

______________________________________

* Incorporated by Reference

** Pursuant to Rule 406T of Regulation S-T, the interactive data files in Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

57