ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION AND FORWARD-LOOKING STATEMENTS
Introduction
The following is management’s discussion and analysis of the significant changes in the financial condition, results of operations, comprehensive income, capital resources, and liquidity presented in its accompanying consolidated financial statements for ACNB Corporation (the Corporation or ACNB), a financial holding company. Please read this discussion in conjunction with the consolidated financial statements and disclosures included herein. Current performance does not guarantee, assure or indicate similar performance in the future.
Forward-Looking Statements
In addition to historical information, this Form 10-Q may contain forward-looking statements. Examples of forward-looking statements include, but are not limited to, (a) projections or statements regarding future earnings, expenses, net interest income, other income, earnings or loss per share, asset mix and quality, growth prospects, capital structure, and other financial terms, (b) statements of plans and objectives of Management or the Board of Directors, and (c) statements of assumptions, such as economic conditions in the Corporation’s market areas. Such forward-looking statements can be identified by the use of forward-looking terminology such as “believes”, “expects”, “may”, “intends”, “will”, “should”, “anticipates”, or the negative of any of the foregoing or other variations thereon or comparable terminology, or by discussion of strategy. Forward-looking statements are subject to certain risks and uncertainties such as local economic conditions, competitive factors, and regulatory limitations. Actual results may differ materially from those projected in the forward-looking statements. Such risks, uncertainties and other factors that could cause actual results and experience to differ from those projected include, but are not limited to, the following: short- and long-term effects of inflation and rising costs on the Corporation, customers and economy; effects of governmental and fiscal policies, as well as legislative and regulatory changes; effects of new laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) and their application with which the Corporation and its subsidiaries must comply; impacts of the capital and liquidity requirements of the Basel III standards; effects of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Financial Accounting Standards Board and other accounting standard setters; ineffectiveness of the business strategy due to changes in current or future market conditions; future actions or inactions of the United States government, including the effects of short- and long-term federal budget and tax negotiations and a failure to increase the government debt limit or a prolonged shutdown of the federal government; effects of economic conditions particularly with regard to the negative impact of severe, wide-ranging and continuing disruptions caused by the spread of Coronavirus Disease 2019 (COVID-19) and any other pandemic, epidemic or health-related crisis and the responses thereto on the operations of the Corporation and current customers, specifically the effect of the economy on loan customers’ ability to repay loans; effects of competition, and of changes in laws and regulations on competition, including industry consolidation and development of competing financial products and services; inflation, securities market and monetary fluctuations; risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities, and interest rate protection agreements, as well as interest rate risks; difficulties in acquisitions and integrating and operating acquired business operations, including information technology difficulties; challenges in establishing and maintaining operations in new markets; effects of technology changes; effect of general economic conditions and more specifically in the Corporation’s market areas; failure of assumptions underlying the establishment of reserves for loan losses and estimations of values of collateral and various financial assets and liabilities; acts of war or terrorism or geopolitical instability; disruption of credit and equity markets; ability to manage current levels of impaired assets; loss of certain key officers; ability to maintain the value and image of the Corporation’s brand and protect the Corporation’s intellectual property rights; continued relationships with major customers; and, potential impacts to the Corporation from continually evolving cybersecurity and other technological risks and attacks, including additional costs, reputational damage, regulatory penalties, and financial losses. We caution readers not to place undue reliance on these forward-looking statements. They only reflect Management’s analysis as of this date. The Corporation does not revise or update these forward-looking statements to reflect events or changed circumstances. Please carefully review the risk factors described in other documents the Corporation files from time to time with the Securities and Exchange Commission, including the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q. Please also carefully review any Current Reports on Form 8-K filed by the Corporation with the Securities and Exchange Commission.
CRITICAL ACCOUNTING POLICIES
The accounting policies that the Corporation’s management deems to be most important to the portrayal of its financial condition and results of operations, and that require management’s most difficult, subjective or complex judgment, often result in the need to make estimates about the effect of such matters which are inherently uncertain. The following policies are deemed to be critical accounting policies by management:
The allowance for loan losses represents management’s estimate of probable losses inherent in the loan portfolio. Management makes numerous assumptions, estimates and adjustments in determining an adequate allowance. The Corporation assesses the level of potential loss associated with its loan portfolio and provides for that exposure through an allowance for loan losses. The allowance is established through a provision for loan losses charged to earnings. The allowance is an estimate of the losses inherent in the loan portfolio as of the end of each reporting period. The Corporation assesses the adequacy of its allowance on a quarterly basis. The specific methodologies applied on a consistent basis are discussed in greater detail under the caption, Allowance for Loan Losses, in a subsequent section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The evaluation of securities for other-than-temporary impairment requires a significant amount of judgment. In estimating other-than-temporary impairment losses, management considers various factors including the length of time the fair value has been below cost, the financial condition of the issuer, and the Corporation’s intent to sell, or requirement to sell, the security before recovery of its value. Declines in fair value that are determined to be other than temporary are charged against earnings.
Accounting Standard Codification (ASC) Topic 350, Intangibles — Goodwill and Other, requires that goodwill is not amortized to expense, but rather that it be assessed or tested for impairment at least annually. Impairment write-downs are charged to results of operations in the period in which the impairment is determined. The Corporation did not identify any impairment on ACNB Insurance Services, Inc.’s outstanding goodwill from its most recent testing, which was performed as of October 1, 2021. The Corporation did not identify any impairment on the Bank’s outstanding goodwill from its most recent qualitative assessment, which was completed as of December 31, 2021. If certain events occur which might indicate goodwill has been impaired, the goodwill is tested for impairment when such events occur. Other acquired intangible assets that have finite lives, such as core deposit intangibles, customer relationship intangibles and renewal lists, are amortized over their estimated useful lives and subject to periodic impairment testing. Core deposit intangibles are primarily amortized over ten years using accelerated methods. Customer renewal lists are amortized using the straight line method over their estimated useful lives which range from eight to fifteen years.
RESULTS OF OPERATIONS
Quarter ended September 30, 2022, compared to Quarter ended September 30, 2021
Executive Summary
Net income for the three months ended September 30, 2022, was $10,324,000 compared to a net income of $7,360,000 for the comparable period in 2021 an increase of $2,964,000 or 40.3%. Basic earnings per share for the three months ended September 30, 2022 and 2021, were $1.20 and $0.84, respectively, a 42.9% increase. The increase in net income for the third quarter of 2022 was primarily driven by increases in net interest income and commissions from insurance sales. Net interest income for the quarter ended September 30, 2022 increased $4,520,000, or 25.1%, from the comparable period in 2021. The increase in net interest income can be attributed to higher interest rates, deployment of excess liquidity, lower funding costs and a shift into higher-yielding assets. Commissions from insurance sales for the quarter ended September 30, 2022 increased $714,000, or 41.6%, from the comparable period in 2021 driven by the acquisition of the business and assets of the Hockley & O’Donnell Agency in the first quarter of 2022.
Net Interest Income
Net interest income totaled $22,520,000 for the three months ended September 30, 2022 compared to $18,000,000 for the comparable period in 2021, an increase of $4,520,000, or 25.1%. The increase in net interest income can be attributed to a higher net interest margin that benefited from higher interest rates, deployment of excess liquidity, lower funding costs and a shift into higher-yielding assets. The net interest margin for the three months ended September 30, 2022 was 3.59%, an 84 basis points increase from 2.75% for the comparable period of 2021. Paycheck Protection Program (PPP) fees and purchase
accounting accretion totaled $853,000 for the three months ended September 30, 2022 compared to $1,722,000 for the three months ended September 30, 2021.
Average earning assets declined year-over-year due to cash balances decreasing attributed to anticipated deposit outflows as market rates increased in 2022. However, interest income increased by $3,900,000 for the three months ended September 30, 2022 compared to the three months ended September 30, 2021 driven by higher interest rates, deployment of excess liquidity and a shift into higher-yielding assets. Late in the first quarter of 2022, excess cash of approximately $185,000,000 was invested into higher-yielding securities. The new purchases were consistent with the current portfolio and investment policy. Yields on average earnings assets increased to 3.76% for the three months ended September 30, 2022 compared to 2.99% for the three months ended September 30, 2021. Interest expense decreased by $620,000 for the three months ended September 30, 2022 compared to the three months ended September 30, 2021, driven by a reduction in long-term borrowings and a reduction in deposit costs due to smaller balances outstanding. The cost of interest-bearing liabilities declined to 0.14% for the three months ended September 30, 2022 compared to 0.27% for the three months ended September 30, 2021.
Provision for Loan Losses
As a result of stable loan risk metrics, combined with low credit losses in the portfolio, the provisions for loan losses for the third quarter of 2022 and 2021 were $0. The determination of the provision was a result of the analysis of the adequacy of the allowance for loan losses calculation. The allowance for loan losses generally does not include the loans acquired through acquisition, which were recorded at fair value as of the acquisition date. Each quarter, the Corporation assesses risk in the loan portfolio compared with the balance in the allowance for loan losses and the current evaluation factors. ACNB charges confirmed loan losses to the allowance and credits the allowance for recoveries of previous loan charge-offs. For the third quarter of 2022, the Corporation had net charge-offs of $991,000 as compared to net charge-offs of $1,066,000 for the third quarter of 2021. For more information, please refer to Allowance for Loan Losses in the following Financial Condition section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Other Income
Total other income was $5,849,000 for the three months ended September 30, 2022, up $575,000, or 10.9%, from the comparable period of 2021. Fees from deposit accounts increased by $182,000, or 20.2%, due to resumption of economic activity that produces fee generating activity. Fee volume varies with balance levels, account transaction activity, and customer-driven events. At the Corporation’s wholly-owned insurance subsidiary, ACNB Insurance Services, Inc., commissions from insurance sales were up by $714,000, or 41.6%, to $2,429,000 driven primarily by the acquisition of the business and assets of the Hockley & O’Donnell Agency in the first quarter of 2022. Income for sold mortgages included in other income decreased by $258,000, or 86.0%, due to less mortgage activity as a result of an increase in the current rate environment. There were no realized gains or losses on sales of securities during the third quarter of 2022 and 2021. An $88,000 net fair value loss was recognized on local bank and CRA-related equity securities during the third quarter of 2022 due to normal variations in market value on publicly-traded local bank stocks compared to a $0 net fair value loss during the third quarter of 2021. No equity securities were sold in either period. Other income in the three months ended September 30, 2022, was up by $58,000, or 19.1%, to $362,000 due to a variety of other fee income variances. During the third quarter of 2022, additional bank-owned life insurance was purchased with a cash surrender value of $12,200,000.
Other Expenses
Other expenses for the quarter ended September 30, 2022 were $15,320,000 an increase of $1,344,000, or 9.6%, from the comparable period in 2021. The largest expense is salaries and benefits, which increased by $399,000, or 4.5%, from the comparable period in 2021. Overall, the increase in salaries and employee benefits can be attributed to all or some of the following factors:
•merit increases to employees and associated payroll taxes;
•increased organic and inorganic growth initiatives at ACNB Insurance Services, Inc.;
•challenges and cost in replacing and retaining staff due to a competitive labor market;
•maintaining staff in support functions and higher skilled mix of employees necessitated by regulations and growth;
•varying and timing on other performance-based commissions and incentives;
•market changes in actively managing employee benefit plan costs, including health insurance; and
•varying cost of 401(k) plan and non-qualified retirement plan benefits,
The Corporation’s overall pension plan investment strategy is to achieve a mix of investments to meet the long-term rate of return assumption and near-term pension obligations with a diversification of asset types, fund strategies, and fund managers. The mix of investments is adjusted periodically by retaining an advisory firm to recommend appropriate allocations after reviewing the Corporation’s risk tolerance on contribution levels, funded status, plan expense, as well as any applicable regulatory requirements. However, the determination of future benefit expense is also dependent on the fair value of assets and the discount rate on the year-end measurement date, which in recent years has experienced fair value volatility and low discount rates. The expense could also be higher in future years due to volatility in the discount rates at the latest measurement date, lower plan returns, and change in mortality tables utilized. The defined benefit pension expense was down by $291,000 when comparing the three months ended September 30, 2022 to the three months ended September 30, 2021 due to an expense in prior year as compared to a contra-expense in the current year. The decrease was driven from the change in discount rates which increases or decreases the future pension obligations (creating volatility in the expense) and return on assets at the latest annual evaluation date due to market conditions.
Net occupancy expense increased by $26,000, or 2.7%, during the period due to an increase in ordinary building repairs. Equipment expense increased by $340,000, or 28.8%, due to additional ongoing expenses related to the September 2021 upgrade to a new core application system that was a major step in the Corporation’s Digital Transformation Strategy. Equipment expense is subject to ever-increasing technology demands and the need for system upgrades for security and reliability purposes. Technology investments and training allowing staff to work from home continues to prove invaluable in the pandemic, but also in attracting a broader talent pool.
Professional services expense totaled $589,000 during the third quarter of 2022 as compared to $422,000 for the comparable period in 2021, an increase of $167,000, or 39.6%. Increase in this category was a result of additional expenses related to the transition of the Corporation’s independent audit firm, as well as higher expenses for consultants and executive recruiters to fill key roles within the Bank. Professional expenses vary with specific engagements that occur at different times of each year, such as loan and compliance reviews.
Marketing and corporate relations expenses were $57,000 for the third quarter of 2022, or 29.6% lower as compared to the comparable period of 2021. Marketing expense varies with the timing and amount of planned advertising production and media expenditures, typically related to the promotion of certain in-market banking and trust products.
Other tax expense increased by $18,000, or 4.6%, during the third quarter of 2022 as compared to the comparable period in 2021. Supplies and postage expense increased by 28.3% due to variation in the timing of necessary replenishments and increased prepaid mailing costs for customer’s year-end tax statements. FDIC and regulatory expense increased 6.5% due to variations in the asset base. FDIC expense varies with changes in net asset size, risk ratings, and FDIC derived assessment rates. Intangible amortization increased 38.6% due to the acquisition of the business and assets of the Hockley & O’Donnell Agency in the first quarter of 2022. Other operating expenses increased by $236,000, or 18.5%, in the third quarter of 2022, as compared to the third quarter of 2021. A consumer loan promotion attributed to the increase in other operating costs in the third quarter of 2022. Increase in other expenses also includes the expense of reimbursing checking and debit card customers for unauthorized transactions to their accounts.
Provision for Income Taxes
The Corporation recognized income taxes of $2,725,000, or 20.9% of pretax income, during the third quarter of 2022 compared to $1,938,000, or 20.8% of pretax income, during the comparable period in 2021. The variances from the federal statutory rate of 21% in the respective periods are generally due to tax-exempt income from investments in and loans to state and local units of government, investment in bank-owned life insurance, and investments in low-income housing partnerships (which qualify for federal tax credits). In addition, both years include Maryland corporation income taxes. Low-income housing tax credits were $70,000 for the three months ended September 30, 2022 and 2021.
Nine Months ended September 30, 2022, compared to Nine Months ended September 30, 2021
Executive Summary
Net income for the nine months ended September 30, 2022, was $25,553,000 compared to $23,339,000 for the comparable period in 2021, an increase of $2,214,000 or 9.5%. Basic earnings per share for the nine month period was $2.95 in 2022 and
$2.67 in 2021 or a 10.5% increase. The higher net income for the first nine months ended September 30, 2022 was primarily driven by increases in net interest income and commissions from insurance sales. Net interest income for the nine months ended September 30, 2022 was $59,377,000, an increase of $5,483,000, or 10.2%, from the comparable period in 2021. The increase was driven by higher interest rates, deployment of excess liquidity, lower funding costs and shift into higher-yielding earning assets. PPP fees and purchase accounting accretion totaled $2,803,000 for the nine months ended September 30, 2022 compared to $6,665,000 for the nine months ended September 30, 2021. Commissions from insurance sales for the nine months ended September 30, 2022 increased $1,486,000, or 30.0%, from the comparable period in 2021 driven by the acquisition of the business and assets of the Hockley & O’Donnell Agency in the first quarter of 2022.
Net Interest Income
Net interest income totaled $59,377,000 for the nine months ended September 30, 2022 compared to $53,894,000 for the comparable period in 2021, an increase of $5,483,000, or 10.2%. The increase in net interest income can be attributed to a higher net interest margin that benefited from higher interest rates, deployment of excess liquidity, lower funding costs and a shift into higher-yielding assets. The net interest margin for the first nine months of 2022 was 3.13%, compared to 2.90% for the same period of 2021. Year-to-date PPP fees and purchase accounting accretion totaled $2,803,000 compared to $6,665,000 for the comparable period in 2021.
Interest income increased by $2,670,000 for the nine months ended September 30, 2022 compared to the same period in 2021 driven by higher interest rates, deployment of excess liquidity, a shift into higher-yielding assets and an increase in average earning assets. Late in the first quarter of 2022, excess cash of approximately $185,000,000 was invested into higher-yielding securities. The new purchases were consistent with the current portfolio and investment policy. Yields on average earnings assets increased to 3.26% for the nine months ended September 30, 2022 compared to 3.19% for the comparable period in 2021. Interest expense decreased by $2,813,000 for the nine months ended September 30, 2022 compared to the same period in 2021 driven by a reduction in long-term borrowings and a reduction in deposit costs due to smaller balances outstanding. The cost of interest-bearing liabilities declined to 0.15% or the nine months ended September 30, 2022 compared to 0.35% for the comparable period in 2021.
Provision for Loan Losses
As a result of stable loan risk metrics, combined with low credit losses in the portfolio, the provision for loan losses was $0 in the first nine months of 2022 compared to $50,000 in the first nine months of 2021. The determination of the provision was a result of the analysis of the adequacy of the allowance for loan losses calculation. The allowance for loan losses generally does not include the loans acquired through acquisition, which were recorded at fair value as of the acquisition date. Each quarter, the Corporation assesses risk in the loan portfolio and reserve required compared with the balance in the allowance for loan losses and the current evaluation factors. ACNB charges confirmed loan losses to the allowance and credits the allowance for recoveries of previous loan charge-offs. For the first nine months of 2022, the Corporation had net charge-offs of $1,081,000, as compared to net charge-offs of $1,135,000 for the first nine months of 2021. For more information, please refer to Allowance for Loan Losses in the following Financial Condition section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Other Income
Total other income was $16,384,000 for the nine months ended September 30, 2022, down $759,000, or 4.4%, from the first nine months of 2021. Fees from deposit accounts increased by $618,000, or 25.5%, due to resumption of economic activity that produces fee generating activity. Fee volume varies with balance levels, account transaction activity, and customer-driven events. Revenue from ATM and debit card transactions decreased by $81,000 or 3.2%, to $2,455,000 due to variations in volume and mix. Income from fiduciary, investment management and brokerage activities, which includes fees from both institutional and personal trust, investment management services, estate settlement and brokerage services, totaled $2,449,000 for the nine months ended September 30, 2022, as compared to $2,363,000 for the first nine months of 2021, a 3.6% net increase. Earnings on bank-owned life insurance decreased by $14,000, or 1.3%, as a net result of varying crediting rates and administrative cost. During the third quarter of 2022, additional bank-owned life insurance was purchased with a cash surrender value of $12,200,000. At the Corporation’s wholly-owned insurance subsidiary, ACNB Insurance Services, Inc., commissions from insurance sales was up by $1,486,000, or 30.0%, to $6,437,000 during the period primarily due to the acquisition of the business and assets of the Hockley & O’Donnell Agency in the first quarter of 2022. Income for sold mortgages included in other income decreased by $2,029,000,or 81.3%, due to less mortgage activity as a result of an increase in the current rate environment. A $345,000 net fair value loss was recognized on local bank and CRA-related equity securities during the first nine months of 2022 due to normal variations in market value on publicly-traded local bank stocks, compared to a $377,000 net fair value gain during the first nine months of 2021. No equity securities were sold in either quarter. There were no realized
gains or losses on sales of securities during the first nine months of 2022 and 2021. Other income in the nine months ended September 30, 2022, was down by $103,000, or 11.1%, to $822,000 due to a variety of other fee income variances. During the third quarter of 2022, additional bank-owned life insurance was purchased with a cash surrender value of $12,200,000.
Other Expenses
Other expenses for the nine months ended September 30, 2022 were $43,608,000, an increase of $2,114,000,or 5.1%, from the first nine months of 2021. The increase was primarily driven by increases in professional, equipment and other expenses. Salaries and employee benefits, which is the largest component of other expenses, decreased by $66,000, or 0.3%, when comparing the first nine months of 2022 to the comparable period in 2021. The nine months ended September 30, 2022 was impacted by a partial reversal of prior year-end incentive compensation accrual as $750,000 of restricted stock was issued in lieu of accrued cash awards. Net occupancy expense increased by $52,000, or 1.7%, during the period due to increased ordinary building repairs. Equipment expense increased by $783,000, or 20.7%, due to increased monthly expenses related to the September 2021 upgrade to a new core processing system that was a major step in the Corporation’s Digital Transformation Strategy.
Professional services expense totaled $1,328,000 during the first nine months of 2022 compared to $890,000 for the same period in 2021, an increase of $438,000 or 49.2%. The increase in professional expenses was a result of additional expenses related to the transition of the Corporation’s independent audit firm, as well as higher expenses for consultants and executive recruiters to fill key roles within the Bank. Professional expenses vary with specific engagements that occur at different times of each year, such as loan and compliance reviews.
Marketing and corporate relations expenses were $227,000 for the first nine months of 2022, or 3.2% higher as compared to the same period of 2021. Marketing expense varies with the timing and amount of planned advertising production and media expenditures, typically related to the promotion of certain in-market banking and trust products.
Other tax expense increased by $52,000, or 4.4%, for the nine months ended September 30, 2022 compared to the same period in 2021, including higher Pennsylvania Bank Shares Tax. Supplies and postage expense increased by 16.9% due to variation in the timing of necessary replenishments and increased costs in mailing of customers year-end tax statements. FDIC and regulatory expense increased $93,000 or 13.2%, due to variations in the asset base. FDIC expense varies with changes in net asset size, risk ratings, and FDIC derived assessment rates. Intangible amortization increased $215,000 or 24.5%, due to the acquisition of the business and assets of the Hockley & O’Donnell Agency in the first quarter of 2022. Other operating expenses increased by $449,000, or 11.2%, in the first nine months of 2022, as compared to the first nine months of 2021. The increase was attributed to an increase in consumer loan waived cost resulting from the consumer loan promotion and the expense of reimbursing checking and debit card customers for unauthorized transactions to their accounts.
Provision for Income Taxes
The Corporation recognized income taxes of $6,600,000, or 20.5% of pretax income, during the first nine months of 2022, as compared to $6,154,000, or 20.9% of pretax income, during the same period in 2021. The variances from the federal statutory rate of 21% in the respective periods are generally due to tax-exempt income from investments in and loans to state and local units of government, investment in bank-owned life insurance, and investments in low-income housing partnerships (which qualify for federal tax credits). In addition, both years include Maryland corporation income taxes. Low-income housing tax credits were $211,000 for the nine months ended September 30, 2022 and 2021.
FINANCIAL CONDITION
Assets totaled $2,654,153,000 at September 30, 2022 compared to $2,786,987,000 at December 31, 2021, and $2,792,792,000 at September 30, 2021. Average earning assets during the nine months ended September 30, 2022 increased to $2,539,550,000 from $2,483,036,000 during the same period in 2021. Average interest bearing liabilities increased in 2022 to $1,822,406,000 from $1,761,808,000 in 2021.
Investment Securities
ACNB uses investment securities to generate interest and dividend income, manage interest rate risk, provide collateral for certain funding products, and provide liquidity. The changes in the securities portfolio were the net result of purchases and matured securities to provide proper collateral for public deposits. The investment portfolio is comprised of U.S. Government agency, municipal, and corporate securities. These securities provide the appropriate characteristics with respect to credit
quality, yield and maturity relative to the management of the overall balance sheet.
At September 30, 2022, the securities balance included a net unrealized loss on available for sale securities of $56,856,000, net of taxes, on amortized cost of $571,944,000 versus a net unrealized loss of $3,474,000, net of taxes, on amortized cost of $441,565,000 at December 31, 2021, and a net unrealized loss of $953,000, net of taxes, on amortized cost of $412,901,000 at September 30, 2021. The change in fair value of available for sale securities during 2022 was a result of the greater amount of investments in the available for sale portfolio and by a decrease in fair value due to a rise in market interest rates.
At September 30, 2022, the securities balance included held to maturity securities with an amortized cost of $66,304,000 and a fair value of $56,801,000 as compared to an amortized cost of $6,454,000 and a fair value of $6,652,000 at December 31, 2021, and an amortized cost of $7,220,000 and a fair value of $7,482,000 at September 30, 2021. During the six months ending June 30, 2022, approximately $39.7 million of municipal securities were transferred from available for sale to held to maturity to mitigate the unrealized loss on available for sale securities. The held to maturity securities also include U.S. government pass-through mortgage-backed securities in which the full payment of principal and interest is guaranteed.
The Corporation does not own investments consisting of pools of Alt-A or subprime mortgages, private label mortgage-backed securities, or trust preferred investments.
Late in the quarter ended March 31, 2022, the Corporation deployed excess liquidity by moving approximately $185,000,000 from cash into higher-yielding securities with a tax equivalent yield of approximately 2.80%. These new purchases were consistent with the current investment portfolio, but with higher yields to enhance the net interest margin and net interest income in future quarters. Purchases were primarily in government sponsored enterprise (GSE) pass-through instruments issued by the Federal National Mortgage Association (FNMA), Government National Mortgage Association (GNMA) or Federal Home Loan Mortgage Corporation (FHLMC), which guarantee the timely payment of principal on these investments.
The fair values of securities available for sale (carried at fair value) are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1) or by matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific security but rather by relying on the security’s relationship to other benchmark quoted prices. The Corporation uses independent service providers to provide matrix pricing. Please refer to Note 7 — “Securities” in the Notes to Consolidated Financial Statements for more information on the security portfolio and Note 9 — “Fair Value Measurements” in the Notes to Consolidated Financial Statements for more information about fair value.
Loans
Loans outstanding increased by $40,242,000, or 2.7%, at September 30, 2022 from September 30, 2021, and increased by $58,701,000, or 4.0%, from December 31, 2021, to September 30, 2022. The increase in loans is largely attributable to growth in the commercial lending portfolio. Despite the intense competition in the Corporation’s market areas, management continues to focus on asset quality and disciplined underwriting standards in the loan origination process. Total commercial purpose segments increased $50,886,000, or 5.0%, as compared to December 31, 2021. Commercial loans are spread among diverse categories that include municipal governments/school districts, commercial real estate, commercial real estate construction, and commercial and industrial. Included in commercial loans are loans to Pennsylvania school districts, municipalities (including townships) and essential purpose authorities. In most cases, these loans are backed by the general obligation of the local municipal body. In many cases, these loans are obtained through a bid process with other local and regional banks. These loans are predominantly bank qualified for mostly tax-free interest income treatment for federal income taxes. These loans totaled $73,644,000 at September 30, 2022, an increase of 17.2% from $62,823,000 held at the end of 2021; these loans are especially subject to refinancing in certain rate environments. Residential real estate mortgage lending increased by $6,329,000, or 1.4%, as compared to December 31, 2021. Of the $448,216,000 total in residential mortgage loans at September 30, 2022, $132,281,000 were secured by junior liens or home equity loans, which are also in many cases junior liens. Junior liens inherently have more credit risk by virtue of the fact that another financial institution may have a senior security position in the case of foreclosure liquidation of collateral to extinguish the debt. Generally, foreclosure actions could become more prevalent if the real estate market weakens, property values deteriorate, or rates increase sharply. Non-real estate secured consumer loans comprise 0.7% of the portfolio, with automobile-secured loans representing less than 0.1% of the portfolio.
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was signed into law on March 27, 2020, and provided over $2.0 trillion in emergency economic relief to individuals and businesses impacted by the COVID-19 pandemic. The CARES Act authorized the SBA to temporarily guarantee loans under a new 7(a) loan program called the PPP. As a qualified SBA lender, the Corporation was automatically authorized to originate PPP loans. As of September 30, 2022, the Corporation had an outstanding balance of $230,000 under the PPP program, net of repayments and forgiveness to date. As of
September 30, 2022, the Corporation had originated an aggregate total of 2,217 loans in the amount of $223,036,703 under the PPP. Deferred fee income was approximately $9.5 million, before costs. The Corporation recognized $2,875,000 of PPP fee income during 2020, $5,627,000 during 2021, and $974,000 during the nine months ended September 30, 2022.
Most of the Corporation’s lending activities are with customers located within southcentral Pennsylvania and in the northern Maryland area. This region currently and historically has lower unemployment rates than the U.S. as a whole. Included in commercial real estate loans are loans made to lessors of non-residential properties that total $432,075,000, or 12.3% of total loans, at September 30, 2022. These borrowers are geographically dispersed throughout ACNB’s marketplace and are leasing commercial properties to a varied group of tenants including medical offices, retail space, and other commercial purpose facilities. Because of the varied nature of the tenants, in aggregate, management believes that these loans present an acceptable risk when compared to commercial loans in general. ACNB does not originate or hold Alt-A or subprime mortgages in its loan portfolio.
Allowance for Loan Losses
ACNB maintains the allowance for loan losses at a level believed to be adequate by management to absorb probable losses in the loan portfolio, and it is funded through a provision for loan losses charged to earnings. On a quarterly basis, ACNB utilizes a defined methodology in determining the adequacy of the allowance for loan losses, which considers specific credit reviews, past loan losses, historical experience, and qualitative factors. This methodology results in an allowance that is considered appropriate in light of the high degree of judgment required and that is prudent and conservative, but not excessive.
Management assigns internal risk ratings for each commercial lending relationship. Utilizing historical loss experience, adjusted for changes in trends, conditions, and other relevant factors, management derives estimated losses for non-rated and non-classified loans. When management identifies impaired loans with uncertain collectibility of principal and interest, it evaluates a specific reserve on a quarterly basis in order to estimate potential losses. Management’s analysis considers:
•adverse situations that may affect the borrower’s ability to repay;
•the current estimated fair value of underlying collateral; and,
•prevailing market conditions.
Loans not tested for impairment do not require a specific reserve allocation. Management places these loans in a pool of loans with similar risk factors and assigns the general loss factor to determine the reserve. For homogeneous loan types, such as consumer and residential mortgage loans, management bases specific allocations on the average loss ratio for the previous twelve quarters for each specific loan pool. Additionally, management adjusts projected loss ratios for other factors, including the following:
•lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices;
•national, regional and local economic and business conditions, as well as the condition of various market segments, including the impact on the value of underlying collateral for collateral dependent loans;
•nature and volume of the portfolio and terms of loans;
•experience, ability and depth of lending management and staff;
•volume and severity of past due, classified and nonaccrual loans, as well as other loan modifications;
•existence and effect of any concentrations of credit and changes in the level of such concentrations; and,
•In 2020, a special allowance was developed to quantify a current expected incurred loss as a result of the COVID-19 crisis. The factor considered the loan mix effects of businesses likely to be harder hit by quarantine closure orders, the relative amount of COVID-19 related modifications requested to date, the estimated regional infection stage and geopolitical factors.
Management determines the unallocated portion of the allowance for loan losses, which represents the difference between the reported allowance for loan losses and the calculated allowance for loan losses, based on the following criteria:
•the risk of imprecision in the specific and general reserve allocations;
•the perceived level of consumer and small business loans with demonstrated weaknesses for which it is not practicable to develop specific allocations;
•other potential exposure in the loan portfolio;
•variances in management’s assessment of national, regional and local economic conditions; and,
•other internal or external factors that management believes appropriate at that time, such as COVID-19.
The unallocated portion of the allowance is deemed to be appropriate as it reflects an uncertainty that remains in the loan portfolio; specifically reserves where the Corporation believes that tertiary losses are probable above the loss amount derived using appraisal-based loss estimation, where such additional loss estimates are in accordance with regulatory and GAAP guidance. Appraisal-based loss derivation does not fully develop the loss present in certain unique, ultimately bank-owned collateral. The Corporation has determined that the amount of provision in 2022 and the resulting allowance at September 30, 2022, are appropriate given management’s current analysis of the continuing level of risk in the loan portfolio. Management also believes the unallocated allowance is appropriate. In addition, there are certain loans that, although they did not meet the criteria for impairment, management believes there was a strong possibility that these loans represented potential losses at September 30, 2022. The amount of the unallocated portion of the allowance was $280,000 at September 30, 2022, as management concluded that the loan portfolio was better reflected in metrics used in the allocated evaluation. Otherwise, the assessment concluded that credit quality was stable, COVID-19 related charge-offs were relatively low and past due loans manageable.
Management believes the above methodology materially reflects losses inherent in the portfolio. Management charges actual loan losses to the allowance for loan losses. Management periodically updates the methodology and the assumptions discussed above.
Management bases the provision for loan losses, or lack of provision, on the overall analysis taking into account the methodology discussed above, which is consistent with recent quarters’ improvement in the credit quality in the loan portfolio, and with lessened risk from the impact of the COVID-19 crisis. The provision for year-to-date September 30, 2022 and 2021, was $0 and $50,000, respectively. The decrease in the allowance for loan losses as a percentage of total loans of 1.29% at September 30, 2021 to 1.18% at September 30, 2022 was primarily related to the improvement in qualitative factors, specifically economic and trends in delinquency and nonaccruals.
Federal and state regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses and may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management. Based on management’s comprehensive analysis of the loan portfolio and economic conditions, management believes the current level of the allowance for loan losses is adequate.
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 requires credit losses on most financial assets measured at amortized cost and certain other instruments to be measured using an expected credit loss model (referred to as the current expected credit loss (CECL) model). Under this model, entities will estimate credit losses over the entire contractual term of the instrument (considering estimated prepayments, but not expected extensions or modifications unless reasonable expectation of a troubled debt restructuring exists) from the date of initial recognition of that instrument. Upon adoption, the change in this accounting guidance could result in an increase in the Corporation’s allowance for loan losses and require the Corporation to record loan losses more rapidly. In October 2019, FASB voted to delay implementation of the CECL standard for certain companies, including those companies that qualify as a smaller reporting company under SEC rules until January 1, 2023. As a result, ACNB used the deferral period to develop the proper procedures, data sources and testing for implementation.
The allowance for loan losses at September 30, 2022, was $17,952,000, or 1.18% of total loans (1.44% of non-acquired loans), as compared to $19,141,000, or 1.29% of loans, at September 30, 2021, and $19,033,000, or 1.30% of loans, at December 31, 2021. The decrease from year-end resulted from charge-offs of $1,081,000 net of recoveries and $0 in provisions as shown in the table below. In the following discussion, acquired loans from Frederick and New Windsor were recorded at fair value at the acquisition date and are not included in the tables and information below, see more information in Note 8 — “Loans” in the Notes to Consolidated Financial Statements.
Changes in the allowance for loan losses were as follows:
| | | | | | | | | | | | | | | | | | | | |
| In thousands | | Nine Months Ended September 30, 2022 | | Year Ended
December 31, 2021 | | Nine Months Ended September 30, 2021 |
| Beginning balance – January 1 | | $ | 19,033 | | | $ | 20,226 | | | $ | 20,226 | |
| Provisions charged to operations | | — | | | 50 | | | 50 | |
| Recoveries on charged-off loans | | 53 | | | 75 | | | 57 | |
| Loans charged-off | | (1,134) | | | (1,318) | | | (1,192) | |
| Ending balance | | $ | 17,952 | | | $ | 19,033 | | | $ | 19,141 | |
Loans past due 90 days and still accruing were $1,476,000 and nonaccrual loans were $2,426,000 as of September 30, 2022. $0 of the nonaccrual balance at September 30, 2022, were in troubled debt restructured loans. $3,489,000 of the impaired loans were accruing troubled debt restructured loans. Loans past due 90 days and still accruing were $430,000 at September 30, 2021, while nonaccrual loans were $5,618,000. $79,000 of the nonaccrual balance at September 30, 2021, was in troubled debt restructured loans. $3,600,000 of the impaired loans were accruing troubled debt restructured loans. Loans past due 90 days and still accruing were $730,000 at December 31, 2021, while nonaccrual loans were $5,489,000. $63,000 of the nonaccrual balance at December 31, 2021, were in troubled debt restructured loans. $3,574,000 of the impaired loans were accruing troubled debt restructured loans.
Because of the manageable level of nonaccrual and substandard loans in 2022, no addition to the allowance was necessary even with year to date net charge-offs of $1,081,000.
The Corporation implemented numerous initiatives to support and protect employees and customers during the COVID-19 pandemic. These efforts continue with current information and guidelines related to ongoing COVID-19 initiatives. As of September 30, 2022 and 2021, the Corporation no longer had any temporary loan modifications or deferrals for either commercial or consumer customers, furthering the positive trend of improvement in 2021.
As to nonaccrual and substandard loans, management believes that adequate collateralization generally exists for these loans in accordance with GAAP. Each quarter, the Corporation assesses risk in the loan portfolio compared with the balance in the allowance for loan losses and the current evaluation factors.
Information on nonaccrual loans, by collateral type rather than loan class, at September 30, 2022, as compared to December 31, 2021, is as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Dollars in thousands | | Number of
Credit
Relationships | | Balance | | Specific Loss
Allocations | | Current
Year
Charge-Offs | | Location | | Originated |
| September 30, 2022 | | | | | | | | | | | | |
| | | | | | | | | | | | |
| Owner occupied commercial real estate | | 4 | | $ | 1,483 | | | $ | — | | | $ | — | | | In market | | 2012 - 2017 |
| Investment/rental residential real estate | | 1 | | 104 | | | — | | | — | | | In market | | 2016 |
| Commercial and industrial | | 2 | | 839 | | | 687 | | | — | | | In market | | 2017 - 2018 |
| Total | | 7 | | $ | 2,426 | | | $ | 687 | | | $ | — | | | | | |
| | | | | | | | | | | | |
| December 31, 2021 | | | | | | | | | | | | |
| | | | | | | | | | | | |
| Owner occupied commercial real estate | | 7 | | $ | 3,890 | | | $ | 599 | | | $ | — | | | In market | | 2008 - 2019 |
| Investment/rental residential real estate | | 1 | | 112 | | | — | | | — | | | In market | | 2016 |
| Commercial and industrial | | 3 | | 1,487 | | | 856 | | | 970 | | | In market | | 2008 - 2019 |
| Total | | 11 | | $ | 5,489 | | | $ | 1,455 | | | $ | 970 | | | | | |
Management deemed it appropriate to provide this type of more detailed information by collateral type in order to provide additional detail on the loans.
All nonaccrual impaired loans are to borrowers located within the market area served by the Corporation in southcentral Pennsylvania and Maryland. All nonaccrual impaired loans were originated by ACNB’s banking subsidiary, except for one participation loan discussed below, for purposes listed in the classifications in the table above.
The Corporation had no impaired and nonaccrual loans included in commercial real estate construction at September 30, 2022.
Owner occupied commercial real estate at September 30, 2022, includes four unrelated loan relationships. The merger-acquired loan relationship for a light manufacturing enterprise was paid off during the third quarter of 2022. An $859,000 relationship in food service that was performing when acquired was added in the first quarter of 2020 after becoming 90 days past due early in the year, subsequent payments have been received. A $255,000 commercial mortgage loan was added to this category in the third quarter of 2022. The other unrelated loans in this category have balances of less than $189,000 each, for which the real estate is collateral and is used in connection with a business enterprise that is suffering economic stress or is out of business. The loans in this category were originated between 2012 and 2017 and are business loans impacted by specific borrower credit situations. Collateral valuation resulted in no specific allocations for these four loan relationships. Most loans in this category are making principal payments. Collection efforts will continue unless it is deemed in the best interest of the Corporation to initiate foreclosure procedures.
The acquired commercial real estate participation loan previously included in this category was transferred to foreclosed assets held for resale. The Corporation previously recognized an $831,000 specific reserve on this loan and the $831,000 was charged-off during the third quarter of 2022.
Investment/rental residential real estate at September 30, 2022, includes one loan relationship (which is deemed to be adequately collateralized) totaling $104,000 for which the real estate is collateral and the purpose of which is for speculation, rental, or other non-owner occupied uses; this relationship is making principal reductions.
A $1,795,000 commercial and industrial loan was added in the fourth quarter of 2020 after ceasing operations, with a current balance of $163,000. Liquidation is mostly complete with a specific allocation of $11,000 after a $970,000 third quarter of 2021 charge-off. A related $441,000 owner occupied real estate loan was also in nonaccrual but settled in the first quarter of 2022. A third unrelated loan relationship was added in the first quarter of 2021 with an outstanding balance of $676,000 and a specific allocation of $676,000 due to concerns on collateralization and liens.
The Corporation utilizes a systematic review of its loan portfolio on a quarterly basis in order to determine the adequacy of the allowance for loan losses. In addition, ACNB engages the services of an outside independent loan review function and sets the timing and coverage of loan reviews during the year. The results of this independent loan review are included in the systematic review of the loan portfolio. The allowance for loan losses consists of a component for individual loan impairment, primarily based on the loan’s collateral fair value and expected cash flow. A watch list of loans is identified for evaluation based on internal and external loan grading and reviews. Loans other than those determined to be impaired are grouped into pools of loans with similar credit risk characteristics. These loans are evaluated as groups with allocations made to the allowance based on historical loss experience adjusted for current trends in delinquencies, trends in underwriting and oversight, concentrations of credit, and general economic conditions within the Corporation’s trading area. The provision expense was based on the loans discussed above, as well as current trends in the watch list and the local economy as a whole. The charge-offs discussed elsewhere in this Management’s Discussion and Analysis create the recent loss history experience and result in the qualitative adjustment which, in turn, affects the calculation of losses inherent in the portfolio. The provision for loan losses for 2022 and 2021 was a result of the measurement of the adequacy of the allowance for loan losses at each period.
Premises and Equipment
On January 12, 2022, ACNB Bank announced plans to build a full-service community banking office to serve the Upper Adams area of Adams County, PA. The Upper Adams Office opened in October 2022 and, as a result, three offices were consolidated and transferred to Assets Held for Sale at fair market value. Also, as part of the Bank’s branch optimization program, in the third quarter of 2022, the Bank announced the planned closure of three additional community banking offices effective December 2022. As a result, two branches were transferred to Assets Held for Sale at fair market value.
Foreclosed Assets Held for Resale
Foreclosed assets held for resale consists of the fair value of real estate acquired through foreclosure on real estate loan collateral or the acceptance of ownership of real estate in lieu of the foreclosure process. These fair values, less estimated costs to sell, become the Corporation’s new cost basis. Fair values are based on appraisals that consider the sales prices of similar
properties in the proximate vicinity less estimated selling costs. One commercial participation loan relationship moved to foreclosed assets held for resale during the third quarter of 2022 in the amount of $474,000.
Deposits
ACNB relies on deposits as a primary source of funds for lending activities with total deposits of $2,336,213,000 as of September 30, 2022. Deposits decreased by $81,348,000, or 3.4%, from September 30, 2021, to September 30, 2022, and decreased by $90,176,000, or 3.7%, from December 31, 2021, to September 30, 2022. Since December 31, 2021, the decrease in deposits was due to customers beginning to seek higher yielding alternative investment products as market interest rates rose during the first three quarters of 2022. Otherwise, deposits vary between quarters mostly reflecting different levels held by local government and school districts during different times of the year. ACNB’s deposit pricing function employs a disciplined pricing approach based upon alternative funding rates, but also strives to price deposits to be competitive with relevant local competition, including a local government investment trusts, credit unions and larger regional banks. Continued periods where rates rise, or when the equity markets are high, funds could leave the Corporation or be priced higher to maintain deposits.
Borrowings
Short-term Bank borrowings are comprised primarily of securities sold under agreements to repurchase and short-term borrowings from the FHLB. As of September 30, 2022, short-term Bank borrowings were $41,641,000, as compared to $35,202,000 at December 31, 2021, and $44,605,000 at September 30, 2021. Agreements to repurchase accounts are within the commercial and local government customer base and have attributes similar to core deposits. Investment securities are pledged in sufficient amounts to collateralize these agreements. In comparison to year-end 2021, repurchase agreement balances were up $6,439,000, or 18.3%, due to changes in the cash flow position of ACNB’s commercial and local government customer base and lack of competition from non-bank sources. There were no short-term FHLB borrowings at September 30, 2022 and 2021, or December 31, 2021. Short-term FHLB borrowings are used to even out Bank funding from seasonal and daily fluctuations in the deposit base. Long-term borrowings consist of longer-term advances from the FHLB that provides term funding for loan assets, and Corporate borrowings that were acquired or originated in regards to the acquisitions and to refund or extend such Corporation borrowings. Long-term borrowings totaled $24,050,000 at September 30, 2022, versus $34,700,000 at December 31, 2021, and $41,700,000 at September 30, 2021. Long-term borrowings decreased 42.3% from September 30, 2021 as excess liquidity was used to pay down higher cost funding. ACNB Insurance Services, Inc. borrowed $1.5 million from a local bank in the first quarter of 2022 to fund its acquisition. Please refer to the Liquidity discussion below for more information on the Corporation’s ability to borrow.
Capital
ACNB’s capital management strategies have been developed to provide an appropriate rate of return, in the opinion of management, to shareholders, while maintaining its “well-capitalized” regulatory position in relationship to its risk exposure. Total shareholders’ equity was $232,370,000 at September 30, 2022, compared to $272,114,000 at December 31, 2021, and $269,840,000 at September 30, 2021. Shareholders’ equity decreased in the first nine months of 2022 by $39,744,000 primarily due to a net decrease in the fair value of the investment portfolio given rising market rates.
The primary source of additional capital to ACNB is earnings retention, which represents net income less dividends declared. During the first nine months of 2022, ACNB earned $25,553,000 and paid dividends of $6,734,000 for a dividend payout ratio of 26.4%. During the first nine months of 2021, ACNB earned $23,339,000 and paid dividends of $6,710,000 for a dividend payout ratio of 28.8%.
ACNB Corporation has a Dividend Reinvestment and Stock Purchase Plan that provides registered holders of ACNB Corporation common stock with a convenient way to purchase additional shares of common stock by permitting participants in the plan to automatically reinvest cash dividends on all or a portion of the shares owned and to make quarterly voluntary cash payments under the terms of the plan. Participation in the plan is voluntary, and there are eligibility requirements to participate in the plan. Year-to-date September 30, 2022, 16,226 shares were issued under this plan with proceeds in the amount of $535,000. Year-to-date September 30, 2021, 17,897 shares were issued under this plan with proceeds in the amount of $510,000.
ACNB Corporation has a Restricted Stock plan available to selected officers and employees of the Bank, to advance the best interest of ACNB Corporation and its shareholders. The plan provides those persons who have responsibility for its growth with additional incentive by allowing them to acquire an ownership in ACNB Corporation and thereby encouraging them to contribute to the success of the Corporation. As of September 30, 2022, there were 25,945 shares of common stock granted as restricted stock awards to employees of the subsidiary bank. The restricted stock plan expired by its own terms after 10 years on
February 24, 2019, and no further shares may be issued under the plan.
On May 1, 2018, stockholders approved and ratified the ACNB Corporation 2018 Omnibus Stock Incentive Plan, effective as of March 20, 2018, in which awards shall not exceed, in the aggregate, 400,000 shares of common stock, plus any shares that are authorized, but not issued, under the 2009 Restricted Stock Plan. As of September 30, 2022, 57,522 shares were issued under this plan and 516,533 shares were available for grant.
On February 25, 2021, the Corporation announced that the Board of Directors approved on February 23, 2021, a plan to repurchase, in open market and privately negotiated transactions, up to 261,000, or approximately 3%, of the outstanding shares of the Corporation’s common stock. This common stock repurchase program replaced and superseded any and all earlier announced repurchase plans. There were 109,931 shares purchased under the plan during the quarter ended September 30, 2022 and 252,227 shares in total purchased under this plan.
On October 24, 2022, the Corporation announced that the Board of Directors approved on October 18, 2022, a plan to repurchase, in open market and privately negotiated transactions, up to 255,575, or approximately 3%, of the outstanding shares of the Corporation’s common stock. This new common stock repurchase program replaces and supersedes any and all earlier announced repurchase plans.
ACNB is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on ACNB. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, ACNB must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and reclassifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require ACNB to maintain minimum amounts and ratios of total and Tier 1 capital to average and risk adjusted assets. Management believes, as of September 30, 2022, and December 31, 2021, that ACNB’s banking subsidiary met all minimum capital adequacy requirements to which it is subject and is categorized as “well capitalized” for regulatory purposes. There are no subsequent conditions or events that management believes have changed the banking subsidiary’s category.
Regulatory Capital Changes
In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for community banking organizations began January 1, 2015, while larger institutions (generally those with assets of $250 billion or more) began compliance effective January 1, 2014. The final rules call for the following capital requirements:
•a minimum ratio of common Tier 1 capital to risk-weighted assets of 4.5%;
•a minimum ratio of Tier 1 capital to risk-weighted assets of 6.0%;
•a minimum ratio of total capital to risk-weighted assets of 8.0%; and,
•a minimum leverage ratio of 4.0%.
In addition, the final rules establish a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. If a banking organization fails to hold capital above the minimum capital ratios and the capital conservation buffer, it will be subject to certain restrictions on capital distributions and discretionary bonus payments. The phase-in period for the capital conservation and countercyclical capital buffers for all banking organizations began on January 1, 2016.
Under the initially proposed rules, accumulated other comprehensive income (AOCI) would have been included in a banking organization’s common equity Tier 1 capital. The final rules allow community banks to make a one-time election not to include these additional components of AOCI in regulatory capital and instead use the existing treatment under the general risk-based capital rules that excludes most AOCI components from regulatory capital. The opt-out election must be made in the first call report or FR Y-9 series report that is filed after the financial institution becomes subject to the final rule. The Corporation elected to opt-out.
The rules permanently grandfather non-qualifying capital instruments (such as trust preferred securities and cumulative perpetual preferred stock) issued before May 19, 2010, for inclusion in the Tier 1 capital of banking organizations with total consolidated assets of less than $15 billion as of December 31, 2009, and banking organizations that were mutual holding companies as of May 19, 2010.
The proposed rules would have modified the risk-weight framework applicable to residential mortgage exposures to require banking organizations to divide residential mortgage exposures into two categories in order to determine the applicable risk weight. In response to commenter concerns about the burden of calculating the risk weights and the potential negative effect on credit availability, the final rules do not adopt the proposed risk weights, but retain the current risk weights for mortgage exposures under the general risk-based capital rules.
Consistent with the Dodd-Frank Act, the new rules replace the ratings-based approach to securitization exposures, which is based on external credit ratings, with the simplified supervisory formula approach in order to determine the appropriate risk weights for these exposures. Alternatively, banking organizations may use the existing gross-up approach to assign securitization exposures to a risk weight category or choose to assign such exposures a 1,250 percent risk weight.
Under the new rules, mortgage servicing assets and certain deferred tax assets are subject to stricter limitations than those applicable under the current general risk-based capital rule. The new rules also increase the risk weights for past due loans, certain commercial real estate loans, and some equity exposures, and makes selected other changes in risk weights and credit conversion factors.
The Corporation calculated regulatory ratios as of September 30, 2022, and confirmed no material impact on the capital, operations, liquidity, and earnings of the Corporation and the banking subsidiary from the changes in the regulations.
Risk-Based Capital
ACNB Corporation considers the capital ratios of the banking subsidiary to be the relevant measurement of capital adequacy.
In 2019, the federal banking agencies issued a final rule to provide an optional simplified measure of capital adequacy for qualifying community banking organizations, including the community bank leverage ratio (CBLR) framework. Generally, under the CBLR framework, qualifying community banking organizations with total assets of less than $10 billion, and limited amounts of off-balance sheet exposures and trading assets and liabilities, may elect whether to be subject to the CBLR framework if they have a CBLR of greater than 9% (subsequently reduced to 8% as a COVID-19 relief measure). Qualifying community banking organizations that elect to be subject to the CBLR framework and continue to meet all requirements under the framework would not be subject to risk-based or other leverage capital requirements and, in the case of an insured depository institution, would be considered to have met the well capitalized ratio requirements for purposes of the FDIC’s Prompt Corrective Action framework. The CBLR framework was available for banks to use in their March 31, 2020 Call Report. The Corporation has performed changes to capital adequacy and reporting requirements within the quarterly Call Report, and it opted out of the CBLR framework.
The banking subsidiary’s capital ratios are as follows:
| | | | | | | | | | | | | | | | | |
| | September 30, 2022 | | December 31, 2021 | | To Be Well Capitalized
Under Prompt
Corrective Action
Regulations |
| Tier 1 leverage ratio (to average assets) | 9.26 | % | | 8.81 | % | | 5.00 | % |
| Common Tier 1 capital ratio (to risk-weighted assets) | 15.01 | % | | 16.32 | % | | 6.50 | % |
| Tier 1 risk-based capital ratio (to risk-weighted assets) | 15.01 | % | | 16.32 | % | | 8.00 | % |
| Total risk-based capital ratio | 16.11 | % | | 17.57 | % | | 10.00 | % |
Liquidity
Effective liquidity management ensures the cash flow requirements of depositors and borrowers, as well as the operating cash needs of ACNB, are met.
ACNB’s funds are available from a variety of sources, including assets that are readily convertible such as interest bearing deposits with banks, maturities and repayments from the securities portfolio, scheduled repayments of loans receivable, the core
deposit base, and the ability to borrow from the FHLB. At September 30, 2022, ACNB’s banking subsidiary had a borrowing capacity of approximately $802,000,000 from the FHLB, of which $786,000,000 was available. Because of various restrictions and requirements on utilizing the available balance, ACNB considers $585,000,000 to be the practicable additional borrowing capacity, which is considered to be sufficient for operational needs. The FHLB system is self-capitalizing, member-owned, and its member banks’ stock is not publicly traded. ACNB creates its borrowing capacity with the FHLB by granting a security interest in certain loan assets with requisite credit quality. ACNB has reviewed information on the FHLB system and the FHLB of Pittsburgh, and has concluded that they have the capacity and intent to continue to provide both operational and contingency liquidity. The FHLB of Pittsburgh instituted a requirement that a member’s investment securities must be moved into a safekeeping account under FHLB control to be considered in the calculation of maximum borrowing capacity. The Corporation currently has securities in safekeeping at the FHLB of Pittsburgh; however, the safekeeping account is under the Corporation’s control. As better contingent liquidity is maintained by keeping the securities under the Corporation’s control, the Corporation has not moved the securities which, in effect, lowered the Corporation’s maximum borrowing capacity. However, there is no practical reduction in borrowing capacity as the securities can be moved into the FHLB-controlled account promptly if they are needed for borrowing purposes.
Another source of liquidity is securities sold under repurchase agreements to customers of ACNB’s banking subsidiary totaling approximately $41,641,000 and $35,202,000 at September 30, 2022, and December 31, 2021, respectively. These agreements vary in balance according to the cash flow needs of customers and competing accounts at other financial organizations.
The liquidity of the parent company also represents an important aspect of liquidity management. The parent company’s cash outflows consist principally of dividends to shareholders and corporate expenses. The main source of funding for the parent company is the dividends it receives from its subsidiaries. Federal and state banking regulations place certain legal restrictions and other practicable safety and soundness restrictions on dividends paid to the parent company from the subsidiary bank.
ACNB manages liquidity by monitoring projected cash inflows and outflows on a daily basis, and believes it has sufficient funding sources to maintain sufficient liquidity under varying degrees of business conditions for liquidity and capital resource requirements for all material short- and long-term cash requirements from known contractual and other obligations.
On March 30, 2021, the Corporation issued $15 million of subordinated debt in order to pay off existing higher rate debt, to potentially repurchase ACNB common stock and to use for inorganic growth opportunities. Otherwise, the $15 million of subordinated debt qualifies as Tier 2 capital at the Holding Company level, but can be transferred to the Bank where it qualifies as Tier 1 Capital. The debt has a 4.00% fixed-to-floating rate and a stated maturity of March 31, 2031. The debt is redeemable by the Corporation at its option, in whole or in part, on or after March 30, 2026, and at any time upon occurrences of certain unlikely events such as receivership insolvency or liquidation of ACNB or ACNB Bank.
Off-Balance Sheet Arrangements
The Corporation is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and, to a lesser extent, standby letters of credit. At September 30, 2022, the Corporation had unfunded outstanding commitments to extend credit of approximately $388,631,000 and outstanding standby letters of credit of approximately $11,989,000. Because these commitments generally have fixed expiration dates and many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements.
Market Risks
Financial institutions can be exposed to several market risks that may impact the value or future earnings capacity of the organization. These risks involve interest rate risk, foreign currency exchange risk, commodity price risk, and equity market price risk. ACNB’s primary market risk is interest rate risk. Interest rate risk is inherent because, as a financial institution, ACNB derives a significant amount of its operating revenue from “purchasing” funds (customer deposits and wholesale borrowings) at various terms and rates. These funds are then invested into earning assets (primarily loans and investments) at various terms and rates.
RECENT LEGAL AND REGULATORY DEVELOPMENTS
Management has reviewed the recent development sections that were previously disclosed in the Annual Report on Form 10-K for the fiscal period ended December 31, 2021 and the Quarterly Reports on Form 10-Q for the periods ended March 31, 2022 and June 30, 2022. There are no material changes in the recent legal and regulatory development section as previously disclosed in the recent developments section on the Form 10-K and 10-Q.
SUPERVISION AND REGULATION
Dividends
ACNB is a legal entity separate and distinct from its subsidiary bank. ACNB’s revenues, on a parent company only basis, result primarily from dividends paid to the Corporation by its subsidiaries. Federal and state laws regulate the payment of dividends by ACNB’s subsidiary bank. For further information, please refer to Regulation of Bank below.
Regulation of Bank
The operations of the subsidiary bank are subject to statutes applicable to banks chartered under the banking laws of Pennsylvania, to state nonmember banks of the Federal Reserve, and to banks whose deposits are insured by the FDIC. The subsidiary bank’s operations are also subject to regulations of the Pennsylvania Department of Banking and Securities, Federal Reserve, and FDIC.
The Pennsylvania Department of Banking and Securities, which has primary supervisory authority over banks chartered in Pennsylvania, regularly examines banks in such areas as reserves, loans, investments, management practices, and other aspects of operations. The subsidiary bank is also subject to examination by the FDIC for safety and soundness, as well as consumer compliance. These examinations are designed for the protection of the subsidiary bank’s depositors rather than ACNB’s shareholders. The subsidiary bank must file quarterly and annual reports to the Federal Financial Institutions Examination Council, or FFIEC.
Monetary and Fiscal Policy
ACNB and its subsidiary bank are affected by the monetary and fiscal policies and regulations of government agencies, including the Federal Reserve and FDIC. Through open market securities transactions and changes in its discount rate and reserve requirements, the Board of Governors of the Federal Reserve exerts considerable influence over the cost and availability of funds for lending and investment. The nature and impact of monetary and fiscal policies on future business and earnings of ACNB cannot be predicted at this time. From time to time, various federal and state legislation is proposed that could result in additional regulation of, and restrictions on, the business of ACNB and the subsidiary bank, or otherwise change the business environment. Management cannot predict whether any of this legislation will have a material effect on the business of ACNB.