Citizens Financial Services Earnings 2018-12-31
CZFS 10K Annual Report
| Balance Sheet | Income Statement | Cash Flow |
|---|---|---|
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
■ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
| For the fiscal year ended | December 31, 2018 |
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 | 000-13222 |
| CITIZENS FINANCIAL SERVICES, INC. | ||||||
| (Exact name of registrant as specified in its charter) | ||||||
| Pennsylvania | 23-2265045 | |||||
| State or other jurisdiction of incorporation or organization | (I.R.S. Employer Identification No.) | |||||
| 15 South Main Street, Mansfield, Pennsylvania | 16933 | |||||
| (Address of principal executive offices) | (Zip Code) | |||||
| Registrant’s telephone number, including area code | (570) 662-2121 | |||||
| Securities registered pursuant to Section 12(b) of the Act: | None | |||||
| Securities registered pursuant to Section 12(g) of the Act: | ||||||
| Common Stock, par value $1.00 per share | ||||||
| (Title of class) | ||||||
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
□ Yes ■ No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
□ Yes ■ No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
■ Yes □ No
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).
■ Yes □ No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
■
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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 ■
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended reporting transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) if the exchange act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
□ Yes ■ No
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $194,033,706 as of June 30, 2018.
As of February 25, 2019, there were 3,500,277 shares of the registrant’s common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Certain information required by Part III is incorporated by reference to the Registrant’s Definitive Proxy Statement for the 2018 Annual Meeting of Shareholders.
| Citizens Financial Services, Inc. Form 10-K INDEX | |
| Page | |
| PART I | |
| ITEM 1 – BUSINESS | 1 – 9 |
| ITEM 1A – RISK FACTORS | 9 – 16 |
| ITEM 1B – UNRESOLVED STAFF COMMENTS | 16 |
| ITEM 2 – PROPERTIES | 16 |
| ITEM 3 – LEGAL PROCEEDINGS | 16 |
| ITEM 4 – MINE SAFETY DISCLOSURES | 16 |
| PART II | |
| ITEM 5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES | 17 – 18 |
| ITEM 6 – SELECTED FINANCIAL DATA | 19 |
| ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 20 – 50 |
| ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK | 50 |
| ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA | 51 – 109 |
| ITEM 9 – CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE | 110 |
| ITEM 9A – CONTROLS AND PROCEDURES | 110 |
| ITEM 9B– OTHER INFORMATION | 110 |
| PART III | |
| ITEM 10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE | 111 |
| ITEM 11 – EXECUTIVE COMPENSATION | 111 |
| ITEM 12 – SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS | 111 – 112 |
| ITEM 13 – CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE | 112 |
| ITEM 14 – PRINCIPAL ACCOUNTANT FEES AND SERVICES | 112 |
| PART IV | |
| ITEM 15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES | 113 – 115 |
| ITEM 16 – FORM 10-K SUMMARY | 115 |
| SIGNATURES | 116 |
PART I
ITEM 1 – BUSINESS.
CITIZENS FINANCIAL SERVICES, INC.
Citizens Financial Services, Inc. (the “Company”), a Pennsylvania corporation, was incorporated on April 30, 1984 to be the holding company for First Citizens Community Bank (the “Bank”), a Pennsylvania-chartered bank and trust company. The Company is primarily engaged in the ownership and management of the Bank and the Bank’s wholly-owned insurance agency subsidiary, First Citizens Insurance Agency, Inc. We completed the acquisition of a branch in Centre County, Pennsylvania on December 8, 2017. On December 11, 2015, the Company completed the acquisition of The First National Bank of Fredericksburg (“FNB”) by merging FNB into the Bank, with the Bank as the resulting institution.
AVAILABLE INFORMATION
A copy of the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current events reports on Form 8-K, and amendments to these reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are made available free of charge through the Company’s web site at www.firstcitizensbank.com as soon as reasonably practicable after such reports are filed with or furnished to the Securities and Exchange Commission. Copies of the reports the Company files electronically with the Securities and Exchange Commission are also available through the Securities and Exchange Commission’s website at www.sec.gov. Information on our website shall not be considered as incorporated by reference into this Form 10-K.
FIRST CITIZENS COMMUNITY BANK
The Bank is a full-service bank engaged in a broad range of banking activities and services for individual, business, governmental and institutional customers. These activities and services principally include checking, savings, and time deposit accounts; residential, commercial and agricultural real estate, commercial and industrial, state and political subdivision and consumer loans; and a variety of other specialized financial services. The Trust and Investment division of the Bank offers a full range of client investment, estate, mineral management and retirement services.
The Bank’s main office is located at 15 South Main Street, Mansfield (Tioga County), Pennsylvania. The Bank’s primary market area consists of the Pennsylvania Counties of Bradford, Clinton, Potter and Tioga in north central Pennsylvania. It also includes Allegany, Steuben, Chemung and Tioga Counties in Southern New York. With the completion of the FNB acquisition, the Bank added seven additional banking offices in south central Pennsylvania; four offices in Lebanon County, two offices in Schuylkill County, and one office in Berks County. During 2016, the Bank opened a full service branch in Lancaster County, Pennsylvania and a limited branch office in Union County, Pennsylvania. In 2017, the Bank opened a limited branch office in Lancaster County, which was closed in 2018. We have been approved and opened in February 2019, a full service branch in Lancaster County to replace the limited branch office that was closed in December 2018. We also purchased a full service branch in State College, Pennsylvania in 2017, which is located in Centre County, Pennsylvania. The economy of the Bank’s market areas are diversified and include manufacturing industries, wholesale and retail trade, service industries, agricultural and the production of natural resources of gas and timber. We are dependent geographically upon the economic conditions in north central, central and south central Pennsylvania, as well as the southern tier of New York. In addition to the main office in Mansfield, the Bank operates 26 full service offices after opening the newest branch in February 2019, and one limited branch office in its market areas.
As of December 31, 2018, the Bank had 238 full time employees and 36 part-time employees, resulting in 257 full time equivalent employees at our corporate offices and other banking locations.
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COMPETITION
The banking industry in the Bank’s service area is intensely competitive, with competitors including local community banks, larger regional banks, and financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions, mortgage banking firms, financial companies, financial affiliates of industrial companies, internet entities, and government sponsored agencies, such as Freddie Mac and Fannie Mae. There has been an increase in competitive pressures as entities continue to seek loan growth and expand into new markets. In north central Pennsylvania there has been additional competition from brokerage firms and retirement fund management firms due to the wealth generated from the exploration for natural gas in the market area. The Bank is generally competitive with all competing financial institutions in its service areas with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.
Additional information related to our business and competition is included in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations”.
SUPERVISION AND REGULATION
GENERAL
The Bank is subject to extensive regulation, examination and supervision by the Pennsylvania Department of Banking (“PDB”) and, as a member of the Federal Reserve System, by the Board of Governors of the Federal Reserve System (the “FRB”). Federal and state banking laws and regulations govern, among other things, the scope of a bank’s business, the investments a bank may make, the reserves against deposits a bank must maintain, terms of deposit accounts, loans a bank makes, the interest rates a bank charges and collateral a bank takes, the activities of a bank with respect to mergers and consolidations and the establishment of branches. The Company is registered as a bank holding company and is subject to supervision and regulation by the FRB under the Bank Holding Company Act of 1956, as amended (the “BHCA”).
PENNSYLVANIA BANKING LAWS
The Pennsylvania Banking Code (“Banking Code”) contains detailed provisions governing the organization, location of offices, rights and responsibilities of directors, officers, and employees, as well as corporate powers, savings and investment operations and other aspects of the Bank and its affairs. The Banking Code delegates extensive rule-making power and administrative discretion to the PDB so that the supervision and regulation of state chartered banks may be flexible and readily responsive to changes in economic conditions and in savings and lending practices.
Pennsylvania law also provides Pennsylvania state chartered institutions elective parity with the power of national banks, federal thrifts, and state-chartered institutions in other states as authorized by the FDIC, subject to a required notice to the PDB. The Federal Deposit Insurance Corporation Act (“FDIA”), however, prohibits state chartered banks from making new investments, loans, or becoming involved in activities as principal and equity investments which are not permitted for national banks unless (1) the FDIC determines the activity or investment does not pose a significant risk of loss to the Deposit Insurance Fund and (2) the bank meets all applicable capital requirements. Accordingly, the additional operating authority provided to the Bank by the Banking Code is restricted by the FDIA.
In April 2008, banking regulators in the States of New Jersey, New York, and Pennsylvania entered into a Memorandum of Understanding (the “Interstate MOU”) to clarify their respective roles, as home and host state regulators, regarding interstate branching activity on a regional basis pursuant to the Riegle-Neal Amendments Act of 1997. The Interstate MOU establishes the regulatory responsibilities of the respective state banking regulators regarding bank regulatory examinations and is intended to reduce the regulatory burden on state chartered banks branching within the region by eliminating duplicative host state compliance exams. Under the Interstate MOU, the activities of branches we established in New York would be governed by Pennsylvania state law to the same extent that federal law governs the activities of the branch of an out-of-state national bank in such host states. Issues regarding whether a particular host state law is preempted are to be determined in the first instance by the PDB. In the event that the PDB and the applicable host state regulator disagree regarding whether a particular host state law is pre-empted, the PDB and the applicable host state regulator would use their reasonable best efforts to consider all points of view and to resolve the disagreement.
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COMMUNITY REINVESTMENT ACT
The Community Reinvestment Act, (“CRA”), as implemented by FRB regulations, provides that the Bank has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the FRB, in connection with its examination of the Bank, to assess the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain corporate applications by such institution, such as mergers and branching. The Bank’s most recent rating was “Satisfactory.” Various consumer laws and regulations also affect the operations of the Bank. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the FRB as it attempts to control the money supply and credit availability in order to influence the economy.
CURRENT CAPITAL REQUIREMENTS
Federal regulations require FDIC-insured depository institutions, including state-chartered, FRB-member banks, to meet several minimum capital standards. These capital standards were effective January 1, 2015, and result from a final rule implementing regulatory amendments based on recommendations of the Basel Committee on Banking Supervision and certain requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).
The capital standards require the maintenance of common equity Tier 1 capital, Tier 1 capital and total capital to risk-weighted assets of at least 4.5%, 6.0% and 8.0%, respectively, and a leverage ratio of at least 4% of Tier 1 capital. Common equity Tier 1 capital is generally defined as common stockholders’ equity and retained earnings. Tier 1 capital is generally defined as common equity Tier 1 and Additional Tier 1 capital. Additional Tier 1 capital generally includes certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries. Total capital includes Tier 1 capital (common equity Tier 1 capital plus Additional Tier 1 capital) and Tier 2 capital. Tier 2 capital is comprised of capital instruments and related surplus meeting specified requirements, and may include cumulative preferred stock and long-term perpetual preferred stock, mandatory convertible securities, intermediate preferred stock and subordinated debt. Also included in Tier 2 capital is the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and, for institutions that have exercised an opt-out election regarding the treatment of Accumulated Other Comprehensive Income (“AOCI”), up to 45% of net unrealized gains on available-for-sale equity securities with readily determinable fair market values. The Company has exercised the AOCI opt-out option and therefore AOCI is not incorporated into common equity Tier 1 capital. Calculation of all types of regulatory capital is subject to deductions and adjustments specified in the regulations.
In determining the amount of risk-weighted assets for purposes of calculating risk-based capital ratios, assets, including certain off-balance sheet assets (e.g., recourse obligations, direct credit substitutes, residual interests) are multiplied by a risk weight factor assigned by the regulations based on the risks believed inherent in the type of asset. Higher levels of capital are required for asset categories believed to present greater risk. For example, a risk weight of 0% is assigned to cash and U.S. government securities, a risk weight of 50% is generally assigned to prudently underwritten first lien one- to four-family residential mortgages, a risk weight of 100% is assigned to commercial and consumer loans, a risk weight of 150% is assigned to certain past due loans and a risk weight of between 0% to 600% is assigned to permissible equity interests, depending on certain specified factors.
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In addition to establishing the minimum regulatory capital requirements, the regulations limit capital distributions by the institution and certain discretionary bonus payments to management if an institution does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets above the amount necessary to meet its minimum risk-based capital requirements. The capital conservation buffer requirement was phased in beginning January 1, 2016 at 0.625% of risk-weighted assets and increased each year until fully implemented at 2.5% on January 1, 2019.
The FRB has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution’s capital level is or may become inadequate in light of the particular risks or circumstances.
As of December 31, 2018, we met all applicable capital adequacy requirements.
PROMPT CORRECTIVE ACTION RULES
Federal law establishes a system of prompt corrective action to resolve the problems of undercapitalized institutions. The law requires that certain supervisory actions be taken against undercapitalized institutions, the severity of which depends on the degree of undercapitalization. The FRB has adopted regulations to implement the prompt corrective action legislation as to state member banks. The regulations were amended to incorporate the previously mentioned increased regulatory capital standards that were effective January 1, 2015. An institution is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a leverage ratio of 5.0% or greater and a common equity Tier 1 ratio of 6.5% or greater. An institution is “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, a leverage ratio of 4.0% or greater and a common equity Tier 1 ratio of 4.5% or greater. An institution is “undercapitalized” if it has a total risk-based capital ratio of less than 8.0%, a Tier 1 risk-based capital ratio of less than 6.0%, a leverage ratio of less than 4.0% or a common equity Tier 1 ratio of less than 4.5%. An institution is deemed to be “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 4.0%, a leverage ratio of less than 3.0% or a common equity Tier 1 ratio of less than 3.0%. An institution is considered to be “critically undercapitalized” if it has a ratio of tangible equity (as defined in the regulations) to total assets that is equal to or less than 2.0%.
Subject to a narrow exception, a receiver or conservator must be appointed for an institution that is “critically undercapitalized” within specified time frames. The regulations also provide that a capital restoration plan must be filed with the FRB within 45 days of the date an institution is deemed to have received notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Compliance with the capital restoration plan must be guaranteed by any parent holding company up to the lesser of 5% of the depository institution’s total assets when it was deemed to be undercapitalized or the amount necessary to achieve compliance with applicable capital requirements. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. The FRB could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors. Significantly and critically undercapitalized institutions are subject to additional mandatory and discretionary measures.
STANDARDS FOR SAFETY AND SOUNDNESS
The federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness in various areas such as internal controls and information systems, internal audit, loan documentation and credit underwriting, interest rate exposure, asset growth and quality, earnings and compensation, fees and benefits. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the FRB determines that a state member bank fails to meet any standard prescribed by the guidelines, the FRB may require the institution to submit an acceptable plan to achieve compliance with the standard.
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ENFORCEMENT
The PDB maintains enforcement authority over the Bank, including the power to issue cease and desist orders and civil money penalties and remove directors, officers or employees. The PDB also has the power to appoint a conservator or receiver for a bank upon insolvency, imminent insolvency, unsafe or unsound condition or certain other situations. The FRB has primary federal enforcement responsibility over FRB-member state banks and has authority to bring actions against the institution and all institution-affiliated parties, including shareholders, who knowingly or recklessly participate in wrongful actions likely to have an adverse effect on the bank. Formal enforcement action may range from the issuance of a capital directive or a cease and desist order, to removal of officers and/or directors. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or even $1 million per day in especially egregious cases. The FDIC, as deposit insurer, has the authority to recommend to the FRB that enforcement action be taken with respect to a member bank. If the FRB does not take action, the FDIC has authority to take such action under certain circumstances. In general, regulatory enforcement actions occur with respect to situations involving unsafe or unsound practices or conditions, violations of law or regulation or breaches of fiduciary duty. Federal and Pennsylvania law also establish criminal penalties for certain violations.
REGULATORY RESTRICTIONS ON BANK DIVIDENDS
The Bank may not declare a dividend without approval of the FRB, unless the dividend to be declared by the Bank's Board of Directors does not exceed the total of: (i) the Bank's net profits for the current year to date, plus (ii) its retained net profits for the preceding two years, less any required transfers to surplus.
Under Pennsylvania law, the Bank may only declare and pay dividends from its accumulated net earnings. In addition, the Bank may not declare and pay dividends from the surplus funds that Pennsylvania law requires that it maintain. Under these policies and subject to the restrictions applicable to the Bank, the Bank could have declared, during 2018, without prior regulatory approval, aggregate dividends of approximately $12.4 million, plus net profits earned to the date of such dividend declaration.
BANK SECRECY ACT
Under the Bank Secrecy Act (BSA), banks and other financial institutions are required to retain records to assure that the details of financial transactions can be traced if investigators need to do so. Banks are also required to report most cash transactions in amounts exceeding $10,000 made by or on behalf of their customers. Failure to meet BSA requirements may expose the Bank to statutory penalties, and a negative compliance record may affect the willingness of regulating authorities to approve certain actions by the Bank requiring regulatory approval, including acquisition and opening new branches.
INSURANCE OF DEPOSIT ACCOUNTS
The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund (DIF) of the FDIC. Under the FDIC’s risk-based assessment system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors, with less risky institutions paying lower assessments. An institution’s assessment rate depends upon the category to which it is assigned, and certain adjustments specified by FDIC regulations.
As required by the Dodd-Frank Act, the FDIC has issued final rules implementing changes to the assessment rules. The rules change the assessment base used for calculating deposit insurance assessments from deposits to total assets less tangible (Tier 1) capital. Since the new base is larger than the previous base, the FDIC also lowered assessment rates so that the rule would not significantly alter the total amount of revenue collected from the industry. The range of adjusted assessment rates is now 2.5 to 45 basis points of the new assessment base. The rule is expected to benefit smaller financial institutions, which typically rely more on deposits for funding, and shift more of the burden for supporting the insurance fund to larger institutions, which are thought to have greater access to nondeposit funding. No institution may pay a dividend if it is in default of its assessments. As a result of the Dodd-Frank Act, deposit insurance per account owner is $250,000 for all types of accounts.
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The Dodd-Frank Act increased the minimum target DIF ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits. The FDIC must seek to achieve the 1.35% ratio by September 30, 2020. Insured institutions with assets of $10 billion or more are supposed to fund the increase. The Dodd-Frank Act eliminated the 1.5% maximum fund ratio, instead leaving it to the discretion of the FDIC. The FDIC has recently exercised that discretion by establishing a long range fund ratio of 2%.
The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what insurance assessment rates will be in the future.
Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or regulatory condition imposed in writing. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
FEDERAL RESERVE SYSTEM
Under FRB regulations, the Bank is required to maintain reserves against its transaction accounts (primarily NOW and regular checking accounts). For 2019, the Bank is required to maintain average daily reserves equal to 3% on aggregate transaction accounts of up to and including $124.2 million, plus 10% on the remainder, and the first $16.3 million of otherwise reservable balances will be exempt. These reserve requirements are subject to annual adjustment by the FRB. The Bank is in compliance with the foregoing requirements.
PROHIBITIONS AGAINST TYING ARRANGEMENTS
State-chartered banks are prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.
OTHER REGULATIONS
Interest and other charges collected or contracted for by the Bank are subject to state usury laws and federal laws concerning interest rates. The Bank’s operations are also subject to federal and state laws applicable to credit transactions, such as the:
| • | Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers; |
| • | Home Mortgage Disclosure Act, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves; |
| • | Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit; |
| • | Fair Credit Reporting Act, governing the use and provision of information to credit reporting agencies; |
| • | Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies; |
| • | Truth in Savings Act; and |
| • | Rules and regulations of the various federal and state agencies charged with the responsibility of implementing such laws. |
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The Bank’s operations also are subject to the:
| • | Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; |
| • | Electronic Funds Transfer Act and Regulation E promulgated thereunder, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services; |
| • | Check Clearing for the 21st Century Act (also known as “Check 21”), which gives “substitute checks,” such as digital check images and copies made from that image, the same legal standing as the original paper check; |
| • | The USA PATRIOT Act, which requires banks operating to, among other things, establish broadened anti-money laundering compliance programs, due diligence policies and controls to ensure the detection and reporting of money laundering. Such required compliance programs are intended to supplement existing compliance requirements, also applicable to financial institutions, under the Bank Secrecy Act and the Office of Foreign Assets Control regulations; and |
| • | The Gramm-Leach-Bliley Act, which places limitations on the sharing of consumer financial information by financial institutions with unaffiliated third parties. Specifically, the Gramm-Leach-Bliley Act requires all financial institutions offering financial products or services to retail customers to provide such customers with the financial institution’s privacy policy and provide such customers the opportunity to “opt out” of the sharing of certain personal financial information with unaffiliated third parties. |
HOLDING COMPANY REGULATION
The Company, as a bank holding company, is subject to examination, supervision, regulation, and periodic reporting under the BHCA, as administered by the FRB. The Company is required to obtain the prior approval of the FRB to acquire all, or substantially all, of the assets of any bank or bank holding company. Prior FRB approval is also required for the Company to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if it would, directly or indirectly, own or control more than 5% of any class of voting shares of the bank or bank holding company.
A bank holding company is generally prohibited from engaging in, or acquiring, direct or indirect control of more than 5% of the voting securities of any company engaged in nonbanking activities. One of the principal exceptions to this prohibition is for activities found by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Some of the principal activities that the FRB has determined by regulation to be closely related to banking are: (i) making or servicing loans; (ii) performing certain data processing services; (iii) providing securities brokerage services; (iv) acting as fiduciary, investment or financial advisor; (v) leasing personal or real property under certain conditions; (vi) making investments in corporations or projects designed primarily to promote community welfare; and (vii) acquiring a savings association.
A bank holding company that meets specified conditions, including that its depository institutions subsidiaries are “well capitalized” and “well managed,” can opt to become a “financial holding company.” A “financial holding company” may engage in a broader array of financial activities than permitted a typical bank holding company. Such activities can include insurance underwriting and investment banking. The Company does not anticipate opting for “financial holding company” status at this time.
The Company is exempt from the FRB’s consolidated capital adequacy guidelines for bank holding companies because the Company’s consolidated assets are less than $3.0 billion. The FRB consolidated capital adequacy guidelines are at least as stringent as those required for the subsidiary depository institutions.
A bank holding company is generally required to give the FRB prior written notice of any purchase or redemption of then outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the Company’s consolidated net worth. The FRB may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, FRB order or directive, or any condition imposed by, or written agreement with, the FRB. The FRB has adopted an exception to that approval requirement for well-capitalized bank holding companies that meet certain other conditions.
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The FRB has issued a policy statement regarding the payment of dividends by bank holding companies. In general, the FRB’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition. The FRB’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by using available resources to provide capital funds during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. The Dodd-Frank Act codified the source of strength policy and requires the promulgation of implementing regulations. Under the prompt corrective action laws, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.
The Federal Deposit Insurance Act makes depository institutions liable to the Federal Deposit Insurance Corporation for losses suffered or anticipated by the insurance fund in connection with the default of a commonly controlled depository institution or any assistance provided by the Federal Deposit Insurance Corporation to such an institution in danger of default. That law would have potential applicability if the Company ever held as a separate subsidiary a depository institution in addition to the Bank.
The status of the Company as a registered bank holding company under the Bank Holding Company Act will not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws.
ACQUISITION OF THE HOLDING COMPANY
Under the Change in Bank Control Act (the “CIBCA”), a federal statute, a notice must be submitted to the FRB if any person (including a company), or group acting in concert, seeks to acquire 10% or more of the Company’s shares of outstanding common stock, unless the FRB has found that the acquisition will not result in a change in control of the Company. Under the CIBCA, the FRB generally has 60 days within which to act on such notices, taking into consideration certain factors, including the financial and managerial resources of the acquirer, the convenience and needs of the communities served by the Company and the Bank, and the anti-trust effects of the acquisition. Under the BHCA, any company would be required to obtain prior approval from the FRB before it may obtain “control” of the Company within the meaning of the BHCA. Control generally is defined to mean the ownership or power to vote 25% or more of any class of voting securities of the Company or the ability to control in any manner the election of a majority of the Company’s directors. An existing bank holding company would be required to obtain the FRB’s prior approval under the BHCA before acquiring more than 5% of the Company’s voting stock.
EFFECT OF GOVERNMENT MONETARY POLICIES
The earnings and growth of the banking industry are affected by the credit policies of monetary authorities, including the Federal Reserve System. An important function of the Federal Reserve System is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures. Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market activities in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These operations are used in varying combinations to influence overall economic growth and indirectly, bank loans, securities, and deposits. These variables may also affect interest rates charged on loans or paid on deposits. The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.
In view of the changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities including the Federal Reserve System, no prediction can be made as to possible changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and the Bank. Additional information is included under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in this Annual Report on Form 10-K.
8
ITEM 1A – RISK FACTORS.
Changing interest rates may decrease our earnings and asset values.
Our net interest income is the interest we earn on loans and investments less the interest we pay on our deposits and borrowings. Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding. Changes in interest rates—up or down—could adversely affect our net interest margin and, as a result, our net interest income. Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract. Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates. As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the asset yields catch up. Changes in the slope of the “yield curve”—or the spread between short-term and long-term interest rates—could also reduce our net interest margin. Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets.
Changes in interest rates also affect the value of the Bank’s interest-earning assets, and in particular the Bank’s securities portfolio. Generally, the value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on securities available for sale are reported as a separate component of shareholder equity, net of tax, while unrealized gains and losses on equity securities directly impact earnings. Decreases in the fair value of securities available for sale resulting from increases in interest rates could have an adverse effect on shareholders’ equity or net income.
Activities related to the drilling for natural gas in the in the Marcellus and Utica Shale formations impacts certain customers of the Bank.
Our north central Pennsylvania market area is predominately centered in the Marcellus and Utica Shale natural gas exploration and drilling area, and as a result, the economy in north central Pennsylvania is influenced by the natural gas industry. Loan demand, deposit levels and the market value of local real estate are impacted by this activity. While the Company does not lend to the various entities directly engaged in exploration, drilling or production activities, many of our customers provide transportation and other services and products that support natural gas exploration and production activities. Therefore, our customers are impacted by changes in the market price for natural gas, as a significant downturn in this industry could impact the ability of our borrowers to repay their loans in accordance with their terms. Additionally, exploration and drilling activities may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection. Regulatory and market pricing of natural gas could also impact and/or reduce demand for loans and deposit levels or loan collateral values. These factors could have a material adverse effect on our business, prospects, financial condition and results of operations.
Higher loan losses could require us to increase our allowance for loan losses through a charge to earnings.
When we loan money we incur the risk that our borrowers do not repay their loans. We reserve for loan losses by establishing an allowance through a charge to earnings. The amount of this allowance is based on our assessment of loan losses inherent in our loan portfolio. The process for determining the amount of the allowance is critical to our financial results and condition. It requires subjective and complex judgments about the future, including forecasts of economic or market conditions that might impair the ability of our borrowers to repay their loans. We might underestimate the loan losses inherent in our loan portfolio and have loan losses in excess of the amount reserved. We might increase the allowance because of changing economic conditions. For example, in a rising interest rate environment, borrowers with adjustable-rate loans could see their payments increase. There may be a significant increase in the number of borrowers who are unable or unwilling to repay their loans, resulting in our charging off more loans and increasing our allowance. In addition, when real estate values decline, the potential severity of loss on a real estate-secured loan can increase significantly, especially in the case of loans with high combined loan-to-value ratios. A decline in the national economy and the local economies of the areas in which the loans are concentrated could result in an increase in loan delinquencies, foreclosures or repossessions resulting in increased charge-off amounts and the need for additional loan loss allowances in future periods. In addition, bank regulators may require us to make a provision for loan losses or otherwise recognize further loan charge-offs following their periodic review of our loan portfolio, our underwriting procedures, and our loan loss allowance. Any increase in our allowance for loan losses or loan charge-offs as required by such regulatory authorities could have a material adverse effect on our financial condition and results of operations.
9
Our allowance for loan losses amounted to $12.9 million, or 1.19% of total loans outstanding and 93.4% of nonperforming loans, at December 31, 2018. Our allowance for loan losses at December 31, 2018 may not be sufficient to cover future loan losses. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would decrease our earnings. In addition, at December 31, 2018 we had a total of 49 loan relationships with outstanding balances that exceeded $3.0 million, 48 of which were performing according to their original terms. These loans represent approximately 24.4% of our entire outstanding loan portfolio as of December 31, 2018 and the deterioration of one or more of these loans could result in a significant increase in our nonperforming loans and our provision for loan losses, which would negatively impact our results of operations.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments, which changes the impairment model for most financial assets. The underlying premise of the Update is that financial assets measured at amortized cost should be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The allowance for credit losses should reflect management’s current estimate of credit losses that are expected to occur over the remaining life of a financial asset. The income statement will be effected for the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the period. ASU 2016-13 is effective for annual and interim periods beginning after December 15, 2019, and early adoption is permitted for annual and interim periods beginning after December 15, 2018. The implementation of this standard may result in significant changes to the balance in the allowance for loan losses and may results in significant costs being expended to implement.
Our emphasis on commercial real estate, agricultural real estate, construction and municipal lending may expose us to increased lending risks.
At December 31, 2018, we had $319.3 million in loans secured by commercial real estate, $284.5 million in agricultural real estate loans, $33.9 million in construction loans and $102.7 million in municipal loans. Commercial real estate loans, agricultural real estate, construction and municipal loans represented 29.5%, 26.3%, 3.1% and 9.5%, respectively, of our loan portfolio. At December 31, 2018, we had $9.2 million of reserves specifically allocated to these loan types. While commercial real estate, agricultural real estate, construction and municipal loans are generally more interest rate sensitive and carry higher yields than do residential mortgage loans, these types of loans generally expose a lender to greater risk of non-payment and loss than single-family residential mortgage loans because repayment of the loans often depends on the successful operation of the property, the income stream of the borrowers and, for construction loans, the accuracy of the estimate of the property’s value at completion of construction and the estimated cost of construction. Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to single-family residential mortgage loans. We monitor loan concentrations on an individual relationship and industry wide basis to monitor the amount of risk we have in our loan portfolio.
Agricultural loans are dependent for repayment on the successful operation and management of the farm property, the health of the agricultural industry broadly, and on the location of the borrower in particular, and other factors outside of the borrower’s control.
10
At December 31, 2018, our agricultural loans, consisting primarily of agricultural real estate loans and other agricultural loans were $326.7 million representing 30.2% of our total loan portfolio. The primary activities of our agricultural customers include dairy and beef farms, poultry and swine operations, crops and support businesses. Agricultural markets are highly sensitive to real and perceived changes in the supply and demand of agricultural products. Weaker prices, could reduce the value of agricultural land in our local markets and thereby increase the risk of default by our borrowers or reduce the foreclosure value of agricultural land, animals and equipment that serves as collateral for certain of our loans. At December 31, 2018, the Company had a loan concentration to the dairy industry as loans to this industry totaled $154,344,000, or 14.3% of total loans.
Our agricultural loans are dependent on the profitable operation and management of the farm property securing the loan and its cash flows. The success of a farm property may be affected by many factors outside the control of the borrower, including:
| • | adverse weather conditions (such as hail, drought and floods), restrictions on water supply or other conditions that prevent the planting of a crop or limit crop yields; |
| • | loss of crops or livestock due to disease or other factors; |
| • | declines in the market prices or demand for agricultural products (both domestically and internationally), for any reason; |
| • | increases in production costs (such as the costs of labor, rent, feed, fuel and fertilizer); |
| • | the impact of government policies and regulations (including changes in price supports, subsidies, government-sponsored crop insurance, minimum ethanol content requirements for gasoline, tariffs, trade barriers and health and environmental regulations); |
| • | access to technology and the successful implementation of production technologies; and |
| • | changes in the general economy that could affect the availability of off-farm sources of income and prices of real estate for borrowers. |
| • | Disruptions in the dairy supply chain as retailers opens plants that allow them to process and bottle milk |
Lower prices for agricultural products may cause farm revenues to decline and farm operators may be unable to reduce expenses as quickly as their revenues decline. In addition, many farms are dependent on a limited number of key individuals whose injury or death could significantly affect the successful operation of the farm. If the cash flow from a farming operation is diminished, the borrower’s ability to repay the loan may be impaired. Consequently, agricultural loans may involve a greater degree of risk than residential mortgage lending, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as farm equipment (some of which is highly specialized with a limited or no market for resale) or perishable assets such as livestock or crops. In such cases, any repossessed collateral for a defaulted agricultural operating loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation or because the assessed value of the collateral exceeds the eventual realization value.
Loan participations comprise a portion of our loan portfolio and a decline in loan participation volume could hurt profits and slow loan growth.
We have actively engaged in loan participations whereby we are invited to participate in loans, primarily commercial real estate and municipal loans, originated by another financial institution known as the lead lender. We have participated with other financial institutions in both our primary markets and out of market areas. We underwrite any loan we participate in as if we are originating the loan. The primary difference is that financial information is received from the participating financial institution and not the borrower. The loans we participate in totaled $67.1 million, $84.7 million, and $86.7 million at December 31, 2018, 2017 and 2016, respectively. As a percent of total loans, participation purchased loans were 6.2%, 8.5% and 10.8% as of December 31, 2018, 2017 and 2016. Our profits and loan growth could be significantly and adversely affected if the volume of loan participations would materially decrease, whether because loan demand declines, loan payoffs, lead lenders may come to perceive us as a potential competitor in their respective market areas, or otherwise.
11
If we conclude that the decline in value of any of our investment securities is other than temporary, we are required to write down the value of that security through a charge to earnings.
We review our investment securities portfolio monthly and at each quarter-end reporting period to determine whether the fair value is below the current carrying value. When the fair value of any of our investment securities has declined below its carrying value, we are required to assess whether the decline is other than temporary. If we conclude that the decline is other than temporary, we are required to write down the value of that security through a charge to earnings. As of December 31, 2018, our investment portfolio included available for sale investment securities with an amortized cost of $242.2 million and a fair value of $241.0 million, which included unrealized losses on 110 securities totaling $1,984,000. Changes in the expected cash flows of these securities and/or prolonged price declines may result in our concluding in future periods that the impairment of these securities is other than temporary, which would require a charge to earnings to write down these securities to their fair value. Any charges for other-than-temporary impairment would not impact cash flow, tangible capital or liquidity.
Our profits, asset values and liquidity could be hurt if the Pennsylvania state legislature and governor fail to pass a state budget.
The Company makes loans to, invests in securities issued by, and maintains deposit accounts of Pennsylvania municipalities, primarily school districts. If a budget impasse occurs, we may incur losses on loans granted to municipalities as well as incur losses, including impairment losses as a result of credit rating downgrades or otherwise, on municipal securities in which we invest. A budget impasse may also reduce municipal funds on deposit with the Company, which could hurt our liquidity and our earnings if we would have to resort to higher cost funding sources to meet our liquidity needs.
Income from secondary mortgage market operations is volatile, and we may incur losses or charges with respect to our secondary mortgage market operations which would negatively affect our earnings.
We generally sell in the secondary market the longer term fixed-rate residential mortgage loans that we originate, earning non-interest income in the form of gains on sale. When interest rates rise, the demand for mortgage loans tends to fall and may reduce the number of loans available for sale. In addition to interest rate levels, weak or deteriorating economic conditions also tend to reduce loan demand. Although we sell loans in the secondary market without recourse, we are required to give customary representations and warranties to the buyers. If we breach those representations and warranties, the buyers can require us to repurchase the loans and we may incur a loss on the repurchase. Because we generally retain the servicing rights on the loans we sell in the secondary market, we are required to record a mortgage servicing right asset, which we test annually for impairment. The value of mortgage servicing rights tends to increase with rising interest rates and to decrease with falling interest rates. If we are required to take an impairment charge on our mortgage servicing rights our earnings would be adversely affected.
As a result of the acquisition of FNB, the Bank acquired a portfolio of loans sold to the FHLB, which were sold under the Mortgage Partnership Finance Program ("MPF"). While the Bank was not an active participant in the MPF program in 2018, we continue to evaluate the program to see if it would be beneficial to our customers and our performance. The MPF portfolio balance was $24,853,000 at December 31, 2018. The FHLB maintains a first-loss position for the MPF portfolio that totals $133,000. Should the FHLB exhaust its first-loss position, recourse to the Bank's credit enhancement would be up to the next $856,000 of losses. The Bank has not experienced any losses for the MPF portfolio.
The Company’s financial condition and results of operations are dependent on the economy in the Bank’s market area.
The Bank’s primary market area consists of the Pennsylvania Counties of Bradford, Clinton, Potter, and Tioga in north central Pennsylvania, Lebanon, Schuylkill, Berks and Lancaster in south central, Pennsylvania and Allegany, Steuben, Chemung and Tioga Counties in southern New York. With the acquisition of the State College branch in December 2017, we consider Centre County to be a primary market going forward. As of December 31, 2018, management estimates that approximately 87.9% of deposits and 64.9% of loans came from households whose primary address is located in the Bank’s primary market areas. Because of the Bank’s concentration of business activities in its market area, the Company’s financial condition and results of operations depend upon economic conditions in its market areas. Adverse economic conditions in our market areas could reduce our growth rate, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations. Conditions such as inflation, recession, unemployment, high interest rates and short money supply and other factors beyond our control may adversely affect our profitability. We are less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies. Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the States of Pennsylvania and New York could adversely affect the value of our assets, revenues, results of operations and financial condition. Moreover, we cannot give any assurance we will benefit from any market growth or favorable economic conditions in our primary market areas if they do occur.
12
A return of recessionary conditions or further volatility in markets could result in increases in our level of nonperforming loans and/or reduce demand for our products and services, which could have an adverse effect on our results of operations.
Although the U.S. economy is not currently in a recession, economic growth has been uneven, and while the unemployment rate remains low, there is still an elevated level of people out of the workforce and the markets have been very volatile. A return to prolonged deteriorating economic conditions and/or negative developments or further volatility in the domestic and international credit and equity markets could significantly affect the markets in which we do business, the value of our loans and investments, and our ongoing operations, costs and profitability. These events may cause us to incur losses and may adversely affect our financial condition and results of operations.
We may fail to realize all of the anticipated benefits of entering new markets.
With the FNB acquisition in 2015, the hiring of additional agricultural lending teams in 2016 and the State College branch acquisition in 2017, the Company entered into new banking market areas. The success of entering these new markets will depend upon, in part, the Company’s ability to realize the anticipated benefits and cost savings from combining the businesses of the Company and the acquisition, as well as organically growing loans and deposits. To realize these anticipated benefits and cost savings, the businesses and individuals must be successfully combined and operated. If the Company is not able to achieve these objectives, the anticipated benefits, including growth and cost savings related to the combined businesses, may not be realized at all or may take longer to realize than expected. If the Company fails to realize the anticipated benefits of the acquisitions and the new employee hiring’s, the Company’s results of operations could be adversely affected.
Regulation of the financial services industry is significant, and future legislation could increase our cost of doing business or harm our competitive position.
We are subject to extensive regulation, supervision and examination by the FRB and the PDB, our primary regulators, and by the FDIC, as insurer of our deposits. Such regulation and supervision governs the activities in which an institution and its holding company may engage and are intended primarily for the protection of the insurance fund and the depositors and borrowers of the Bank rather than for holders of our common stock. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on our profitability and operations. Future legislative changes could require changes to business practices or force us to discontinue businesses and potentially expose us to additional costs, liabilities, enforcement action and reputational risk.
We are periodically subject to examination and scrutiny by a number of banking agencies and, depending upon the findings and determinations of these agencies, we may be required to make adjustments to our business that could adversely affect us.
13
Federal and state banking agencies periodically conduct examinations of our business, including compliance with applicable laws and regulations. If, as a result of an examination, a banking agency was to determine that the financial condition, capital resources, asset quality, asset concentration, earnings prospects, management, liquidity, sensitivity to market risk or other aspects of any of our operations has become unsatisfactory, or that we or our management is in violation of any law or regulation, it could take a number of different remedial actions as it deems appropriate. These actions include the power to enjoin “unsafe or unsound” practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to restrict our growth, to change the composition of our assets or liabilities, to assess civil monetary penalties against us and/or our officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate our deposit insurance. If we become subject to such regulatory actions, our business, results of operations and reputation may be negatively impacted.
Strong competition within the Bank’s market areas could hurt profits and slow growth.
The Bank faces intense competition both in making loans and attracting deposits. This competition has made it more difficult for the Bank to make new loans and at times has forced the Bank to offer higher deposit rates. Price competition for loans and deposits might result in the Bank earning less on loans and paying more on deposits, which would reduce net interest income. Competition also makes it more difficult to increase the volume of our loan and deposit portfolios. As of June 30, 2018, which is the most recent date for which information is available, we held 35.4% of the FDIC insured deposits in Bradford, Potter and Tioga Counties, Pennsylvania, which was the largest share of deposits out of eight financial institutions with offices in the area, and 6.4% of the FDIC insured deposits in Allegany County, New York, which was the fourth largest share of deposits out of five financial institutions with offices in this area. As of June 30, 2018, we held 7.3% of the deposits in Lebanon County, Pennsylvania, which was the fifth largest share out of the 11 financial institutions with offices in the County. Our offices in Centre, Clinton, Berks, Lancaster and Schuylkill Counties all have less than 3% of the deposits of the corresponding County. This data does not include deposits held by credit unions. Competition also makes it more difficult to hire and retain experienced employees. Some of the institutions with which the Bank competes have substantially greater resources and lending limits than the Bank has and may offer services that the Bank does not provide. Management expects competition to increase in the future as a result of legislative, regulatory and technological changes (fintech) and the continuing trend of consolidation in the financial services industry. The Bank’s profitability depends upon its continued ability to compete successfully in its market area.
We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.
We are and will continue to be dependent upon the services of our executive management team. In addition, we will continue to depend on our ability to retain and recruit key commercial and agricultural loan officers. The unexpected loss of services of any key management personnel or commercial and agricultural loan officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
Environmental liability associated with lending activities could result in losses.
In the course of our business, we may foreclose on and take title to properties securing our loans. If hazardous substances were discovered on any of these properties, we could be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage. Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination. In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site even if we neither own nor operate the disposal site. Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.
14
Our ability to pay dividends is limited by law.
Our ability to pay dividends to our shareholders largely depends on our receipt of dividends from the Bank. The amount of dividends that the Bank may pay to us is limited by federal and state laws and regulations. We also may decide to limit the payment of dividends even when we have the legal ability to pay them in order to retain earnings for use in our business.
Federal and state banking laws, our articles of incorporation and our by-laws may have an anti-takeover effect.
Federal law imposes restrictions, including regulatory approval requirements, on persons seeking to acquire control over us. Pennsylvania law also has provisions that may have an anti-takeover effect. These provisions may serve to entrench management or discourage a takeover attempt that shareholders consider to be in their best interest or in which they would receive a substantial premium over the current market price.
We are subject to certain risks in connection with our use of technology.
Communications and information systems are essential to the conduct of our business, as we use such systems to manage our customer relationships, our general ledger, our deposits, our loans, and to deliver on-line and electronic banking services. Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, the security of our computer systems, software, and networks may be vulnerable to breaches, unauthorized access, misuse, computer viruses, or other malicious code and cyber attacks that could have a security impact.
In addition, breaches of security may occur through intentional or unintentional acts by those having authorized or unauthorized access to our confidential or other information or the confidential or other information of our customers, clients, or counterparties. If one or more of such events were to occur, the confidential and other information processed and stored in, and transmitted through, our computer systems and networks could potentially be jeopardized, or could otherwise cause interruptions or malfunctions in our operations or the operations of our customers, clients, or counterparties. This could cause us significant reputational damage or result in our experiencing significant losses from fraud or otherwise.
Furthermore, we may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures arising from operational and security risks. Also, we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance we maintain.
We routinely transmit and receive personal, confidential, and proprietary information by e-mail and other electronic means. We have discussed and worked with our customers, clients, and counterparties to develop secure transmission capabilities, but we do not have, and may be unable to put in place, secure capabilities with all of these constituents, and we may not be able to ensure that these third parties have appropriate controls in place to protect the confidentiality of such information. Any interception, misuse, or mishandling of personal, confidential, or proprietary information being sent to or received from a customer, client, or counterparty could result in legal liability, regulatory action, and reputational harm, and could have a significant adverse effect on our competitive position, financial condition, and results of operations.
Our risk management framework may not be effective in mitigating risks and/or losses to us.
We have implemented a risk management framework to manage our risk exposure. This framework is comprised of various processes, systems and strategies, and is designed to manage the types of risk to which we are subject, including, among others, credit, market, liquidity, interest rate and compliance. Our framework also includes financial or other modeling methodologies which involve management assumptions and judgment. There is no assurance that our risk management framework will be effective under all circumstances or that it will adequately mitigate any risk or loss to us. If our framework is not effective, we could suffer unexpected losses and our business, financial condition, results of operations or prospects could be materially and adversely affected. We may also be subject to potentially adverse regulatory consequences.
15
Impairment of goodwill could require charges to earnings, which could result in a negative impact on our results of operations.
Our goodwill could become impaired in the future. If goodwill were to become impaired, it could limit the ability of the Bank to pay dividends to the Company, adversely impacting the Company’s liquidity and ability to pay dividends. The most significant assumptions affecting our goodwill impairment evaluation are variables including the market price of our Common Stock, projections of earnings, and the control premium above our current stock price that an acquirer would pay to obtain control of us. We are required to test goodwill for impairment at least annually or when impairment indicators are present. If an impairment determination is made in a future reporting period, our earnings and book value of goodwill will be reduced by the amount of the impairment. If an impairment loss is recorded, it will have little or no impact on the tangible book value of our Common Stock, or our regulatory capital levels, but such an impairment loss could significantly reduce the Bank’s earnings and thereby restrict the Bank's ability to make dividend payments to us without prior regulatory approval, because Federal Reserve policy states the bank holding company dividends should be paid from current earnings. At December 31, 2018, the book value of our goodwill was $23.3 million, all of which was recorded at the Bank.
ITEM 1B – UNRESOLVED STAFF COMMENTS.
Not applicable.
ITEM 2 – PROPERTIES.
The headquarters of the Company and Bank are located at 15 South Main Street, Mansfield, Pennsylvania. The building contains the central offices of the Company and Bank. Our bank owns twenty one banking facilities and leases eight other facilities, including one to be opened in the first quarter of 2019. All buildings owned by the Bank are free of any liens or encumbrances.
The net book value of owned banking facilities and leasehold improvements totaled $15,218,000 as of December 31, 2018. The properties are adequate to meet the needs of the employees and customers. We have equipped all of our facilities with current technological improvements for data processing.
ITEM 3 - LEGAL PROCEEDINGS.
Management is not aware of any pending or threatened litigation that would have a material adverse effect on the consolidated financial position of the Company. Other than as disclosed in Note 16 of the accompanying consolidated financial statements, any other pending proceedings are ordinary, routine litigation incidental to the business of the Company and its subsidiary. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company and its subsidiary by government authorities.
ITEM 4 – MINE SAFETY DISCLOSURES
Not applicable.
16
PART II
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
The Company's stock is not listed on any stock exchange, but it is quoted on the OTC Pink Market under the trading symbol CZFS. Prices presented in the table below are bid prices between broker-dealers published by the OTC Pink Market and the Pink Sheets Electronic Quotation Service. The prices do not include retail markups or markdowns or any commission to the broker-dealer. The bid prices do not necessarily reflect prices in actual transactions. For 2018 and 2017, cash dividends were declared on a quarterly basis and are summarized in the table below:
| Dividends | Dividends | |||||||||||||||||||||||
| | 2018 | declared | 2017 | declared | ||||||||||||||||||||
| High | Low | per share | High | Low | per share | |||||||||||||||||||
| First quarter | $ | 62.38 | $ | 61.25 | $ | 0.435 | $ | 50.29 | $ | 48.29 | $ | 0.425 | ||||||||||||
| Second quarter | 62.75 | 61.49 | 0.435 | 53.50 | 50.10 | 0.425 | ||||||||||||||||||
| Third quarter | 63.25 | 61.75 | 0.440 | 57.00 | 52.65 | 0.430 | ||||||||||||||||||
| Fourth quarter | 62.60 | 55.12 | 0.440 | 62.51 | 57.05 | 0.430 | ||||||||||||||||||
The Company has paid dividends since April 30, 1984, the effective date of our formation as a bank holding company. The Company's Board of Directors expects that comparable cash dividends will continue to be paid by the Company in the future; however, future dividends necessarily depend upon earnings, financial condition, appropriate legal restrictions and other factors in existence at the time the Board of Directors considers a dividend distribution. Cash available for dividend distributions to stockholders of the Company comes primarily from dividends paid to the Company by the Bank. Therefore, restrictions on the ability of the Bank to make dividend payments are directly applicable to the Company. Under the Pennsylvania Business Corporation Law of 1988, the Company may pay dividends only if, after payment, the Company would be able to pay debts as they become due in the usual course of our business and total assets will be greater than the sum of total liabilities. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions. Also see “Supervision and Regulation – Regulatory Restrictions on Bank Dividends,” “Supervision and Regulation – Holding Company Regulation,” and “Note 15 – Regulatory Matters” to the consolidated financial statements.
As of February 25, 2019, the Company had 1,769 stockholders of record. The computation of stockholders of record excludes investors whose shares were held for them by a bank or broker at that date. The following table presents information regarding the Company’s stock repurchases during the three months ended December 31, 2018:
| Period | Total Number of Shares (or units Purchased) | Average Price Paid per Share (or Unit) | Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans of Programs | Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (1) | ||||||||||||
| | ||||||||||||||||
| 10/1/18 to 10/31/18 | 2,000 | $ | 61.75 | 2,000 | 74,762 | |||||||||||
| 11/1/18 to 11/30/18 | 3,883 | $ | 61.56 | 3,883 | 70,879 | |||||||||||
| 12/1/18 to 12/31/18 | 350 | $ | 60.50 | 350 | 70,529 | |||||||||||
| Total | 6,233 | $ | 61.56 | 6,233 | 70,529 | |||||||||||
| (1) | On October 20, 2015, the Company announced that the Board of Directors authorized the Company to repurchase up to an additional 150,000 shares. The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors. No time limit was placed on the duration of the share repurchase program. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes. |
17
Set forth below is a line graph comparing the yearly dollar changes in the cumulative shareholder return on the Company’s common stock against the cumulative total return of the S&P 500 Stock index, SNL Mid-Atlantic Bank Index, SNL Bank $1 Billion to $5 Billion index and SNL Bank $500 Million to $1 Billion index for the period of seven fiscal years assuming the investment of $100.00 on December 31, 2011 and assuming the reinvestment of dividends. The $1 Billion to $5 Billion index was added to the chart in 2015 due to the Company exceeding $1.0 billion in assets in December of 2015 as a result of the FNB acquisition. The shareholder return shown on the graph below is not necessarily indicative of future performance and was obtained from SNL Financial LC, Charlottesville, VA.
| | Period Ending | |||||||
| Index | 12/31/11 | 12/31/12 | 12/31/13 | 12/31/14 | 12/31/15 | 12/31/16 | 12/31/17 | 12/31/18 |
| Citizens Financial Services, Inc. | 100 | 130.88 | 176.92 | 184.81 | 174.87 | 197.56 | 254.13 | 232.79 |
| S&P 500 | 100 | 116.00 | 153.57 | 174.60 | 177.01 | 198.18 | 241.45 | 230.86 |
| SNL Mid-Atlantic Bank | 100 | 133.96 | 180.57 | 196.72 | 204.10 | 259.43 | 317.95 | 271.67 |
| SNL Bank $1B-$5B | 100 | 123.31 | 179.31 | 187.48 | 209.86 | 301.92 | 321.88 | 282.00 |
| SNL Bank $500M-$1B | 100 | 128.21 | 166.25 | 182.39 | 205.86 | 277.96 | 339.11 | 327.31 |
18
ITEM 6 - SELECTED FINANCIAL DATA.
The following table sets forth certain financial data as of and for each of the years in the five year period ended December 31, 2018:
| (in thousands, except per share data) | 2018 | 2017 | 2016 | 2015 | 2014 | |||||||||||||||
| Interest and dividend income | $ | 56,758 | $ | 48,093 | $ | 43,005 | $ | 35,653 | $ | 35,291 | ||||||||||
| Interest expense | 9,574 | 5,839 | 5,041 | 4,820 | 4,953 | |||||||||||||||
| Net interest income | 47,184 | 42,254 | 37,964 | 30,833 | 30,338 | |||||||||||||||
| Provision for loan losses | 1,925 | 2,540 | 1,520 | 480 | 585 | |||||||||||||||
| Net interest income after provision | ||||||||||||||||||||
| for loan losses | 45,259 | 39,714 | 36,444 | 30,353 | 29,753 | |||||||||||||||
| Non-interest income | 7,754 | 7,621 | 7,644 | 6,994 | 6,740 | |||||||||||||||
| Investment securities gains (losses), net | (19 | ) | 1,035 | 255 | 429 | 616 | ||||||||||||||
| Non-interest expenses | 31,557 | 29,314 | 28,671 | 23,429 | 20,165 | |||||||||||||||
| Income before provision for income taxes | 21,437 | 19,056 | 15,672 | 14,347 | 16,944 | |||||||||||||||
| Provision for income taxes | 3,403 | 6,031 | 3,034 | 2,721 | 3,559 | |||||||||||||||
| Net income | $ | 18,034 | $ | 13,025 | $ | 12,638 | $ | 11,626 | $ | 13,385 | ||||||||||
| | ||||||||||||||||||||
| Per share data: | ||||||||||||||||||||
| Net income - Basic (1) | $ | 5.14 | $ | 3.70 | $ | 3.57 | $ | 3.56 | $ | 4.09 | ||||||||||
| Net income - Diluted (1) | 5.14 | 3.70 | 3.57 | 3.56 | 4.09 | |||||||||||||||
| Cash dividends declared (1) | 1.74 | 1.65 | 1.57 | 1.61 | 2.02 | |||||||||||||||
| Stock dividend | 1 | % | 5 | % | 1 | % | 0 | % | 1 | % | ||||||||||
| Book value (1) (2) | 40.85 | 37.60 | 35.42 | 33.63 | 30.49 | |||||||||||||||
| | ||||||||||||||||||||
| End of Period Balances: | ||||||||||||||||||||
| Total assets | $ | 1,430,712 | $ | 1,361,886 | $ | 1,223,018 | $ | 1,162,984 | $ | 925,048 | ||||||||||
| Available for sale securities | 241,010 | 254,782 | 314,017 | 359,737 | 306,146 | |||||||||||||||
| Loans | 1,081,883 | 1,000,525 | 799,611 | 695,031 | 554,105 | |||||||||||||||
| Allowance for loan losses | 12,884 | 11,190 | 8,886 | 7,106 | 6,815 | |||||||||||||||
| Total deposits | 1,185,156 | 1,104,943 | 1,005,503 | 988,031 | 773,933 | |||||||||||||||
| Total borrowings | 91,194 | 114,664 | 79,662 | 41,631 | 41,799 | |||||||||||||||
| Stockholders' equity | 139,229 | 129,011 | 123,268 | 119,760 | 100,528 | |||||||||||||||
| | ||||||||||||||||||||
| Key Ratios: | ||||||||||||||||||||
| Return on assets (net income to average total assets) | 1.29 | % | 1.03 | % | 1.06 | % | 1.22 | % | 1.48 | % | ||||||||||
| Return on equity (net income to average total equity) | 13.00 | % | 10.04 | % | 10.24 | % | 11.20 | % | 13.73 | % | ||||||||||
| Equity to asset ratio (average equity to average total assets, | ||||||||||||||||||||
| excluding other comprehensive income) | 9.90 | % | 10.31 | % | 10.35 | % | 10.91 | % | 10.74 | % | ||||||||||
| Net interest margin (tax equivalent) | 3.66 | % | 3.80 | % | 3.68 | % | 3.76 | % | 3.84 | % | ||||||||||
| Efficiency (3) | 55.04 | % | 54.82 | % | 57.97 | % | 54.50 | % | 48.61 | % | ||||||||||
| Dividend payout ratio (dividends declared divided | ||||||||||||||||||||
| by net income) | 34.08 | % | 44.97 | % | 44.12 | % | 46.00 | % | 49.32 | % | ||||||||||
| Tier 1 leverage | 9.15 | % | 9.18 | % | 9.46 | % | 11.01 | % | 10.99 | % | ||||||||||
| Common equity risk based capital | 11.47 | % | 11.27 | % | 12.89 | % | 14.14 | % | N/A | |||||||||||
| Tier 1 risk-based capital | 12.18 | % | 12.04 | % | 13.81 | % | 15.20 | % | 17.30 | % | ||||||||||
| Total risk-based capital | 13.42 | % | 13.21 | % | 14.93 | % | 16.23 | % | 18.55 | % | ||||||||||
| Nonperforming assets/total loans | 1.33 | % | 1.18 | % | 1.61 | % | 1.22 | % | 1.67 | % | ||||||||||
| Nonperforming loans/total loans | 1.27 | % | 1.07 | % | 1.48 | % | 1.03 | % | 1.34 | % | ||||||||||
| Allowance for loan losses/total loans | 1.19 | % | 1.12 | % | 1.11 | % | 1.02 | % | 1.23 | % | ||||||||||
| Net (recoveries) charge-offs/average loans | 0.02 | % | 0.03 | % | (0.04 | %) | 0.03 | % | 0.16 | % | ||||||||||
| | ||||||||||||||||||||
| (1) Amounts were adjusted to reflect stock dividends. | ||||||||||||||||||||
| (2) Calculation excludes accumulated other comprehensive income. | ||||||||||||||||||||
| (3) Noninterest expenses to tax adjusted net interest income and non-interest income, excluding security gains. | ||||||||||||||||||||
19
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
CAUTIONARY STATEMENT
We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Company, the Bank, First Citizens Insurance Agency, Inc. or the Company on a consolidated basis. When we use words such as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements. Forward-looking statements may prove inaccurate. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements:
| • | Interest rates could change more rapidly or more significantly than we expect. |
| • | The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate. |
| • | The financial markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities. |
| • | It could take us longer than we anticipate implementing strategic initiatives, including expansions, designed to increase revenues or manage expenses, or we may be unable to implement those initiatives at all. |
| • | Acquisitions and dispositions of assets could affect us in ways that management has not anticipated. |
| • | We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition or operating results. |
| • | We may become subject to new and unanticipated accounting, tax, regulatory or compliance practices or requirements. Failure to comply with any one or more of these requirements could have an adverse effect on our operations. |
| • | We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition. |
• We could experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
| • | We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge. |
| • | The agricultural economy is subject to extreme swings in both the costs of resources and the prices received from the sale of products, which could negatively impact certain of our customers. |
| • | Loan concentrations in certain industries could negatively impact our results, if financial results or economic conditions deteriorate. |
| • | A budget impasse in the Commonwealth of Pennsylvania could impact our asset values, liquidity and profitability as a result of either delayed or reduced funding to school districts and municipalities who are customers of the bank. |
| • | Companies providing support services related to the exploration and drilling of the natural gas reserves in our market area may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection, which could negatively impact our customers and, as a result, negatively impact our loan and deposit volume and loan quality. Additionally, the activities the companies providing support services related to the exploration and drilling of the natural gas reserves may be dependent on the market price of natural gas. As a result, decreases in the market price of natural gas could also negatively impact these companies, our customers. |
Additional factors are discussed in this Annual Report on Form 10-K under “Item 1A. Risk Factors.” These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Forward-looking statements speak only as of the date they are made and the Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date of the forward-looking statements or to reflect the occurrence of unanticipated events. Accordingly, past results and trends should not be used by investors to anticipate future results or trends.
20
INTRODUCTION
The following is management’s discussion and analysis of the significant changes in financial condition, the results of operations, capital resources and liquidity presented in the accompanying consolidated financial statements for the Company. The Company’s consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes. Except as noted, tabular information is presented in thousands of dollars.
The Company currently engages in the general business of banking throughout our service area of Bradford, Tioga, Clinton, Potter and Centre counties in north central Pennsylvania, Lebanon, Berks, Schuylkill and Lancaster counties in south central Pennsylvania and Allegany County in southern New York. We also have a limited branch office in Union county, Pennsylvania, which primarily serves agricultural customers in the central Pennsylvania market. We maintain our main office in Mansfield, Pennsylvania. Presently we operate 29 banking facilities, 28 of which operate as bank branches. In Pennsylvania, the Company has full service offices located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, Rome, the Mansfield Wal-Mart Super Center, Mill Hall, Schuylkill Haven, Friedensburg, Mt. Aetna, Fredericksburg, Mount Joy, State College and three branches near the city of Lebanon, Pennsylvania. We also have a limited branch office in Winfield, Pennsylvania. In New York, our office is in Wellsville. In February of 2019, we opened a full service branch in Fivepointville, Pennsylvania.
Risk identification and management are essential elements for the successful management of the Company. In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity, reputational and regulatory risk.
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates. Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company. The Company uses its asset/liability and funds management policies to control and manage interest rate risk.
Credit risk represents the possibility that a customer may not perform in accordance with contractual terms. Credit risk results from loans with customers and the purchasing of securities. The Company’s primary credit risk is in the loan portfolio. The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses. Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors. The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk. These guidelines include, among other things, contingent funding alternatives.
Reputational risk, or the risk to our business, earnings, liquidity, and capital from negative public opinion, could result from our actual or alleged conduct in a variety of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, ethical issues, or inadequate protection of customer information, which could include identify theft, or theft of customer information through third parties. We expend significant resources to comply with regulatory requirements. Failure to comply could result in reputational harm or significant legal or remedial costs. Damage to our reputation could adversely affect our ability to retain and attract new customers, and adversely impact our earnings and liquidity.
Regulatory risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company and its subsidiary. We cannot predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations.
21
Readers should carefully review the risk factors described in other documents the Company files with the SEC, including the annual reports on Form 10-K, the quarterly reports on Form 10-Q and any current reports on Form 8-K filed by us.
TRUST AND INVESTMENT SERVICES; OIL AND GAS SERVICES
Our Investment and Trust Division is committed to helping our customers meet their financial goals. The Trust Division offers professional trust administration, investment management services, estate planning and administration, custody of securities and individual retirement accounts. In addition to traditional trust and investment services offered, we assist our customers through various oil and gas specific leasing matters from lease negotiations to establishing a successful approach to personal wealth management. Assets held by the Bank in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Bank. As of December 31, 2018 and 2017, assets owned and invested by customers of the Bank through the Bank’s investment representatives totaled $178.5 million and $156.0 million, respectively. Additionally, as summarized in the table below, the Trust Department had assets under management as of December 31, 2018 and 2017 of $117.6 million and $122.7 million, respectively. During the year, we opened $10.3 million of new trust accounts and had $6.5 million of accounts closed. As a result of market fluctuations, the market value of the trust accounts decreased approximately $9.0 million.
| (market values - in thousands) | 2018 | 2017 | ||||||
| INVESTMENTS: | ||||||||
| Bonds | $ | 17,559 | $ | 18,672 | ||||
| Stock | 16,372 | 18,957 | ||||||
| Savings and Money Market Funds | 16,100 | 13,076 | ||||||
| Mutual Funds | 60,847 | 67,027 | ||||||
| Mineral interests | 4,500 | 3,885 | ||||||
| Mortgages | 1,082 | 343 | ||||||
| Real Estate | 839 | 513 | ||||||
| Miscellaneous | 279 | 238 | ||||||
| Cash | 9 | 9 | ||||||
| TOTAL | $ | 117,587 | $ | 122,720 | ||||
| ACCOUNTS: | ||||||||
| Trusts | 30,736 | 28,714 | ||||||
| Guardianships | 2,347 | 748 | ||||||
| Employee Benefits | 51,907 | 57,035 | ||||||
| Investment Management | 32,595 | 36,221 | ||||||
| Custodial | 2 | 2 | ||||||
| TOTAL | $ | 117,587 | $ | 122,720 | ||||
Our financial consultants offer full service brokerage and financial planning services throughout the Bank’s market areas. Appointments can be made at any Bank branch. Products such as mutual funds, annuities, health and life insurance are made available through our insurance subsidiary, First Citizens Insurance Agency, Inc.
RESULTS OF OPERATIONS
Net income for the year ended December 31, 2018 was $18,034,000, which represents an increase of $5,009,000, or 38.5%, when compared to the 2017 related period. Net income for the year ended December 31, 2017 was $13,025,000, which represents an increase of $387,000, or 3.1%, when compared to the 2016 related period. Basic and diluted earnings per share were $5.14, $3.70 and $3.57 for the years ended 2018, 2017 and 2016, respectively.
Net income is influenced by five key components: net interest income, provision for loan losses, non-interest income, non-interest expenses, and the provision for income taxes.
22
Net Interest Income
The most significant source of revenue is net interest income; the amount by which interest earned on interest-earning assets exceeds interest paid on interest-bearing liabilities. Factors that influence net interest income are changes in volume of interest-earning assets and interest-bearing liabilities as well as changes in the associated interest rates.
The following table sets forth our Company’s average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created. It should be noted that the acquisition of the State College branch, which closed on December 8, 2017, impacted the average balances and rates for 2018 and had an immaterial impact on the average balance and interest rates for 2017:
23
| Analysis of Average Balances and Interest Rates | ||||||||||||||||||||||||||||||||||||
| | 2018 | 2017 | 2016 | |||||||||||||||||||||||||||||||||
| | Average | Average | Average | Average | Average | Average | ||||||||||||||||||||||||||||||
| | Balance (1) | Interest | Rate | Balance (1) | Interest | Rate | Balance (1) | Interest | Rate | |||||||||||||||||||||||||||
| (dollars in thousands) | $ | $ | % | $ | $ | % | $ | $ | % | |||||||||||||||||||||||||||
| ASSETS | ||||||||||||||||||||||||||||||||||||
| Short-term investments: | ||||||||||||||||||||||||||||||||||||
| Interest-bearing deposits at banks | 8,929 | 20 | 0.22 | 8,790 | 15 | 0.17 | 22,726 | 82 | 0.36 | |||||||||||||||||||||||||||
| Total short-term investments | 8,929 | 20 | 0.22 | 8,790 | 15 | 0.17 | 22,726 | 82 | 0.36 | |||||||||||||||||||||||||||
| Interest bearing time deposits at banks | 12,734 | 299 | 2.35 | 8,346 | 171 | 2.05 | 7,232 | 139 | 1.92 | |||||||||||||||||||||||||||
| Investment securities: | ||||||||||||||||||||||||||||||||||||
| Taxable | 191,991 | 4,237 | 2.21 | 194,716 | 3,366 | 1.73 | 254,673 | 3,971 | 1.56 | |||||||||||||||||||||||||||
| Tax-exempt (3) | 64,728 | 2,208 | 3.41 | 84,235 | 3,657 | 4.34 | 99,689 | 4,499 | 4.51 | |||||||||||||||||||||||||||
| Total investment securities | 256,719 | 6,445 | 2.51 | 278,951 | 7,023 | 2.52 | 354,362 | 8,470 | 2.39 | |||||||||||||||||||||||||||
| Loans (2)(3)(4): | ||||||||||||||||||||||||||||||||||||
| Residential mortgage loans | 214,458 | 11,205 | 5.22 | 206,321 | 10,660 | 5.17 | 204,278 | 10,749 | 5.26 | |||||||||||||||||||||||||||
| Construction loans | 25,698 | 1,235 | 4.80 | 24,299 | 1,040 | 4.28 | 15,242 | 752 | 4.93 | |||||||||||||||||||||||||||
| Commercial loans | 388,037 | 20,611 | 5.31 | 329,767 | 17,525 | 5.31 | 302,717 | 16,163 | 5.34 | |||||||||||||||||||||||||||
| Agricultural loans | 305,003 | 13,638 | 4.47 | 214,200 | 9,251 | 4.32 | 91,279 | 4,374 | 4.79 | |||||||||||||||||||||||||||
| Loans to state & political subdivisions | 101,496 | 3,759 | 3.70 | 98,427 | 4,146 | 4.21 | 101,329 | 4,278 | 4.22 | |||||||||||||||||||||||||||
| Other loans | 9,558 | 737 | 7.71 | 10,341 | 823 | 7.96 | 11,036 | 916 | 8.30 | |||||||||||||||||||||||||||
| Loans, net of discount | 1,044,250 | 51,185 | 4.90 | 883,355 | 43,445 | 4.92 | 725,881 | 37,232 | 5.13 | |||||||||||||||||||||||||||
| Total interest-earning assets | 1,322,632 | 57,949 | 4.38 | 1,179,442 | 50,654 | 4.29 | 1,110,201 | 45,923 | 4.14 | |||||||||||||||||||||||||||
| Cash and due from banks | 6,807 | 6,774 | 7,357 | |||||||||||||||||||||||||||||||||
| Bank premises and equipment | 16,338 | 16,799 | 17,218 | |||||||||||||||||||||||||||||||||
| Other assets | 54,722 | 55,910 | 57,604 | |||||||||||||||||||||||||||||||||
| Total non-interest earning assets | 77,867 | 79,483 | 82,179 | |||||||||||||||||||||||||||||||||
| Total assets | 1,400,499 | 1,258,925 | 1,192,380 | |||||||||||||||||||||||||||||||||
| LIABILITIES AND STOCKHOLDERS' EQUITY | ||||||||||||||||||||||||||||||||||||
| Interest-bearing liabilities: | ||||||||||||||||||||||||||||||||||||
| NOW accounts | 326,040 | 1,642 | 0.50 | 323,105 | 1,139 | 0.35 | 301,681 | 917 | 0.30 | |||||||||||||||||||||||||||
| Savings accounts | 192,727 | 323 | 0.17 | 179,557 | 191 | 0.11 | 172,182 | 184 | 0.11 | |||||||||||||||||||||||||||
| Money market accounts | 164,916 | 1,618 | 0.98 | 127,888 | 650 | 0.51 | 118,486 | 523 | 0.44 | |||||||||||||||||||||||||||
| Certificates of deposit | 276,213 | 3,327 | 1.20 | 261,758 | 2,645 | 1.01 | 271,117 | 2,623 | 0.97 | |||||||||||||||||||||||||||
| Total interest-bearing deposits | 959,896 | 6,910 | 0.72 | 892,308 | 4,625 | 0.52 | 863,466 | 4,247 | 0.49 | |||||||||||||||||||||||||||
| Other borrowed funds | 117,912 | 2,664 | 2.26 | 68,536 | 1,214 | 1.77 | 47,004 | 794 | 1.69 | |||||||||||||||||||||||||||
| Total interest-bearing liabilities | 1,077,808 | 9,574 | 0.89 | 960,844 | 5,839 | 0.61 | 910,470 | 5,041 | 0.55 | |||||||||||||||||||||||||||
| Demand deposits | 171,353 | 153,523 | 145,968 | |||||||||||||||||||||||||||||||||
| Other liabilities | 12,647 | 14,802 | 12,524 | |||||||||||||||||||||||||||||||||
| Total non-interest-bearing liabilities | 184,000 | 168,325 | 158,492 | |||||||||||||||||||||||||||||||||
| Stockholders' equity | 138,691 | 129,756 | 123,418 | |||||||||||||||||||||||||||||||||
| Total liabilities & stockholders' equity | 1,400,499 | 1,258,925 | 1,192,380 | |||||||||||||||||||||||||||||||||
| Net interest income | 48,375 | 44,815 | 40,882 | |||||||||||||||||||||||||||||||||
| Net interest spread (5) | 3.49 | % | 3.68 | % | 3.59 | % | ||||||||||||||||||||||||||||||
| Net interest income as a percentage | ||||||||||||||||||||||||||||||||||||
| of average interest-earning assets | 3.66 | % | 3.80 | % | 3.68 | % | ||||||||||||||||||||||||||||||
| Ratio of interest-earning assets | ||||||||||||||||||||||||||||||||||||
| to interest-bearing liabilities | 1.23 | 1.23 | 1.22 | |||||||||||||||||||||||||||||||||
| | ||||||||||||||||||||||||||||||||||||
| (1) Averages are based on daily averages. | ||||||||||||||||||||||||||||||||||||
| (2) Includes loan origination and commitment fees. | ||||||||||||||||||||||||||||||||||||
| (3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using | ||||||||||||||||||||||||||||||||||||
| a statutory federal income tax rate of 21% for 2018 and 34% for 2017 and 2016. | ||||||||||||||||||||||||||||||||||||
| (4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets. | ||||||||||||||||||||||||||||||||||||
| (5) Interest rate spread represents the difference between the average rate earned on interest-earning assets | ||||||||||||||||||||||||||||||||||||
| and the average rate paid on interest-bearing liabilities. | ||||||||||||||||||||||||||||||||||||
Tax exempt interest revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 21% for 2018 and 34% for 2017 and 2016, which is the Bank’s federal income tax rate for those years.
24
For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Federal statutory rate for the corresponding year. Accordingly, tax equivalent adjustments for investments and loans have been made accordingly to the previous table for the years ended December 31, 2018, 2017 and 2016, respectively (in thousands):
| | 2018 | 2017 | 2016 | |||||||||
| Interest and dividend income from investment securities, | ||||||||||||
| interest bearing time deposits and short-term investments (non-tax adjusted) | $ | 6,300 | $ | 5,966 | $ | 7,161 | ||||||
| Tax equivalent adjustment | 464 | 1,243 | 1,530 | |||||||||
| Interest and dividend income from investment securities, | ||||||||||||
| interest bearing time deposits and short-term investments (tax equivalent basis) | $ | 6,764 | $ | 7,209 | $ | 8,691 | ||||||
| | ||||||||||||
| | 2018 | 2017 | 2016 | |||||||||
| Interest and fees on loans (non-tax adjusted) | $ | 50,458 | $ | 42,127 | $ | 35,844 | ||||||
| Tax equivalent adjustment | 727 | 1,318 | 1,388 | |||||||||
| Interest and fees on loans (tax equivalent basis) | $ | 51,185 | $ | 43,445 | $ | 37,232 | ||||||
| | ||||||||||||
| | 2018 | 2017 | 2016 | |||||||||
| Total interest income | $ | 56,758 | $ | 48,093 | $ | 43,005 | ||||||
| Total interest expense | 9,574 | 5,839 | 5,041 | |||||||||
| Net interest income | 47,184 | 42,254 | 37,964 | |||||||||
| Total tax equivalent adjustment | 1,191 | 2,561 | 2,918 | |||||||||
| Net interest income (tax equivalent basis) | $ | 48,375 | $ | 44,815 | $ | 40,882 | ||||||
The following table shows the tax-equivalent effect of changes in volume and rates on interest income and expense (in thousands):
| Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis | ||||||||||||||||||||||||
| | 2018 vs. 2017 (1) | 2017 vs. 2016 (1) | ||||||||||||||||||||||
| | Change in | Change | Total | Change in | Change | Total | ||||||||||||||||||
| | Volume | in Rate | Change | Volume | in Rate | Change | ||||||||||||||||||
| Interest Income: | ||||||||||||||||||||||||
| Short-term investments: | ||||||||||||||||||||||||
| Interest-bearing deposits at banks | $ | - | $ | 5 | $ | 5 | $ | (36 | ) | $ | (31 | ) | $ | (67 | ) | |||||||||
| Interest bearing time deposits at banks | 100 | 28 | 128 | 23 | 9 | 32 | ||||||||||||||||||
| Investment securities: | ||||||||||||||||||||||||
| Taxable | (46 | ) | 917 | 871 | (1,121 | ) | 516 | (605 | ) | |||||||||||||||
| Tax-exempt | (752 | ) | (697 | ) | (1,449 | ) | (677 | ) | (165 | ) | (842 | ) | ||||||||||||
| Total investment securities | (798 | ) | 220 | (578 | ) | (1,798 | ) | 351 | (1,447 | ) | ||||||||||||||
| Total investment income | (698 | ) | 253 | (445 | ) | (1,811 | ) | 329 | (1,482 | ) | ||||||||||||||
| Loans: | ||||||||||||||||||||||||
| Residential mortgage loans | 424 | 121 | 545 | 110 | (199 | ) | (89 | ) | ||||||||||||||||
| Construction loans | 63 | 132 | 195 | 371 | (83 | ) | 288 | |||||||||||||||||
| Commercial Loans | 3,095 | (9 | ) | 3,086 | 1,437 | (75 | ) | 1,362 | ||||||||||||||||
| Agricultural Loans | 4,049 | 338 | 4,387 | 5,263 | (386 | ) | 4,877 | |||||||||||||||||
| Loans to state & political subdivisions | 136 | (523 | ) | (387 | ) | (122 | ) | (10 | ) | (132 | ) | |||||||||||||
| Other loans | (62 | ) | (24 | ) | (86 | ) | (56 | ) | (37 | ) | (93 | ) | ||||||||||||
| Total loans, net of discount | 7,705 | 35 | 7,740 | 7,003 | (790 | ) | 6,213 | |||||||||||||||||
| Total Interest Income | 7,007 | 288 | 7,295 | 5,192 | (461 | ) | 4,731 | |||||||||||||||||
| Interest Expense: | ||||||||||||||||||||||||
| Interest-bearing deposits: | ||||||||||||||||||||||||
| NOW accounts | 11 | 492 | 503 | 69 | 153 | 222 | ||||||||||||||||||
| Savings accounts | 15 | 117 | 132 | 8 | (1 | ) | 7 | |||||||||||||||||
| Money Market accounts | 229 | 739 | 968 | 44 | 83 | 127 | ||||||||||||||||||
| Certificates of deposit | 152 | 530 | 682 | (78 | ) | 100 | 22 | |||||||||||||||||
| Total interest-bearing deposits | 407 | 1,878 | 2,285 | 43 | ||||||||||||||||||||