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Section 1: 10-K

 
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, 2016

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 No.: 000-25805

Fauquier Bankshares, Inc.
(Exact name of registrant as specified in its charter)
 
Virginia
 
54-1288193
(State or other jurisdiction of  incorporation or organization)
 
(I.R.S. Employer Identification No.)

10 Courthouse Square, Warrenton, Virginia
 
20186
(Address of principal executive offices)
 
(Zip Code)

(540) 347-2700
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
 
Name of each exchange on which registered
Common Stock, par value $3.13 per share
 
The NASDAQ Stock Market LLC
 
 
(NASDAQ Capital Market)

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes   No

 Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange 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 and posted on its corporate Web Site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes    No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
   
(Do not check if smaller reporting company)
 

Indicate by check mark if the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes No  

The aggregate market value of the registrant's common shares held by "non-affiliates" of the registrant, based upon the closing sale price of its common stock on the NASDAQ Capital Market on June 30, 2016, was $52.0 million. Shares held by each executive officer, director and holder of 10% or more of the registrant's outstanding common stock have been excluded as shares held by affiliates. Such determination of affiliate status is not a conclusive determination for other purposes.

The registrant had 3,769,201 shares of common stock outstanding as of March 17, 2017.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement for the 2017 Annual Meeting of Shareholders to be held on May 16, 2017 are incorporated by reference into Part III of this Form 10-K.


TABLE OF CONTENTS

 
 
 
Page
PART I
 
 
 
 
 
 
 
Item 1.
Business
2
 
 
 
 
 
Item 1A.
Risk Factors
8
 
 
 
 
 
Item 1B.
Unresolved Staff Comments
8
       
 
Item 2.
Properties
9
 
 
 
 
 
Item 3.
Legal Proceedings
9
 
 
 
 
 
Item 4.
Mine Safety Disclosures
9
 
 
 
 
PART II
 
 
 
 
 
 
 
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
10
 
 
 
 
 
Item 6.
Selected Financial Data
11
 
 
 
 
 
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operation
12
       
 
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
28
 
 
 
 
 
Item 8.
Financial Statements and Supplementary Data
29
 
 
 
 
 
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
65
 
 
 
 
 
Item 9A.
Controls and Procedures
65
 
 
 
 
 
Item 9B.
Other Information
65
 
 
 
 
PART III
 
 
 
 
 
 
 
Item 10
Directors, Executive Officers and Corporate Governance
65
 
 
 
 
 
Item 11.
Executive Compensation
65
 
 
 
 
 
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
66
 
 
 
 
 
Item 13.
Certain Relationships and Related Transactions, and Director Independence
66
 
 
 
 
 
Item 14.
Principal Accounting Fees and Services
66
 
 
 
 
PART IV
 
 
 
 
 
 
 
Item 15.
Exhibits, Financial Statement Schedules
66
       
 
Item 16.
10-K Summary
67

1

ITEM 1. BUSINESS

GENERAL

Fauquier Bankshares, Inc. ("the Company") was incorporated under the laws of the Commonwealth of Virginia on January 13, 1984. The Company is a registered bank holding company and owns all of the voting shares of The Fauquier Bank ("the Bank"). The Company engages in its business through the Bank, a Virginia state-chartered bank that commenced operations in 1902. The Company has no significant operations other than owning the stock of the Bank. The Company had issued and outstanding 3,753,919 shares of common stock, par value $3.13 per share, held by approximately 334 holders of record on December 31, 2016. The Bank has 11 full service branch offices located in the Virginia communities of Old Town-Warrenton, Warrenton, Catlett, The Plains, Sudley Road-Manassas, New Baltimore, Bealeton, Bristow, Haymarket, Gainesville and Centreville Road-Manassas, Virginia. The executive offices of the Company and the main office of the Bank are located at 10 Courthouse Square, Warrenton, Virginia 20186.

THE FAUQUIER BANK

The Bank's general market area principally includes Fauquier County, Prince William County, and neighboring communities and is located approximately 50 miles southwest of Washington, D.C. The Bank provides a range of consumer and commercial banking services to individuals, businesses and industries. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC"). The basic services offered by the Bank include: interest and non-interest bearing demand deposit accounts, money market deposit accounts, negotiable order of withdrawal ("NOW") accounts, time deposits, safe deposit services, automated teller machines ("ATM"), debit and credit cards, cash management, direct deposits, notary services, night depository, prepaid debit cards, cashier's checks, domestic and international collections, savings bonds, automated teller services, drive-in tellers, mobile and internet banking, telephone banking, and banking by mail. In addition, the Bank makes secured and unsecured commercial and real estate loans, issues stand-by letters of credit and grants available credit for installment, unsecured and secured personal loans, residential mortgages and home equity loans, as well as automobile and other types of consumer financing. The Bank provides ATM cards, as a part of the Maestro, Accel - Exchange, and Plus ATM networks, thereby permitting customers to utilize the convenience of larger ATM networks. The Bank also is a member of the Certificate of Deposit Account Registry Service ("CDARS") and Insured Cash Sweep Service ("ICS"), to provide customers multi-million dollar FDIC insurance on certificate of deposit investments and deposit sweeps through the transfer and/or exchange with other FDIC insured institutions. CDARS and ICS are registered service marks of Promontory Interfinancial Network, LLC.

The Bank operates a Wealth Management Services ("WMS" or "Wealth Management") division that began with the granting of trust powers to the Bank in 1919. The WMS division provides personalized services that include investment management, trust, estate settlement, retirement, insurance, and brokerage services.

The Bank, through its subsidiary Fauquier Bank Services, Inc., has equity ownership interests in Bankers Insurance, LLC, a Virginia independent insurance company, Bankers Title Shenandoah, LLC, a title insurance company, and Infinex Investments, Inc., a full service broker/dealer. Bankers Insurance and Bankers Title Shenandoah are owned by a consortium of Virginia community banks, and Infinex is owned by banks and banking associations in various states.

The revenues of the Bank are primarily derived from interest on, and fees received in connection with, real estate and other loans, and from interest and dividends from investment and mortgage-backed securities, and short-term investments. The principal sources of funds for the Bank's lending activities are its deposits, repayment of loans, the sale and maturity of investment securities, and borrowings from the Federal Home Loan Bank ("FHLB") of Atlanta. Additional revenues are derived from fees for deposit-related and WMS-related services. The Bank's principal expenses are salaries and benefits and occupancy expense.

As is the case with banking institutions generally, the Bank's operations are materially and significantly influenced by general economic conditions and by related monetary and fiscal policies of financial institution regulatory agencies, including the Board of Governors of the Federal Reserve System ("Federal Reserve"). As a Virginia-chartered bank and a member of the Federal Reserve, the Bank is supervised and examined by the Federal Reserve and the Bureau of Financial Institutions of the Virginia State Corporation Commission ("SCC"). Interest rates on competing investments and general market rates of interest influence deposit flows and costs of funds. Lending activities are affected by the demand for financing of real estate and other types of loans, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds. The Bank faces strong competition in the attraction of deposits (its primary source of lendable funds) and in the origination of loans. See "Competition" below.

As of December 31, 2016, the Company had total consolidated assets of $624.4 million, total consolidated loans net of allowance for loan losses of $458.6 million, total consolidated deposits of $546.2 million, and total consolidated shareholders' equity of $54.5 million.

LENDING ACTIVITIES

The Bank offers a range of lending services, including real estate and commercial loans, to individuals as well as small-to-medium sized businesses and other organizations that are located in or conduct a substantial portion of their business in the Bank's market area. The Bank's total loans, net of allowance, at December 31, 2016 were $458.6 million, or 73.4% of total assets. The interest rates charged on loans vary with the degree of risk, maturity, and amount of the loan, and are further subject to competitive pressures, money market rates, availability of funds and government regulations. The Bank has no foreign loans, sub-prime loans or loans for highly leveraged transactions.

The Bank's general market area for lending consists of Fauquier and Prince William Counties, Virginia and the neighboring communities. There is no assurance that this area will experience economic growth. Continued adverse economic conditions in any one or more of the industries operating in Fauquier or Prince William Counties, sluggishness in general economic conditions, and/or declines in the market value of local commercial and/or residential real estate may have an adverse effect on the Company and the Bank.

The Bank's loans are concentrated in the following areas: residential real estate loans, commercial real estate loans, construction and land loans, commercial and industrial loans, consumer loans, and U.S. Government guaranteed student loans. The majority of the Bank's loans are made on a secured basis. As of December 31, 2016, approximately 91.0% of the loan portfolio consisted of loans secured by mortgages on real estate. Income from loans decreased $157,000 to $19.9 million for 2016 compared with $20.1 million for 2015 due to the decline in the average rate received, partially offset by the increase in average loans balances.

2

LOANS SECURED BY REAL ESTATE

ONE TO FOUR ("1-4") FAMILY RESIDENTIAL REAL ESTATE LOANS. The Bank's 1-4 family residential real estate loan portfolio primarily consists of conventional loans, generally with fixed interest rates with 15 or 30 year terms, and balloon loans with fixed interest rates, and 3, 5, 7, or 10-year maturities but utilizing amortization schedules of 30 years or less. As of December 31, 2016, the Bank's 1-4 family residential loans amounted to $162.4 million, or 35.1% of the total loan portfolio. Substantially, the Bank's entire single-family residential mortgage loans are secured by properties located in the Bank's market area. The Bank requires private mortgage insurance if the principal amount of the loan exceeds 80% of the value of the property held as collateral.

HOME EQUITY LINES OF CREDIT LOANS. The Bank's home equity line of credit loan portfolio primarily consists of conventional loans, generally with variable interest rates that are tied to the Wall Street Journal prime rate and with 10 year terms. As of December 31, 2016, the Bank's home equity loans amounted to $43.9 million, or 9.5% of the total loan portfolio. Substantially, the Bank's entire home equity line of credit loan portfolio is secured by properties located in the Bank's market area. The Bank allows a maximum loan-to-value ratio of 85% of the value of the property held as collateral at the time of origination.

CONSTRUCTION AND LAND LOANS. The majority of the Bank's construction and land loans are made to individuals to construct a primary residence. Such loans have a maximum term of twelve months, a fixed rate of interest, and loan-to-value ratios of 80% or less of the appraised value upon completion. The Bank requires that permanent financing, with the Bank or some other lender, be in place prior to closing any construction loan. Construction loans are generally considered to involve a higher degree of credit risk than single-family residential mortgage loans. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion. The Bank also provides construction loans and lines of credit to developers. Such loans generally have maximum loan-to-value ratios of 80% of the appraised value upon completion. The loans are made with a fixed rate of interest. The majority of construction loans are made to selected local developers for the building of single-family dwellings on either a pre-sold or speculative basis. The Bank limits the number of unsold units under construction at one time. Loan proceeds are disbursed in stages after inspections of the project indicate that such disbursements are for costs already incurred and that have added to the value of the project. Construction loans include loans to developers to acquire the necessary land, develop the site and construct the residential units. As of December 31, 2016, the Bank's construction and land loans totaled $49.8 million, or 10.7% of the total loan portfolio. Included in the $49.8 million of construction and land loans are $9.1 million of commercial acquisition and development loans, $30.9 million of raw land loans and $1.9 million of agricultural land loans.

COMMERCIAL REAL ESTATE LOANS. Loans secured by commercial real estate comprised $165.3 million, or 35.7% of total loans at December 31, 2016, and consist principally of commercial loans for which real estate constitutes a source of collateral. Approximately $76.1 million or 46.0% of commercial real estate loans are owner-occupied. Approximately $3.2 million or 2.0% of commercial real estate loans are tax exempt loans to local governmental entities. Commercial real estate loans generally involve a greater degree of risk than single-family residential mortgage loans because repayment of commercial real estate loans may be more vulnerable to adverse conditions in the real estate market or the economy.

COMMERCIAL LOANS

The Bank's commercial loans include loans to individuals and small-to-medium sized businesses located primarily in Fauquier and Prince William Counties for working capital, equipment purchases, and various other business purposes. Equipment or similar assets secure approximately 82.4% of the Bank's commercial loans, on a dollar-value basis, and the remaining 17.6% of commercial loans are on an unsecured basis. Commercial loans have variable or fixed rates of interest. Commercial lines of credit are typically granted on a one-year basis. Other commercial loans with terms or amortization schedules longer than one year will normally carry interest rates that vary with the prime lending rate and other financial indices and will be payable in full in three to five years.

Loan originations are derived from a number of sources, including existing customers and borrowers, walk-in customers, advertising, and direct solicitation by the Bank's loan officers. Certain credit risks are inherent in originating and keeping loans on the Bank's balance sheet. These include interest rate and prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. In particular, longer maturities increase the risk that economic conditions will change and adversely affect our ability to collect. The Bank attempts to minimize loan losses through various means. In particular, on larger credits, the Bank generally relies on the cash flow of a debtor as the source of repayment and secondarily on the value of the underlying collateral. In addition, the Bank attempts to utilize shorter loan terms in order to reduce the risk of a decline in the value of such collateral. The commercial loan portfolio was $25.7 million or 5.6% of total loans at December 31, 2016.

CONSUMER AND STUDENT LOANS
 
The Bank's consumer loans include loans to individuals such as auto loans, credit card loans and overdraft loans. The consumer loan portfolio was $3.1 million or 0.7% of total loans at December 31, 2016.

The Bank has U.S. Government guaranteed student loans, which were purchased through and serviced by a third party and have a variable rate of interest. The U.S. Government guaranteed student loan portfolio was $13.0 million or 2.8% of total loans at December 31, 2016.

DEPOSIT ACTIVITIES

Deposits are the major source of the Bank's funds for lending and other investment activities. The Bank considers its regular savings, demand, NOW, premium NOW, money market deposit accounts, and non-brokered time deposits under $100,000 to be core deposits. These accounts comprised approximately 93.9% of the Bank's total deposits at December 31, 2016. Generally, the Bank attempts to maintain the rates paid on its deposits at a competitive level. Time deposits of $100,000 through $250,000, and time deposits greater than $250,000 made up approximately 3.6% and 2.5%, respectively, of the Bank's total deposits at December 31, 2016. During 2016, time deposits of $100,000 and over generally paid interest at rates the same or higher than certificates of less than $100,000. The majority of the Bank's deposits are generated from Fauquier and Prince William Counties, Virginia.  Included in interest-bearing deposits at December 31, 2016 were $15.6 million of brokered deposits, or 2.9% of total deposits. Of the brokered deposits, $11.3 million or 2.1% of total deposits represent a reciprocal arrangement for existing Bank customers who desire FDIC insurance for deposits above current limits.

3

INVESTMENTS

The Bank invests a portion of its assets in U.S. Government-sponsored corporation and agency obligations, state, county and municipal obligations, corporate obligations, mutual funds, FHLB stock and equity securities. The Bank's investments are managed in relation to loan demand and deposit growth, and are generally used to provide for the investment of excess funds at reduced yields and risks relative to yields and risks of the loan portfolio, while providing liquidity to fund increases in loan demand or to offset fluctuations in deposits. The Bank's total unrestricted and restricted investments, at fair value, were $50.0 million and $1.8 million, respectively, or 8.0% and 0.3% of total assets, respectively, at December 31, 2016. During 2016, income from investments totaled $1.3 million, consisting of $1.3 million of interest and dividend income and $1,000 in gains on the sale/calls of investments.

GOVERNMENT SUPERVISION AND REGULATION

GENERAL. Bank holding companies and banks are extensively regulated under both federal and state law. The following summary briefly addresses certain provisions of federal and state laws that apply to the Company or the Bank. This summary does not purport to be complete and is qualified in its entirety by reference to the particular statutory or regulatory provisions.

EFFECT OF GOVERNMENTAL MONETARY POLICIES. The earnings and business of the Company and the Bank are affected by the economic and monetary policies of various regulatory authorities of the United States, especially the Federal Reserve. The Federal Reserve, among other things, regulates the supply of credit and money and setting interest rates in order to influence general economic conditions within the United States. The instruments of monetary policy employed by the Federal Reserve for those purposes influence in various ways the overall level of investments, loans, other extensions of credits, and deposits, and the interest rates paid on liabilities and received on assets. Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

SARBANES-OXLEY ACT OF 2002. The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), including the filing of annual, quarterly, and other reports with the Securities and Exchange Commission (the "SEC"). As an Exchange Act reporting company, the Company is directly affected by the Sarbanes-Oxley Act of 2002 (the "SOX"), which is aimed at improving corporate governance, internal controls and reporting procedures. The Company is complying with applicable SEC and other rules and regulations implemented pursuant to the SOX.

FINANCIAL SERVICES MODERNIZATION LEGISLATION. The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (the "GLB Act") was intended to modernize the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers under a "financial holding company" structure. Under the GLB Act, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become "financial holding companies." As financial holding companies, they and their subsidiaries are permitted to acquire or engage in previously impermissible activities such as insurance underwriting, securities underwriting and distribution, travel agency activities, insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary to these activities. Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLB Act applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. Although the Company could qualify to become a financial holding company under the GLB Act, it does not contemplate seeking to do so unless it identifies significant specific benefits from doing so. The GLB Act has not had a material effect on the Company operations.

BANK HOLDING COMPANY REGULATION. The Company is a one-bank holding company, registered with the Federal Reserve under the Bank Holding Company Act of 1956 (the "BHC Act"). As such, the Company is subject to the supervision, examination, and reporting requirements of the BHC Act and the regulations of the Federal Reserve. The Company is required to furnish to the Federal Reserve an annual report of its operations at the end of each fiscal year and such additional information as the Federal Reserve may require pursuant to the BHC Act. The BHC Act generally prohibits the Company from engaging in activities other than banking or managing or controlling banks or other permissible subsidiaries and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be sufficiently related to banking or managing or controlling banks. With some limited exceptions, the BHC Act requires every bank holding company to obtain the prior approval of the Federal Reserve before: acquiring substantially all the assets of any bank; acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares); or merging or consolidating with another bank holding company.  In addition, and subject to some exceptions, the BHC Act and the Change in Bank Control Act, together with the regulations promulgated thereunder, require Federal Reserve approval prior to any person or company acquiring "control" of a bank holding company.

BANK REGULATION. The Bank is chartered under the laws of the Commonwealth of Virginia. The FDIC insures the deposits of the Bank's customers to the maximum extent provided by law. The Bank is subject to comprehensive regulation, examination and supervision by the Federal Reserve and to other laws and regulations applicable to banks. These regulations include limitations on loans to a single borrower and to the Bank's directors, officers and employees; requirements on the opening and closing of branch offices; requirements regarding the maintenance of prescribed regulatory capital and liquidity ratios; requirements to grant credit under equal and fair conditions; and requirements to disclose the costs and terms of such credit. The Bank, as a Virginia chartered commercial bank, is subject to extensive regulatory examination and supervision by the SCC. The SCC also has broad enforcement powers over the Bank, including the power to impose fines and other civil or criminal penalties and to appoint a receiver in order to conserve the Bank's assets for the benefit of depositors and other creditors.

The Bank is also subject to the provisions of the Community Reinvestment Act of 1977 ("CRA"). Under the terms of the CRA, the appropriate federal bank regulatory agency is required, in connection with its examination of a bank, to assess the bank's record in meeting the credit needs of the community served by that bank, including low-and moderate-income neighborhoods. The regulatory agency's assessment of a bank's record is made available to the public. Such assessment is required of any bank that has applied to (i) charter a national bank, (ii) obtain deposit insurance coverage for a newly chartered institution, (iii) establish a new branch office that will accept deposits, (iv) relocate an office, or (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. The Bank received a rating of "satisfactory" at its last CRA performance evaluation as of February 9, 2015.

4

DIVIDENDS. Dividends from the Bank constitute the primary source of funds for dividends to be paid by the Company. There are various statutory and contractual limitations on the ability of the Bank to pay dividends, extend credit, or otherwise supply funds to the Company, including the requirement under Virginia banking laws that cash dividends only be paid out of net undivided profits and only if such dividends would not impair the capital of the Bank. The Federal Reserve also has the general authority to limit the dividends paid by bank holding companies and state member banks, if the payment of dividends is deemed to constitute an unsafe and unsound practice. The Federal Reserve has indicated that banking organizations should generally pay dividends only if (i) the organization's net income available to common shareholders over the past year has been sufficient to fund fully the dividends and (ii) the prospective rate of earnings retention appears consistent with the organization's capital needs, asset quality and overall financial condition. The Bank does not expect any of these laws, regulations or policies to materially impact its ability to pay dividends to the Company.

DEPOSIT INSURANCE. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund (the "DIF") of the FDIC and are subject to deposit insurance assessments to maintain the DIF. On April 1, 2011, the deposit insurance assessment base changed from total deposits to average total assets minus average tangible equity, pursuant to a rule issued by the FDIC as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act").

Also, on April 1, 2011, the FDIC began utilizing a risk-based assessment system that imposed insurance premiums based upon a risk category matrix that took into account a bank's capital level and supervisory rating. Effective, July 1, 2016, the FDIC again changed its deposit insurance pricing and eliminated all risk categories and now uses the "financial ratios method" based on CAMELS composite ratings to determine assessment rates for small established institutions with less than $10 billion in assets. The CAMELS rating system is a supervisory rating system designed to take into account and reflect all financial and operational risks that a bank may face, including capital adequacy, asset quality, management capability, earnings, liquidity and sensitivity to market risk ("CAMELS"). CAMELS composite ratings set a maximum assessment for CAMELS 1 and 2 rated banks, and set minimum assessments for lower rated institutions.

The FDIC's "reserve ratio" of the DIF to total industry deposits reached its 1.15% target effective June 30, 2016. On March 15, 2016, the FDIC implemented by final rule certain Dodd-Frank Act provisions by raising the DIF's minimum reserve ratio from 1.15% to 1.35%. The FDIC imposed a 4.5 basis point annual surcharge on insured depository institutions with total consolidated assets of $10 billion or more. The new rule grants credits to smaller banks for the portion of their regular assessments that contribute to increasing the reserve ratio from 1.15% to 1.35%. Prior to when the new assessment system became effective, the Bank's overall rate for assessment calculations was 9 basis points or less, which was within the range of assessment rates for the lowest risk category under the former FDIC assessment rules. In 2016 and 2015, the Company recorded expense of $489,000 and $386,000, respectively, for FDIC insurance premiums.

In addition, all FDIC insured institutions are required to pay assessments to the FDIC at an annual rate of approximately one basis point of insured deposits to fund interest payments on bonds issued by the Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments will continue until the Financing Corporation bonds mature in 2019.

CAPITAL REQUIREMENTS. The Company meets the eligibility criteria of a small bank holding company in accordance with the Federal Reserve's Small Bank Holding Company Policy Statement issued in February 2015, and is no longer obligated to report consolidated regulatory capital. The Bank continues to be subject to various capital requirements administered by banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and discretionary actions by regulators that could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings and other factors.

In July 2013, the Federal Reserve issued final rules that make technical changes to its capital rules to align them with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. The final rules maintain the general structure of the prompt corrective action framework in effect at such time while incorporating certain increased minimum requirements. The final rules modified or left unchanged the components of regulatory capital, which are: (i) "total capital", defined as core capital and supplementary capital less certain specified deductions from total capital such as reciprocal holdings of depository institution capital instruments and equity investments; (ii) "Tier 1 capital," which consists principally of common and certain qualifying preferred shareholders' equity (including grandfathered trust preferred securities) as well as retained earnings, less certain intangibles and other adjustments; and (iii) "Tier 2 capital", which consists of cumulative preferred stock, long-term perpetual preferred stock, a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments), and a limited amount of the general loan loss allowance. The Federal Reserve also has established a minimum leverage capital ratio of Tier 1 capital to average adjusted assets ("Tier 1 leverage ratio").

Effective January 1, 2015, the final rules require the Bank to comply with the following minimum capital ratios: (i) a new common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from the prior requirement of 4.0%); (iii) a total capital ratio of 8.0% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4.0% of total assets (unchanged from the prior requirement). These are the initial capital requirements, which are being phased in over a four-year period. When fully phased in on January 1, 2019, the rules will require the  Bank to maintain (i) a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% common equity Tier 1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7.0% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation), and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets.

The phase in of the capital conservation buffer requirement began on January 1, 2016 at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of common equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall.

As of December 31, 2016, the Tier 1 and total capital to risk-weighted assets ratios of the Bank were 12.2% and 13.2%, respectively, thus exceeding the minimum requirements. The common equity Tier 1 capital ratio and leverage ratio of the Bank were 12.2% and 9.2%, respectively, as of December 31, 2016, well above the minimum requirements. Based on management's understanding and interpretation of the new capital rules, it believes that, as of December 31, 2016, the Company and the Bank would meet all capital adequacy requirements under such rules on a fully phased-in basis as if such requirements were in effect as of such date.

5

PROMPT CORRECTIVE ACTION. Federal banking regulators are authorized and, under certain circumstances, required to take certain actions against banks that fail to meet their capital requirements. The federal bank regulatory agencies have additional enforcement authority with respect to undercapitalized depository institutions. "Well capitalized" institutions may generally operate without supervisory restriction. With respect to "adequately capitalized" institutions, such banks cannot normally pay dividends or make any capital contributions that would leave it undercapitalized, they cannot pay a management fee to a controlling person if, after paying the fee, it would be undercapitalized, and they cannot accept, renew or roll over any brokered deposit unless the bank has applied for and been granted a waiver by the FDIC.

Immediately upon becoming "undercapitalized," a depository institution becomes subject to the provisions of Section 38 of the Federal Deposit Insurance Act ("FDIA"), which: (i) restrict payment of capital distributions and management fees; (ii) require that the appropriate federal banking agency monitor the condition of the institution and its efforts to restore its capital; (iii) require submission of a capital restoration plan; (iv) restrict the growth of the institution's assets; and (v) require prior approval of certain expansion proposals. The appropriate federal banking agency for an undercapitalized institution also may take any number of discretionary supervisory actions if the agency determines that any of these actions is necessary to resolve the problems of the institution at the least possible long-term cost to the DIF, subject in certain cases to specified procedures. These discretionary supervisory actions include: (i) requiring the institution to raise additional capital; (ii) restricting transactions with affiliates; (iii) requiring divestiture of the institution or the sale of the institution to a willing purchaser; and (iv) any other supervisory action that the agency deems appropriate. These and additional mandatory and permissive supervisory actions may be taken with respect to significantly undercapitalized and critically undercapitalized institutions.

The new capital requirement rules issued by the Federal Reserve incorporated new requirements into the prompt corrective action framework, pursuant to Section 38 of the FDIA, by (i) introducing a common equity Tier 1 capital ratio requirement at each level (other than critically undercapitalized), with the required ratio being 6.5% for well capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category, with the minimum ratio for well-capitalized status being 8.0% (as compared to the prior ratio of 6.0%); and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3.0% Tier 1 leverage ratio and still be well-capitalized. These new thresholds were effective for the Bank as of January 1, 2015. The minimum total capital to risk-weighted assets ratio (10.0%) and minimum leverage ratio (5.0%) for well-capitalized status were unchanged by the final rules. The Bank meets the definition of being "well capitalized" as of December 31, 2016.

The new capital requirements also include changes in the risk weights of assets to better reflect credit risk and other risk exposures. These include a 150% risk weight (up from 100%) for certain high volatility commercial real estate acquisition, development and construction loans and nonresidential mortgage loans that are 90 days past due or otherwise on nonaccrual status, a 20% (up from 0%) credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable, a 250% risk weight (up from 100%) for mortgage servicing rights and deferred tax assets that are not deducted from capital, and increased risk-weights (from 0% to up to 600%) for equity exposures.

SOURCE OF STRENGTH. Federal Reserve policy has historically required bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. The Dodd-Frank Act codified this policy as a statutory requirement. Under this requirement, the Company is expected to commit resources to support the Bank, including at times when the Company may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.

FEDERAL HOME LOAN BANK OF ATLANTA. The Bank is a member of the FHLB of Atlanta, which is one of eleven regional FHLBs that provide funding to their members for making housing loans as well as loans for affordable housing and community development lending. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB system. It makes loans to its members (i.e., advances) in accordance with policies and procedures established by the Board of Directors of the FHLB. As a member, the Bank is required to purchase and maintain stock in the FHLB in an amount equal to at least 5% of the aggregate outstanding advances made by the FHLB to the Bank. In addition, the Bank is required to pledge collateral for outstanding advances. The borrowing agreement with the FHLB of Atlanta provides for the pledge by the Bank of various forms of securities and mortgage loans as collateral.

USA PATRIOT ACT. The USA PATRIOT Act became effective on October 26, 2001 and provides for the facilitation of information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering. Among other provisions, the USA PATRIOT Act permits financial institutions, upon providing notice to the United States Treasury, to share information with one another in order to better identify and report to the federal government concerning activities that may involve money laundering or terrorists' activities. The USA PATRIOT Act is considered a significant banking law in terms of information disclosure regarding certain customer transactions. Certain provisions of the USA PATRIOT Act impose the obligation to establish anti-money laundering programs, including the development of a customer identification program, and the screening of all customers against any government lists of known or suspected terrorists. Although it does create a reporting obligation and a cost of compliance, the USA PATRIOT Act has not materially affected the Bank's products, services, or other business activities.

MORTGAGE BANKING REGULATION. The Bank's mortgage banking activities are subject to the rules and regulations of, and examination by the Department of Housing and Urban Development, the Federal Housing Administration, the Department of Veterans Affairs and state regulatory authorities with respect to originating, processing and selling mortgage loans. Those rules and regulations, among other things, establish standards for loan origination, prohibit discrimination, provide for inspections and appraisals of property, require credit reports on prospective borrowers and, in some cases, restrict certain loan features, and fix maximum interest rates and fees. In addition to other federal laws, mortgage origination activities are subject to the Equal Credit Opportunity Act, Truth-in-Lending Act, Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act, and Home Ownership Equity Protection Act, S.A.F.E. Act, and the regulations promulgated under these acts. These laws prohibit discrimination, require the disclosure of certain basic information to mortgagors concerning credit and settlement costs, limit payment for settlement services to the reasonable value of the services rendered and require the maintenance and disclosure of information regarding the disposition of mortgage applications based on race, gender, geographical distribution and income level.

CONSUMER LAWS AND REGULATIONS. The Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth-in-Lending Act, the Truth-in-Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, and the Fair Housing Act, and regulations issued under such acts, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits, making loans to or engaging in other types of transactions with such customers.

6

The Dodd-Frank Act centralized responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau (the "CFPB"), and giving it responsibility for implementing, examining, and enforcing compliance with federal consumer protection laws. The CFPB focuses on (i) risks to consumers and compliance with the federal consumer financial laws, (ii) the markets in which firms operate and risks to consumers posed by activities in those markets, (iii) depository institutions that offer a wide variety of consumer financial products and services, and (iv) non-depository companies that offer one or more consumer financial products or services.

The CFPB has broad rulemaking authority for a wide range of consumer financial laws that apply to all banks, including, among other things, the authority to prohibit "unfair, deceptive or abusive" acts and practices. Abusive acts or practices are defined as those that materially interfere with a consumer's ability to understand a term or condition of a consumer financial product or service or take unreasonable advantage of a consumer's (i) lack of financial savvy, (ii) inability to protect himself in the selection or use of consumer financial products or services, or (iii) reasonable reliance on a covered entity to act in the consumer's interests. The CFPB can issue cease-and-desist orders against banks and other entities that violate consumer financial laws. The CFPB may also institute a civil action against an entity in violation of federal consumer financial law in order to impose a civil penalty or injunction.

LOANS TO INSIDERS. The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and some affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the bank's loan-to-one borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed the Bank's unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans, above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and principal shareholders of a bank or bank holding company, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the bank with any "interested" director not participating in the voting. The FDIC has prescribed the loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.

ABILITY-TO-REPAY AND QUALIFIED MORTGAGE RULE. Pursuant to the Dodd-Frank Act, the CFPB issued a final rule effective January 10, 2014, amending Regulation Z as implemented by the Truth in Lending Act, requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Mortgage lenders are required to determine consumers' ability to repay in one of two ways. The first alternative requires the mortgage lender to consider the following eight underwriting factors when making the credit decision: (i) current or reasonably expected income or assets; (ii) current employment status; (iii) the monthly payment on the covered transaction; (iv) the monthly payment on any simultaneous loan; (v) the monthly payment for mortgage-related obligations; (vi) current debt obligations, alimony, and child support; (vii) the monthly debt-to-income ratio or residual income; and (viii) credit history. Alternatively, the mortgage lender can originate "qualified mortgages," which are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a "qualified mortgage" is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. In addition, to be a qualified mortgage the points and fees paid by a consumer cannot exceed 3% of the total loan amount. Qualified mortgages that are "higher-priced" (e.g. subprime loans) garner a rebuttable presumption of compliance with the ability-to-repay rules, while qualified mortgages that are not "higher-priced" (e.g. prime loans) are given a safe harbor of compliance. The Company is predominantly an originator of compliant qualified mortgages.

CYBERSECURITY.  In March 2015, federal regulators issued two related statements regarding cybersecurity. One statement indicates that financial institutions should design multiple layers of security controls to establish lines of defense and to ensure that their risk management processes also address the risk posed by compromised customer credentials, including security measures to reliably authenticate customers accessing internet-based services of the financial institution. The other statement indicates that a financial institution's management is expected to maintain sufficient business continuity planning processes to ensure the rapid recovery, resumption and maintenance of the institution's operations after a cyber-attack involving destructive malware. A financial institution is also expected to develop appropriate processes to enable recovery of data and business operations and address rebuilding network capabilities and restoring data if the institution or its critical service providers fall victim to this type of cyber-attack. If the Company fails to observe the regulatory guidance, it could be subject to various regulatory sanctions, including financial penalties. To date, the Company has not experienced a significant compromise, significant data loss or any material financial losses related to cybersecurity attacks, but its systems and those of its customers and third-party service providers are under constant threat and it is possible that the Company could experience a significant event in the future. Risks and exposures related to cybersecurity attacks are expected to remain high for the foreseeable future due to the rapidly evolving nature and sophistication of these threats, as well as due to the expanding use of Internet banking, mobile banking and other technology-based products and services by the Company and its customers.

INCENTIVE COMPENSATION. In June 2010, the federal bank regulatory agencies issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of financial institutions do not undermine the safety and soundness of such institutions by encouraging excessive risk-taking. The Interagency Guidance on Sound Incentive Compensation Policies, which covers all employees that have the ability to materially affect the risk profile of a financial institutions, either individually or as part of a group, is based upon the key principles that a financial institution's incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the institution's ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the financial institution's board of directors.

The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of financial institutions, such as the Bank, that are not "large, complex banking organizations." These reviews will be tailored to each financial institution based on the scope and complexity of the institution's activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the institution's supervisory ratings, which can affect the institution's ability to make acquisitions and take other actions. Enforcement actions may be taken against a financial institution if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the institution's safety and soundness and the financial institution is not taking prompt and effective measures to correct the deficiencies. At December 31, 2016, the Company had not been made aware of any instances of non-compliance with the guidance.

7

FUTURE REGULATORY UNCERTAINTY. Congress may enact legislation from time to time that affects the regulation of the financial services industry, and state legislatures may enact legislation from time to time affecting the regulation of financial institutions chartered by or operating in those states. Federal and state regulatory agencies also periodically propose and adopt changes to their regulations or change the manner in which existing regulations are applied. The substance or impact of pending or future legislation or regulation, or the application thereof, cannot be predicted, although enactment of the proposed legislation could impact the regulatory structure under which the Company and the Bank operate and may significantly increase costs, impede the efficiency of internal business processes, require an increase in regulatory capital, require modifications to business strategy, and limit the ability to pursue business opportunities in an efficient manner. A change in statutes, regulations or regulatory policies applicable to the Company or the Bank could have a material, adverse effect on the business, financial condition and results of operations of the Company and the Bank.

At this time, it is difficult to predict the legislation and regulatory changes that will result from the combination of a new President of the United States and the first year since 2010 in which both Houses of Congress and the White House have majority memberships from the same political party. In recent years, however, both the new President and senior members of the House of Representatives have advocated for significant reduction for financial services regulation, to include amendments to the Dodd-Frank Act and structural changes to the CFPB. The new administration and Congress also may cause broader economic changes due to changes in governing ideology and governing style. Future legislation, regulation, and government policy could affect the banking industry as a whole, including the business and results of operations of the Company and the Bank, in ways that are difficult to predict.

COMPETITION

The Company encounters strong competition both in making loans and in attracting deposits. In one or more aspects of its business, the Bank competes with other commercial banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking companies, and other financial intermediaries. Most of these competitors, some of which are affiliated with bank holding companies, have substantially greater resources and lending limits, and may offer certain services that the Bank does not currently provide. In addition, many of the Bank's non-bank competitors are not subject to the same level of federal regulation that governs bank holding companies and federally insured banks. Recent federal and state legislation has heightened the competitive environment in which financial institutions must conduct their business, and the potential for competition among financial institutions of all types has increased significantly. To compete, the Bank relies upon specialized services, responsive handling of customer needs, and personal contacts by its officers, directors, and staff. Large multi-branch banking institutions tend to compete based primarily on price and the number and location of branches while smaller, independent financial institutions tend to compete primarily on price and personal service.
 
EMPLOYEES
 
As of December 31, 2016, the Company and the Bank employed 142 full-time employees and 12 part-time employees compared with 139 full-time and 9 part-time employees as of December 31, 2015. No employee is represented by a collective bargaining unit. The Company and the Bank consider relations with employees to be good.
 
AVAILABLE INFORMATION
 
The Company files annual, quarterly and current reports, proxy statements and other information with the SEC. The Company's SEC filings are filed electronically and are available to the public over the internet at the SEC's website at http://www.sec.gov. In addition, any document filed by the Company with the SEC can be read and copied at the SEC's public reference facilities at 100 F Street, N.E., Washington, D.C. 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the public reference room by calling 1-800-SEC-0330. The Company's website is http://www.tfb.bank. The Company makes its SEC filings available through this website under "Investor Relations," "Documents" as soon as practicable after filing or furnishing the material to the SEC. Copies of documents can also be obtained free of charge by writing to Danielle Jenkins, Investor Relations, Fauquier Bankshares, Inc. at 10 Courthouse Square, Warrenton, Virginia 20186 or by calling 800-638-3798. The information on the Company's website is not incorporated into this report or any other filing the Company makes with the SEC.

The Company's transfer agent and registrar is American Stock Transfer & Trust Company, LLC and can be contacted by writing to 6201 15th Avenue, Brooklyn, New York 11209 or by phone 800-937-5449. Their website is www.amstock.com.


ITEM 1A. RISK FACTORS

Not applicable as the Company is a smaller reporting company under SEC rules.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

8

ITEM 2. PROPERTIES

The Bank owns or leases property and operates branches at the following locations except as noted:
 
Location
Lease/Own
 
Rent (Annual)
   
Expiration
   
Renewal
 
Main Office *
P.O. Box 561
10 Courthouse Square
Warrenton, VA 20186
Own
   
N/A
     
N/A
     
N/A
 
 
 
                       
Catlett Office
Rt. 28 and 806
Catlett, VA 20119
Own
   
N/A
     
N/A
     
N/A
 
 
 
                       
Sudley Road Office
8091 Sudley Rd.
Manassas, VA 20109
Lease
 
$251,000 for 2017 to 2018; $271,000 for 2019 to 2023; $325,000 for 2024 to 2029
     
2029
   
None
 
 
 
                       
New Baltimore Office
5119 Lee Highway
Warrenton, VA 20187
Own
   
N/A
     
N/A
     
N/A
 
 
 
                       
The Plains Office
6464 Main Street
The Plains, VA 20198
Own
   
N/A
     
N/A
     
N/A
 
 
 
                       
View Tree Property
87 Lee Highway
Warrenton, VA 20186
Own
   
N/A
     
N/A
     
N/A
 
 
 
                       
Bealeton Office
US Rt. 17 & Station Dr.
Bealeton, VA 22712
Own
   
N/A
     
N/A
     
N/A
 
 
 
                       
Haymarket Property
Market Square at Haymarket
Haymarket, VA 20169
Lease
 
$216,000 for 2017 and increasing 3% annually
     
2029
   
Two additional options for 5 years each
 
 
 
                       
Bristow Property
Bristow Shopping Center
10250 Bristow Center Drive
Bristow, VA 20136
Lease
 
$213,000 for 2017 and increasing 3% annually
     
2019
   
Two additional options for 5 years
 
                           
Gainesville Property
7485 Limestone Drive
Gainesville, VA 20155
Own
   
N/A
     
N/A
     
N/A
 
                           
Centreville Road Property
8780 Centerville Road
Manassas, VA 20110
Own
   
N/A
     
N/A
     
N/A
 

* The Bank and the Company occupy this location.

All of these properties are in good operating condition and are adequate for the Company's and the Bank's present and anticipated future needs. The Bank maintains comprehensive general liability and casualty loss insurance covering its properties and activities conducted in or about its properties. Management believes this insurance provides adequate protection for liabilities or losses that might arise out of the ownership and use of these properties.

ITEM 3. LEGAL PROCEEDINGS

In the ordinary course of operations, the Company and the Bank are parties to various legal proceedings. There are no pending or threatened legal proceedings to which the Company or the Bank is a party or to which the property of either the Company or the Bank is subject that, in the opinion of management, may materially impact the financial condition of either entity.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

9

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The Company's common stock trades on the NASDAQ Capital Market of the NASDAQ Stock Market LLC ("NASDAQ") under the symbol "FBSS". As of March 17, 2017, there were 3,769,201 shares outstanding of the Company's common stock, which is the Company's only class of stock outstanding. These shares were held by approximately 334 holders of record. As of March 17, 2017, the closing market price of the Company's common stock was $18.37.

The following table sets forth the high and low sales prices as reported by NASDAQ for the Company's common stock and the amounts of the cash dividends paid for each full quarterly period within the two most recent fiscal years.

 
 
2016
   
2015
   
Dividends per share
 
 
 
High
   
Low
   
High
   
Low
   
2016
   
2015
 
1st Quarter
 
$
15.96
   
$
14.38
   
$
21.00
   
$
16.04
   
$
0.12
   
$
0.12
 
 
                                               
2nd Quarter
 
$
15.75
   
$
14.47
   
$
17.99
   
$
15.68
   
$
0.12
   
$
0.12
 
 
                                               
3rd Quarter
 
$
14.95
   
$
14.13
   
$
16.49
   
$
13.47
   
$
0.12
   
$
0.12
 
 
                                               
4th Quarter
 
$
16.79
   
$
14.49
   
$
15.90
   
$
14.05
   
$
0.12
   
$
0.12
 

The Company's future dividend policy is subject to the discretion of the Board of Directors and will depend upon a number of factors, including future earnings, financial condition, cash and capital requirements, and general business conditions. The Company's ability to pay cash dividends will depend entirely upon the Bank's ability to pay dividends to the Company. Transfers of funds from the Bank to the Company in the form of loans, advances and cash dividends are restricted by federal and state regulatory authorities. As of December 31, 2016, the aggregate amount of unrestricted funds that could be transferred from the Bank to the Company without prior regulatory approval totaled $4.5 million.

On an annual basis, the Company's Board of Directors authorizes the number of shares of common stock that can be repurchased. On January 21, 2017, the Board of Directors authorized the Company to repurchase up to 112,336 shares (3% of the shares of common stock outstanding on January 1, 2017) beginning January 1, 2017. During the year ended December 31, 2016, 3,661 shares of common stock were repurchased at an average price of $15.30 per share. No shares were repurchased during the fourth quarter of 2016.

10

ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operation" and the consolidated financial statements and accompanying notes included elsewhere in this report. The historical results are not necessarily indicative of results to be expected for any future period.

Selected Financial Data
 
 
 
For the Year Ended December 31,
 
(Dollars in thousands)
 
2016
   
2015
   
2014
   
2013
   
2012
 
EARNINGS STATEMENT DATA:
                             
Interest income
 
$
21,574
   
$
21,694
   
$
21,935
   
$
23,045
   
$
24,954
 
Interest expense
   
1,843
     
1,962
     
2,564
     
3,062
     
4,029
 
Net interest income
   
19,731
     
19,732
     
19,371
     
19,983
     
20,925
 
Provision for (recovery of) loan losses
   
(508
)
   
8,000
     
-
     
1,800
     
5,807
 
Net interest income after provision for loan losses
   
20,239
     
11,732
     
19,371
     
18,183
     
15,118
 
Non-interest income
   
5,296
     
6,414
     
6,619
     
6,551
     
6,199
 
Securities gains
   
1
     
4
     
3
     
144
     
166
 
Non-interest expense
   
20,925
     
20,186
     
19,807
     
19,106
     
19,070
 
Income (loss) before income taxes
   
4,611
     
(2,036
)
   
6,186
     
5,772
     
2,413
 
Income taxes
   
937
     
(1,424
)
   
1,380
     
1,441
     
360
 
Net income (loss)
 
$
3,674
   
$
(612
)
 
$
4,806
   
$
4,331
   
$
2,053
 
PER SHARE DATA:
                                       
Net income (loss) per share, basic
 
$
0.98
   
$
(0.16
)
 
$
1.29
   
$
1.17
   
$
0.56
 
Net income (loss) per share, diluted
 
$
0.98
   
$
(0.16
)
 
$
1.28
   
$
13.16
   
$
0.55
 
Cash dividends
 
$
0.48
   
$
0.48
   
$
0.53
   
$
0.48
   
$
0.48
 
Average basic shares outstanding
   
3,753,757
     
3,742,725
     
3,728,316
     
3,710,802
     
3,691,517
 
Average diluted shares outstanding
   
3,763,929
     
3,742,725
     
3,747,247
     
3,727,886
     
3,707,094
 
Book value at period end
 
$
14.51
   
$
14.06
   
$
14.78
   
$
13.80
   
$
12.92
 
 
                                       
BALANCE SHEET DATA:
                                       
Total assets
 
$
624,445
   
$
601,400
   
$
606,286
   
$
615,774
   
$
601,387
 
Loans, net
   
458,608
     
442,669
     
435,070
     
444,710
     
445,108
 
Investment securities, at fair value
   
51,755
     
56,510
     
58,700
     
55,033
     
50,429
 
Deposits
   
546,157
     
524,294
     
525,215
     
540,204
     
515,134
 
Shareholders' equity
   
54,451
     
52,633
     
55,157
     
51,227
     
47,748
 
 
                                       
PERFORMANCE RATIOS:
                                       
Net interest margin(1)
   
3.50
%
   
3.62
%
   
3.55
%
   
3.64
%
   
3.85
%
Return on average assets
   
0.60
%
   
(0.10
)%
   
0.80
%
   
0.72
%
   
0.35
%
Return on average equity
   
6.82
%
   
(1.09
)%
   
8.98
%
   
8.89
%
   
4.25
%
Dividend payout
   
49.07
%
   
(293.79
)%
   
41.16
%
   
41.15
%
   
86.41
%
Efficiency ratio(2)
   
82.36
%
   
75.50
%
   
74.96
%
   
70.72
%
   
68.98
%
 
                                       
ASSET QUALITY RATIOS:
                                       
Allowance for loan losses to period end loans
   
0.98
%
   
0.94
%
   
1.22
%
   
1.48
%
   
1.39
%
Allowance for loan losses to period end non-performing loans
   
128.44
%
   
226.77
%
   
439.36
%
   
305.27
%
   
58.76
%
Non-performing assets to period end total assets
   
0.78
%
   
0.53
%
   
0.43
%
   
1.23
%
   
2.06
%
Non-performing loans to period end loans
   
0.76
%
   
0.41
%
   
0.28
%
   
0.48
%
   
2.36
%
Net charge-offs (recoveries) to average loans
   
(0.19
)%
   
2.04
%
   
0.29
%
   
0.31
%
   
1.38
%
 
                                       
CAPITAL RATIOS:
                                       
Leverage
   
9.23
%
   
9.13
%
   
9.83
%
   
9.24
%
   
9.12
%
Common Equity Tier 1 Capital Ratio
   
12.22
%
   
11.64
%
 
NA
   
NA
   
NA
 
Tier 1 Capital Ratio
   
12.22
%
   
11.64
%
   
14.05
%
   
13.28
%
   
12.52
%
Total Capital Ratio
   
13.17
%
   
12.53
%
   
15.30
%
   
14.54
%
   
13.78
%

(1)     Net interest margin is calculated as fully taxable equivalent net interest income divided by average earning assets and represents the Company's net yield on its earning assets.
(2)     Efficiency ratio is computed by dividing non-interest expense by the sum of fully taxable equivalent net interest income and fully taxable equivalent non-interest income. Gains and losses on the sale or impairment of securities are excluded from non-interest income in the calculation of this ratio.

11

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

In addition to the historical information contained herein, this report contains forward-looking statements. Forward-looking statements are based on certain assumptions and describe future plans, strategies, and expectations of the Company and are generally identifiable by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" "may," "will" or similar expressions. Although we believe our plans, intentions and expectations reflected in these forward-looking statements are reasonable, we can give no assurance that these plans, intentions, or expectations will be achieved. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain, and actual results could differ materially from those contemplated. Factors that could have a material adverse effect on our operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve, the quality and composition of the Bank's loan or investment portfolios, the value of the collateral securing loans in the loan portfolio, demand for loan products, deposit flows, level of net charge-offs on loans and the adequacy of our allowance for loan losses, competition, demand for financial services in our market area, our plans to increase our market share, and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements in this report and you should not place undue reliance on such statements, which reflect our position as of the date of this report.

CRITICAL ACCOUNTING POLICIES

GENERAL. The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in our estimates. In addition, GAAP itself may change from one previously acceptable accounting method to another method. Although the economics of the Company's transactions would be the same, the timing of events that would impact the Company's transactions could change.

ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on three basic principles of accounting: (i) Accounting Standards Codification ("ASC") 450 "Contingencies" which requires that losses be accrued when they are probable of occurring and estimable, (ii) ASC 310 "Receivables" which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance and (iii) SEC Staff Accounting Bulletin No. 102, "Selected Loan Loss Allowance Methodology and Documentation Issues," which requires adequate documentation to support the allowance for loan losses estimate.

The Company's allowance for loan losses has three basic components: the specific allowance, the general allowance and the unallocated component. Each of these components is determined based upon estimates that can and do change as actual events occur. The specific allowance is used to individually allocate an allowance for larger balance and/or non-homogeneous loans identified as impaired. The specific allowance uses various techniques to arrive at an estimate of loss. Analysis of the borrower's overall financial condition, resources and payment record, the prospects for support and financial guarantors, and the fair market value of collateral are used to estimate the probability and severity of inherent losses. The general allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans and other consumer loans. Also, the general allowance is used for the remaining pool of larger balance and/or non-homogeneous loans which were not identified as impaired. The general allowance begins with estimates of probable losses inherent in the homogeneous portfolio based upon various statistical analyses. These include analysis of historical delinquency and credit loss experience, together with analyses that reflect current trends and conditions. The Company also considers trends and changes in the volume and term of loans, changes in the credit process and/or lending policies and procedures, and an evaluation of overall credit quality. The general allowance uses a historical loss view as an indicator of future losses. As a result, even though this history is regularly updated with the most recent loss information, it could differ from the loss incurred in the future. The general allowance also captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized.  The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Specifically, the Company uses both external and internal qualitative factors when determining the non-loan-specific allowances. The external factors utilized include: unemployment in the Company's defined market area of Fauquier County, Prince William County, and the City of Manassas ("market area"), as well as state and national unemployment trends; new residential construction permits for the market area; bankruptcy statistics for the Virginia Eastern District and trends for the United States; and foreclosure statistics for the market area and the state. Quarterly, these external qualitative factors, as well as relevant anecdotal information, are evaluated from data compiled from local periodicals such as The Washington Post, The Fauquier Times, and The Bull Run Observer, which cover the Company's market area. Additionally, data is gathered from the Federal Reserve Beige Book for the Richmond Federal Reserve District, Global Insight's monthly economic review, the George Mason School of Public Policy Center for Regional Analysis, and daily economic updates from various other sources. Internal Bank data utilized includes: past due loan aging statistics, non-performing loan trends, trends in collateral values, loan concentrations, loan review status downgrade trends, and lender turnover and experience trends. Both external and internal data is analyzed on a rolling eight quarter basis to determine risk profiles for each qualitative factor. Ratings are assigned through a defined matrix to calculate the allowance consistent with authoritative accounting literature. A narrative summary of the reserve allowance is produced quarterly and reported directly to the Company's Board of Directors. The Company's application of these qualitative factors to the allowance for loan losses has been consistent over the reporting period.

The Company employs an independent outsourced loan review function, which annually substantiates and/or adjusts internally generated risk ratings. This independent review is reported directly to the Company's Board of Directors' audit committee, and the results of this review are factored into the calculation of the allowance for loan losses.
 
12

INCOME TAXES AND DEFERRED INCOME TAX ASSETS AND LIABILITIES. Deferred income tax assets and liabilities are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination. There were no unrecognized tax benefits recorded as a liability as of December 31, 2016 and 2015. Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the statement of income. The Company has no uncertain tax positions.

EXECUTIVE OVERVIEW

This discussion is intended to focus on certain financial information regarding the Company and the Bank and may not contain all the information that is important to the reader. The purpose of this discussion is to provide the reader with a more thorough understanding of our financial statements. As such, this discussion should be read carefully in conjunction with the consolidated financial statements and accompanying notes contained elsewhere in this report.

The Bank is the primary independent community bank in its immediate market area as measured by deposit market share. It seeks to be the primary financial service provider for its market area by providing the right mix of consistently high quality customer service, efficient technological support, value-added products, and a strong commitment to the community.

The Company had net income of $3.67 million in 2016 compared with a net loss of $612,000 for 2015. The net loss for 2015 was primarily due to an $8.5 million charge-off on an $8.5 million commercial loan relationship. See Management's Discussion and Analysis of Financial Condition and Results of Operations "Provision for Loan Losses, Allowance for Loan Losses and Asset Quality" for further discussion. The year to year increase in net income was primarily due to an $8.5 million decrease in the provision for loan losses, partially offset by a $1.1 million decrease in other income and a $739,000 increase in other expense. The $8.5 million decrease in the provision for loan losses from 2015 to 2016 was largely in response to the $10.0 million decrease in net loan charge-offs from 2015 to 2016, partially offset by an increase in non-performing loans from $1.8 million at December 31, 2015 to $3.5 million at December 31, 2016. The Company and the Bank's primary operating businesses are in commercial and retail lending, core deposit account relationships, and assets under WMS management. Loans, net of reserve, were $458.6 million at year-end 2016 and $442.7 million at year-end 2015, an increase of 3.6%, compared with an increase of 1.7% from year-end 2014 to year-end 2015. Deposits increased 4.2% from year-end 2015 to year-end 2016 compared with a decrease of 0.2% from year-end 2014 to year-end 2015. The market value of assets under WMS management increased 6.3% from year-end 2015 to year-end 2016, and decreased 19.6% from year-end 2014 to year-end 2015. The changes in assets under WMS management reflect both the changes in the U.S. stock market, as well as the net decrease in WMS customer relationships. Assets under WMS management are not reflected in the Company's consolidated balance sheets.

Net interest income is the largest component of net income, and equals the difference between income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities. Future trends regarding net interest income are dependent on the absolute level of market interest rates, the shape of the yield curve, the amount of lost income from non-performing assets, the amount of prepaying loans, the mix and amount of various deposit types, and many other factors, as well as the overall volume of interest-earning assets. Many of these factors are individually difficult to predict, and when taken together, the uncertainty of future trends compounds. Based on management's current projections, net interest income may increase in 2017 with the growth of average loans, but this may be offset in part or in whole by a possible contraction in the Bank's net interest margin resulting from the prolonged historically low levels in market interest rates. The Bank is also subject to a decline in net interest income due to competitive market conditions and/or a flat or inverted yield curve. A steeper yield curve is projected to result in an increase in net interest income, while a flatter or inverted yield curve is projected to result in a decrease in net interest income.

The Bank's non-performing assets totaled $4.9 million or 0.78% of total assets at December 31, 2016, as compared with $3.2 million or 0.53% of total assets at December 31, 2015. There was a $(508,000) provision for (recovery of) loan losses for 2016 compared with $8.0 million for 2015. Net loan recoveries totaled $840,000 or (0.19)% of total average loans for 2016, compared with net loan charge-offs of $9.2 million or 2.04% of total average loans for 2015.

13

The following table presents a quarterly summary of consolidated net income for the last two years.

Consolidated Net Income

 
 
Three Months Ended 2016
   
Three Months Ended 2015
 
(Dollars in thousands, except per share data)
 
Dec. 31
   
Sep. 30
   
June 30
   
Mar. 31
   
Dec. 31
   
Sep. 30
   
June 30
   
Mar. 31
 
Interest income
 
$
5,569
   
$
5,423
   
$
5,325
   
$
5,257
   
$
5,436
   
$
5,460
   
$
5,425
   
$
5,373
 
Interest expense
   
489
     
458
     
456
     
440
     
438
     
448
     
516
     
560
 
Net interest income
   
5,080
     
4,965
     
4,869
     
4,817
     
4,998
     
5,012
     
4,909
     
4,813
 
Provision for (recovery of) loan losses
   
-
     
425
     
(1,133
)
   
200
     
7,800
     
100
     
100
     
-
 
Net interest income after provision for (recovery of) loan losses
   
5,080
     
4,540
     
6,002
     
4,617
     
(2,802
)
   
4,912
     
4,809
     
4,813
 
Other income
   
1,283
     
1,290
     
1,337
     
1,386
     
1,562
     
1,881
     
1,695
     
1,276
 
Securities gains
   
-
     
1
     
-
     
-
     
1
     
3
     
-
     
-
 
Other expense
   
5,357
     
5,017
     
5,215
     
5,336
     
4,609
     
5,212
     
5,150
     
5,215
 
Income (loss) before income taxes
   
1,006
     
814
     
2,124
     
667
     
(5,848
)
   
1,584
     
1,354
     
874
 
Income tax (benefit) expense
   
198
     
116
     
562
     
61
     
(2,098
)
   
238
     
305
     
131
 
Net income (loss)
 
$
808
   
$
698
   
$
1,562
   
$
606
   
$
(3,750
)
 
$
1,346
   
$
1,049
   
$
743
 
 
                                                               
Net income (loss) per share, basic
 
$
0.22
   
$
0.19
   
$
0.42
   
$
0.16
   
$
(1.00
)
 
$
0.36
   
$
0.28
   
$
0.20
 
 
                                                               
Net income (loss) per share, diluted
 
$
0.22
   
$
0.19
   
$
0.42
   
$
0.16
   
$
(1.00
)
 
$
0.36
   
$
0.28
   
$
0.20
 

2016 COMPARED WITH 2015
The Company had net income of $3.67 million in 2016 compared with a net loss of $612,000 for 2015. Net earnings per share on a fully diluted basis were $0.98 in 2016 compared with a net loss per share of $0.16 on a fully diluted basis in 2015. Profitability as measured by return on average equity increased from (1.09)% in 2015 to 6.82% in 2016. Profitability as measured by return on average assets increased from (0.10)% in 2015 to 0.60% in 2016. The year to year increase in net income was primarily due to a $8.5 million decrease in the provision for loan losses, partially offset by a $1.1 million decrease in other income and a $739,000 increase in other expense. The $8.5 million decrease in the provision for loan losses from 2015 to 2016 was largely in response to the $10.0 million decrease in net loan charge-offs from 2015 to 2016, partially offset by an increase in non-performing loans from $1.8 million at December 31, 2015 to $3.5 million at December 31, 2016. See Management's Discussion and Analysis of Financial Condition and Results of Operations "Provision for Loan Losses, Allowance for Loan Losses and Asset Quality" for further discussion.

2015 COMPARED WITH 2014
The Company's net loss of $612,000 in 2015 was an 112.7% decrease from 2014 net income of $4.81 million. Net loss per share on a fully diluted basis was $0.16 in 2015 compared with net earnings per share of $1.28 in 2014. Profitability as measured by return on average equity decreased from 8.98% in 2014 to (1.09)% in 2015. Profitability as measured by return on average assets decreased from 0.80% in 2014 to (0.10)% in 2015. The year to year decrease in net income was primarily due to a $8.0 million increase in the provision for loan losses.

NET INTEREST INCOME AND EXPENSE

2016 COMPARED WITH 2015
Net interest income remained relatively flat at $19.73 million for the year ended December 31, 2016 and 2015. The flat net interest income was the result of a decrease in interest income being equally offset by a decrease in interest expense as described below. The Company's net interest margin decreased from 3.62% in 2015 to 3.50% in 2016. Total average earning assets increased from $550.9 million in 2015 to $568.9 million in 2016. The percentage of average earning assets to total assets increased from 92.1% in 2015 to 92.2% in 2016.

Total interest income decreased $120,000 or 0.6% to $21.57 million in 2016 from $21.69 million in 2015. This decrease was due to the 15 basis point decrease in the average yield on assets, partially offset by the increase in total average earning assets of $18.0 million or 3.3%, from 2015 to 2016. The yield on earning assets declined  from 3.98% in 2015 to 3.83% in 2016 due to the decline in market interest rates in the economy at large over the last seven years.

Average total loan balances increased $1.5 million or 0.3% from $451.8 million in 2015 to $453.2 million in 2016. The tax-equivalent average yield on loans decreased to 4.42% in 2016 compared with 4.48% in 2015. Together, this resulted in a $157,000 decrease in interest and fee income from loans for 2016 compared with 2015. On a tax-equivalent basis, the year-to-year decrease in interest and fee income on loans was $186,000.

Average investment security balances decreased $5.5 million from $57.7 million in 2015 to $52.2 million in 2016. The tax-equivalent average yield on investments decreased from 2.71% in 2015 to 2.68% in 2016. Together interest and dividend income on security investments decreased $165,000 from 2015 to 2016 on a tax-equivalent basis.

Interest income on deposits at other banks increased from $139,000 in 2015 to $338,000 in 2016 due to the increase in average balances from $41.5 million in 2015 to $63.5 million in 2016 and an increase in average yield from 0.34% in 2015 to 0.53% in 2016.

14

Total interest expense decreased $119,000 or 6.1% from $1.96 million in 2015 to $1.84 million in 2016, primarily due to the replacement of more costly time deposits with less expensive demand deposit accounts, NOW accounts, and savings deposits. Interest paid on deposits decreased $111,000 or 7.8% from $1.43 million in 2015 to $1.32 million in 2016. Average NOW deposit balances increased $19.9 million from 2015 to 2016 while the average rate on NOW accounts increased from 0.21% during 2015 to 0.23% during 2016, resulting in $92,000 more interest expense in 2016. Average money market account deposit balances increased $1.7 million from 2015 to 2016, and the average rate on money market account deposits remained at 0.21% for both respective years, resulting in $3,000 more interest expense in 2016. Average savings account deposit balances increased $2.0 million from 2015 to 2016, and the average rate on savings account deposits remained at 0.10%, resulting in no interest expense change in 2016. Average time deposit balances decreased $6.0 million from 2015 to 2016 while the average rate on time deposits decreased from 1.10% to 0.88%, resulting in a decrease of $206,000 in interest expense from 2015 to 2016.

Interest expense on FHLB of Atlanta advances decreased $1,000 from 2015 to 2016 due to a $70,000  decrease in average balances over the same time periods due to an amortizing advance. The interest expense on trust preferred capital securities increased from $199,000 in 2015 to $200,000 in 2016. The average rate on total interest-bearing liabilities decreased from 0.45% in 2015 to 0.41% in 2016.

2015 COMPARED WITH 2014
Net interest income increased $361,000 or 1.9% to $19.73 million for the year ended December 31, 2015 from $19.37 million for the year ended December 31, 2014. The increase in net interest income was primarily due to a reduction in interest expense on deposits as described below. This led to the Company's net interest margin increasing from 3.55% in 2014 to 3.62% in 2015. Total average earning assets decreased from $552.5 million in 2014 to $550.9 million in 2015. The percentage of average earning assets to total assets decreased from 92.4% in 2014 to 92.1% in 2015.

Total interest income decreased $241,000 or 1.1% to $21.69 million in 2015 from $21.94 million in 2014. This decrease was due to the four basis point decrease in the average yield on assets, as well as the decrease in total average earning assets of $1.5 million or 0.3%, from 2014 to 2015. The yield on earning assets declined from 4.02% in 2014 to 3.98% in 2015 due to the decline in market interest rates in the economy at large over the last six years.

Average total loan balances increased $9.0 million or 2.0% from $442.8 million in 2014 to $451.8 million in 2015. The tax-equivalent average yield on loans decreased to 4.48% in 2015 compared with 4.60% in 2014. Together, this resulted in a $139,000 decrease in interest and fee income from loans for 2015 compared with 2014. On a tax-equivalent basis, the year-to-year decrease in interest and fee income on loans was $165,000.

Average investment security balances increased $913,000 from $56.8 million in 2014 to $57.7 million in 2015. The tax-equivalent average yield on investments decreased from 2.90% in 2014 to 2.71% in 2015. Together, interest and dividend income on security investments decreased $83,000 from 2014 to 2015.

Interest income on deposits at other banks decreased from $171,000 in 2014 to $139,000 in 2015 due to the decrease in the average balances from $52.9 million in 2014 to $41.5 million in 2015.

Total interest expense decreased $602,000 or 23.5% from $2.56 million in 2014 to $1.96 million in 2015, primarily due to the replacement of more costly time deposits with less expensive demand deposit accounts, NOW accounts, and savings deposits. Interest paid on deposits decreased $608,000 or 29.8% from $2.04 million in 2014 to $ 1.43 million in 2015. Average NOW deposit balances increased $4.9 million from 2014 to 2015 while the average rate on NOW accounts decreased from 0.22% during 2014 to 0.21% during 2015, resulting in $2,000 less interest expense in 2015. Average money market account deposit balances increased $2.8 million from 2014 to 2015, and the average rate on money market account deposits remained at 0.21% for both respective years, resulting in $8,000 more interest expense in 2015. Average savings account deposit balances increased $6.7 million from 2014 to 2015 while the average rate on savings account deposits decreased from 0.11% to 0.10%, resulting in $5,000 more interest expense in 2015. Average time deposit balances decreased $25.7 million from 2014 to 2015 while the average rate on time deposits decreased from 1.44% to 1.10%, resulting in a decrease of $619,000 in interest expense from 2014 to 2015.

Interest expense on FHLB of Atlanta advances decreased $2,000 from 2014 to 2015 due to a $66,000 decrease in average balances over the same time periods. The interest expense on trust preferred capital securities were $199,000 for both 2014 and 2015. The average on total interest-bearing liabilities decreased from 0.57% in 2014 to 0.45% in 2015.

15

The following table sets forth information relating to the Company's average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields and rates paid for the periods indicated. These yields and costs are derived by dividing income or expense by the average daily balances of assets and liabilities, respectively, for the periods presented.

Average Balances, Income and Expenses, and Average Yields and Rates

(Dollars in thousands)
 
12 Months Ended
December 31, 2016
   
12 Months Ended
December 31, 2015
   
12 Months Ended
December 31, 2014
 
Assets
 
Average
Balances
   
Income/
Expense
   
Average
Rate
   
Average
Balances
   
Income/
Expense
   
Average
Rate
   
Average
Balances
   
Income/
Expense
   
Average
Rate
 
Loans
                                                     
Taxable
 
$
446,094
   
$
19,783
     
4.43
%
 
$
443,303
   
$
19,884
     
4.49
%
 
$
434,111
   
$
19,973
     
4.60
%
Tax-exempt (1)
   
4,716
     
253
     
5.36
%
   
6,007
     
338
     
5.63
%
   
6,527
     
414
     
6.34
%
Non-accrual (2)
   
2,436
     
-
             
2,457
     
-
             
2,125
     
-
         
Total Loans
   
453,246
     
20,036
     
4.42
%
   
451,767
     
20,222
     
4.48
%
   
442,763
     
20,387
     
4.60
%
 
                                                                       
Securities
                                                                       
Taxable
   
46,501
     
1,076
     
2.32
%
   
51,722
     
1,230
     
2.38
%
   
50,177
     
1,276
     
2.54
%
Tax-exempt (1)
   
5,649
     
320
     
5.66
%
   
5,946
     
331
     
5.57
%
   
6,578
     
368
     
5.60
%
Total securities
   
52,150
     
1,396
     
2.68
%
   
57,668
     
1,561
     
2.71
%
   
56,755
     
1,644
     
2.90
%
 
                                                                       
Deposits in banks
   
63,534
     
338
     
0.53
%
   
41,480
     
139
     
0.34
%
   
52,931
     
171
     
0.32
%
Federal funds sold
   
9
     
-
     
0.37
%
   
9
     
-
     
0.17
%
   
11
     
-
     
0.20
%
Total earning assets
 
$
568,939
   
$
21,770
     
3.83
%
 
$
550,924
   
$
21,922
     
3.98
%
 
$
552,460
   
$
22,202
     
4.02
%
 
                                                                       
Less: Reserve for loan losses
   
(4,695
)
                   
(5,730
)
                   
(6,862
)
               
Cash and due from banks
   
4,728
                     
5,308
                     
5,123
                 
Bank premises and equipment, net
   
19,990
                     
20,807
                     
19,954
                 
Other real estate owned
   
1,384
                     
1,516
                     
1,961
                 
Other assets
   
26,447
                     
25,536
                     
25,214
                 
Total Assets
 
$
616,793
                   
$
598,361
                   
$
597,850
                 
 
                                                                       
Liabilities & Shareholders' Equity
                                                                       
Deposits
                                                                       
Demand deposits
 
$
102,403
                   
$
96,538
                   
$
89,240
                 
 
                                                                       
Interest-bearing deposits
                                                                       
NOW accounts
   
231,142
   
$
535
     
0.23
%
   
211,273
   
$
443
     
0.21
%
   
206,343
   
$
445
     
0.22
%
Money market accounts
   
54,511
     
115
     
0.21
%
   
52,787
     
112
     
0.21
%
   
50,027
     
104
     
0.21
%
Savings accounts
   
84,660
     
85
     
0.10
%
   
82,626
     
85
     
0.10
%
   
75,908
     
80
     
0.11
%
Time deposits
   
66,027
     
584
     
0.88
%
   
72,056
     
790
     
1.10
%
   
97,786
     
1,409
     
1.44
%
Total interest-bearing deposits
   
436,340
     
1,319
     
0.30
%
   
418,742
     
1,430
     
0.34
%
   
430,064
     
2,038
     
0.47
%
 
                                                                       
 
                                                                       
Federal  funds purchased
   
2
     
-
     
0.99
%
   
1,415
     
8
     
0.53
%
   
2
     
-
     
0.79
%
Federal Home Loan Bank advances
   
12,971
     
324
     
2.50
%
   
13,041
     
325
     
2.49
%
   
13,107
     
327
     
2.49
%
Capital securities of subsidiary trust
   
4,124
     
200
     
4.84
%
   
4,124
     
199
     
4.83
%
   
4,124
     
199
     
4.83
%
Total interest-bearing liabilities
   
453,437
     
1,843
     
0.41
%
   
437,322
     
1,962
     
0.45
%
   
447,297
     
2,564
     
0.57
%
 
                                                                       
Other liabilities
   
7,114
                     
8,543
                     
7,796
                 
Shareholders' equity
   
53,839
                     
55,958
                     
53,517
                 
 
                                                                       
Total Liabilities & Shareholders' Equity
 
$
616,793
                   
$
598,361
                   
$
597,850
                 
 
                                                                       
Net interest income (tax equivalent basis)
           
19,927
     
3.42
%
           
19,960
     
3.53
%
           
19,638
     
3.45
%
Less: tax equivalent adjustment
           
196
                     
228
                     
(93
)
       
Net interest income
         
$
19,731
                   
$
19,732
                   
$
19,731
         
 
                                                                       
Interest expense as a percent of average earning assets
                   
0.32
%
                   
0.36
%
                   
0.46
%
Net interest margin
                   
3.50
%
                   
3.62
%
                   
3.55
%
 

(1)  Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.
(2)  Loans are included in the average balance of total loans and total earning assets.

16

RATE/VOLUME ANALYSIS
 
The following table sets forth certain information regarding changes in interest income and interest expense of the Company for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate); and changes in rates (change in rate multiplied by old volume). Changes in rate-volume, which cannot be separately identified, are allocated proportionately between changes in rate and changes in volume.

Rate / Volume Variance
 
 
 
2016 Compared to 2015
   
2015 Compared to 2014
 
(In thousands)
 
Change
   
Due to
Volume
   
Due to
Rate
   
Change
   
Due to
Volume
   
Due to
Rate
 
Interest Income
                                   
Loans; taxable
 
$
(101
)
 
$
125
   
$
(226
)
 
$
(89
)
 
$
423
   
$
(512
)
Loans; tax-exempt (1)
   
(85
)
   
(73
)
   
(12
)
   
(76
)
   
(33
)
   
(43
)
Securities; taxable
   
(154
)
   
(124
)
   
(30
)
   
(46
)
   
39
     
(85
)
Securities; tax-exempt (1)
   
(11
)
   
(16
)
   
5
     
(37
)
   
(36
)
   
(1
)
Deposits in banks
   
199
     
74
     
125
     
(32
)
   
(37
)
   
5
 
Federal funds sold
   
-
     
-
     
-
     
-
     
-
     
-
 
Total Interest Income
   
(152
)
   
(14
)
   
(138
)
   
(280
)
   
356
     
(636
)
 
                                               
Interest Expense
                                               
Checking accounts
   
92
     
42
     
50
     
(2
)
   
11
     
(13
)
Money market accounts
   
3
     
4
     
(1
)
   
8
     
6
     
2
 
Savings accounts
   
-
     
2
     
(2
)
   
5
     
7
     
(2
)
Time deposits
   
(206
)
   
(66
)
   
(140
)
   
(619
)
   
(370
)
   
(249
)
Federal funds purchased and securities sold under agreements to repurchase
   
(8
)
   
(8
)
   
-
     
8
     
-
     
8
 
Federal Home Loan Bank advances
   
(1
)
   
(2
)
   
1
     
(2
)
   
(2
)
   
-
 
Capital securities of subsidiary trust
   
1
     
-
     
1
     
-
     
-
     
-
 
Total Interest Expense
   
(119
)
   
(28
)
   
(91
)
   
(602
)
   
(348
)
   
(254
)
Net Interest Income
 
$
(33
)
 
$
14
   
$
(47
)
 
$
322
   
$
704
   
$
(382
)
 

(1)  Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.

PROVISION FOR LOAN LOSSES, ALLOWANCE FOR LOAN LOSSES, AND ASSET QUALITY

There was a $(508,000) provision for (recovery of) loan losses during 2016. There was an $8.0 million provision for loan losses for 2015, and no provision was provided for in 2014. The amount of the provision for loan loss for 2016, 2015, and 2014 was based upon management's continual evaluation of the adequacy of the allowance for loan losses, which encompasses the overall risk characteristics of the loan portfolio, trends in the Bank's delinquent and non-performing loans, estimated values of collateral, and the impact of economic conditions on borrowers. The loss history by loan category, prolonged changes in portfolio delinquency trends by loan category, and changes in economic trends are also utilized in the determining the allowance. There can be no assurances, however, that future losses will not exceed estimated amounts, or that increased amounts of provisions for loan losses will not be required in future periods.

The $8.5 million decrease in the provision for loan losses from 2015 to 2016 was largely in response to the $10.0 million decrease in net loan charge-offs from 2015 to 2016, offset somewhat by an increase in specific reserves on impaired loans and an increase in nonperforming loans.

The ratio of allowance for loan losses as a percentage of total loans increased from 0.94% in 2015 to 0.98% in 2016, and the ratio of allowance for loan losses as a percentage of non-performing loans declined from 227% to 128% over the same time period. During 2016, four loan relationships, which totaled $1.7 million at December 31, 2016, were added to non-performing loans. Non-performing loans increased from $1.8 million at December 31, 2015 to $3.5 million at December 31, 2016. The increase in non-accrual loans from 2015 to 2016 was the major factor in the year-end 2015 to year-end 2016 increase in the allowance for loan losses.

The $8.0 million increase in the provision for loan losses from 2014 to 2015 was largely in response to the $7.9 million increase in net loan charge-offs in 2015 from 2014 as a result of the $8.5 million charge-off on a commercial and industrial loan relationship made up of five loans with one borrower.

LOAN PORTFOLIO
 
At December 31, 2016, 2015, and 2014, net loans accounted for 73.4%, 73.6%, and 71.8% of total assets, respectively, and were the largest category of the Company's earning assets. Loans are shown on the balance sheets net of unearned discounts and the allowance for loan losses. Interest is computed by methods that result in level rates of return on principal. Loans are charged-off when deemed by management to be uncollectible, after taking into consideration such factors as the current financial condition of the customer and the underlying collateral and guarantees.

Authoritative accounting guidance requires that the impairment of loans that have been separately identified as impaired is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. The guidance also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

17

A loan is considered impaired when there is an identified weakness that makes it probable that the Bank will not be able to collect all principal and interest amounts according to the contractual terms of the loan agreement. Factors involved in determining if a loan is impaired include, but are not limited to, expected future cash flows, financial condition of the borrower, and the current economic conditions. A performing loan may be considered impaired if the factors above indicate a need for impairment. A loan on non-accrual status may not necessarily be impaired if it is in the process of collection or if the shortfall in payment is insignificant. A delay of less than 30 days or a shortfall of less than 5% of the required principal and interest payments generally is considered "insignificant" and would not indicate an impairment situation, if in management's judgment the loan will be paid in full. Loans that meet the regulatory definitions of doubtful or loss generally qualify as impaired loans under authoritative accounting guidance. As is the case for all loans, charge-offs for impaired loans occur when the loan or portion of the loan is determined to be uncollectible.

The Bank considers all consumer installment loans and smaller residential mortgage loans to be homogenous loans. These loans are not subject to individual evaluation for impairment under authoritative accounting guidelines unless the loan is identified as a troubled debt restructuring ("TDR").

ASSET QUALITY

Non-performing assets, in most cases, consist of loans, other real estate owned, repossessed property such as automobiles, and loans that are 90 days or more past due and for which the accrual of interest has been discontinued. Management evaluates all loans and investments that are 90 days or more past due, as well as borrowers that have suffered financial distress, to determine if they should be placed on non-accrual status. Factors considered by management include the net realizable value of collateral, if any, and other resources of the borrower that may be available to satisfy the delinquency.

Loans are placed on non-accrual status when principal or interest is delinquent for 90 days or more, unless the loans are well secured and in the process of collection. Any unpaid interest previously accrued on such loans is reversed from income. Interest income generally is not recognized on nonaccrual loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance.

A TDR identification process has been established using a template of questions that determine whether a borrower is experiencing financial difficulty and, if so, whether the Bank has granted a concession to the borrower by modifying the loan. Then, mitigating factors are evaluated to determine a final conclusion as to the whether the loan should be classified as a TDR. Once a loan has been identified as a TDR, it remains so until it is paid off according to the modified terms or until it reverts to the terms and conditions of the original contract. 

There are 12 loans in the portfolio totaling $6.9 million that have been identified as TDRs at December 31, 2016.  No loans were modified and identified as TDRs during 2016. Four loans totaling $4.2 million and five loans totaling $5.6 million were modified and identified as TDRs during 2015 and 2014, respectively. At December 31, 2016, seven of the TDR loans were current and performing in accordance with the modified terms. Three of the TDRs, totaling $1.5 million to a single borrower, were in nonaccrual status due to prior irregular payments, but were paying in accordance with a bankruptcy plan. An additional loan totaling $96,000 was in nonaccrual status due to continued irregular payments. The remaining TDR totaling $40,000 is on accrual status but was 30 days past due at December 31, 2016. Reserves on TDRs have been established as appropriate.

Non-performing assets totaled $4.9 million or 0.78% of total assets at December 31, 2016, as compared with $3.2 million or 0.53% of total assets at December 31, 2015 and $2.6 million or 0.43% of total assets at December 31, 2014. The increase was primarily due to the addition of a residential real estate loan totaling $1.0 million and a commercial loan totaling $500,000 during the fourth quarter of 2016, both of which are expected to be disposed of in the first half of 2017. Included in non-performing assets at December 31, 2016 were $1.4 million of other real estate owned, and $3.5 million of non-accrual loans.

At December 31, 2016, no concentration of loans to commercial borrowers engaged in similar activities exceeded 10% of total loans. The largest industry concentration at December 31, 2016 was approximately $17.9 million or 3.9% of loans to the hospitality industry.

Based on regulatory guidelines, the Bank is required to monitor the commercial investment real estate loan portfolio for: (a) concentrations above 100% of Tier 1 capital and loan loss reserve for construction and land loans and (b) 300% for permanent investor real estate loans. As of December 31, 2016, construction and land loans are $39.5 million or 63.2% of the concentration limit, while permanent investor real estate loans (by NAICS code) are $128.9 million or 206.0% of the concentration level.

The allowance for loan losses as a percentage of non-performing loans was 128.4%, 226.8%, and 439.4% at December 31, 2016, 2015, and 2014, respectively. The primary reason for the decrease in this coverage ratio from 2015 to 2016 was due to an increase in nonaccrual loans from $1.8 million at December 31, 2015 to $3.5 million at December 31, 2016, and the relative levels of allowance needed for these specific loans. Management believes that adequate reserves existed on nonperforming loans as of December 31, 2016.

The number of non-performing loan relationships was eight at December 31, 2016 compared with four at December 31, 2015, and 11 at December 31, 2014.

The Bank's other real estate owned at December 31, 2016 was one property with a total net value of $1.36 million consisting of 47 acres of undeveloped land in Opal, Virginia. The Bank is engaged in ongoing, active discussions regarding the marketing, development, and disposition of this property. It is revalued on an annual basis, and management believes it was properly valued at December 31, 2016. Other real estate owned at December 31, 2015 was the same property valued at $1.36 million.

Excluding student loans, loans that were 90 days past due and accruing interest totaled $321,000 at December 31, 2016 and consisted of a single loan that was in the process of renewal. There were no loans, excluding student loans, that were 90 days past due and accruing interest at December 31, 2015 and 2014.

There were 17 loans totaling $8.4 million at December 31, 2016 that were considered impaired and were allocated $880,000 of loan loss reserves. This included eight loans totaling $5.3 million that were performing and accruing interest at December 31, 2016. Additionally, there were nine loans totaling $3.2 million that were not in accrual status. There are no loans, other than those disclosed above as either non-performing or impaired, where information known about the borrower has caused management to have serious doubts about the borrower's ability to repay.

At December 31, 2016, there are no other interest-bearing assets that would be subject to disclosure as either non-performing or impaired.

18

Total loans on the balance sheet are comprised of the following classifications as of December 31, 2016, 2015, 2014, 2013, and 2012.

Loan Portfolio

 
 
December 31,
 
(In thousands)
 
2016
   
2015
   
2014
   
2013
   
2012
 
Loans secured by real estate:
                             
Construction and land
 
$
49,777
   
$
49,855
   
$
39,085
   
$
32,807
   
$
40,045
 
Residential real estate
   
162,383
     
150,575
     
143,477
     
142,256
     
136,590
 
Home equity lines of credit
   
43,861
     
44,013
     
42,732
     
43,476
     
45,025
 
Commercial real estate
   
165,271
     
160,036
     
165,528
     
176,320
     
193,005
 
Commercial and industrial loans (except those secured by real estate)
   
25,735
     
23,705
     
26,924
     
24,746
     
27,140
 
Consumer loans to individuals (except those secured by real estate)
   
3,100
     
3,160
     
3,015
     
3,810
     
4,567
 
Student
   
13,006
     
15,518
     
19,700
     
27,962
     
4,994
 
Total loans
 
$
463,133
   
$
446,862
   
$
440,461
   
$
451,377
   
$
451,366
 

The following table sets forth certain information with respect to the Bank's non-accrual, restructured and past due loans, as well as foreclosed assets, at the dates indicated:

Non-Performing Assets and Loans Contractually Past Due

 
 
At December 31,
 
(Dollars in thousands)
 
2016
   
2015
   
2014
   
2013
   
2012
 
 
                             
Non-accrual loans
 
$
3,523
   
$
1,849
   
$
1,227
   
$
2,184
   
$
10,650
 
Other real estate owned
   
1,356
     
1,356
     
1,406
     
4,085
     
1,406
 
Other repossessed assets owned
   
-
     
-
     
-
     
-
     
-
 
Non-performing corporate bond investments, at fair value
   
-
     
-
     
-
     
1,300
     
325
 
Total non-performing assets
   
4,879
     
3,205
     
2,633
     
7,569
     
12,381
 
 
                                       
Restructured loans still accruing
   
5,305
     
5,495
     
7,431
     
8,613
     
5,556
 
 
Student loans (U.S. Gov. guaranteed) past due 90 or more days and still accruing
   
2,538
     
2,814
     
4,551
     
7,917
     
-
 
 
Loans past due 90 days and still accruing interest
   
321
     
-
     
-
     
506
     
132
 
Total non-performing and other risk assets
 
$
13,043
   
$
11,514
   
$
14,615
   
$
24,605
   
$
18,069
 
 
                                       
Allowance for loan losses as percentage of total loans, period end
   
0.98
%
   
0.94
%
   
1.22
%
   
1.48
%
   
1.39
%
 
                                       
Non-accrual loans to total loans, period end
   
0.76
%
   
0.41
%
   
0.28
%
   
0.48
%
   
2.36
%
 
                                       
Allowance for loan losses as percentage of non-performing loans, period end
   
128.44
%
   
226.77
%
   
439.36
%
   
305.27
%
   
58.76
%
 
                                       
Non-accrual loans and restructured loans still accruing to total loans, period end
   
1.91
%
   
1.64
%
   
1.97
%
   
2.39
%
   
3.59
%
 
                                       
Non-performing assets as percentage of total assets, period end
   
0.78
%
   
0.53
%
   
0.43
%
   
1.23
%
   
2.06
%

Potential Problem Loans: For additional information regarding non-performing assets and potential loan problems, see "Loans and Allowance for Loan Losses" Note 3 of the Notes to Consolidated Financial Statements contained herein.

19

ANALYSIS OF LOAN LOSS EXPERIENCE

The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectability of the loan portfolio, credit concentration, trends in historical loan loss experience, specific impaired loans, and current economic conditions. Management periodically reviews the loan portfolio to determine probable credit losses related to specifically identified loans as well as credit losses inherent in the remainder of the loan portfolio. Allowances for impaired loans are generally determined based on net realizable values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge-offs, net of recoveries. Changes in the allowances relating to impaired loans are charged or credited to the provision for loan losses. Because of uncertainties inherent in the estimation process, management's estimate of credit losses inherent in the loan portfolio and the related allowance remains subject to change. Additions to the allowance for loan losses, recorded as the provision for loan losses on the Company's statements of income, are made as needed to maintain the allowance at an appropriate level based on management's analysis of the inherent risk in the loan portfolio. The amount of the provision is a function of the level of loans outstanding, the level and nature of impaired and non-performing loans, historical loan loss experience, the amount of loan losses actually charged off or recovered during a given period and current national and local economic conditions.

At December 31, 2016, 2015, 2014, 2013, and 2012, the allowance for loan losses was $4.5 million, $4.2 million, $5.4 million, $6.7 million, and $6.3 million, respectively. As a percentage of total loans, the allowance for loan losses decreased from 1.22% at December 31, 2014 to 0.94% at December 31, 2015 and increased to 0.98% at December 31, 2016. The allowance for loan losses equaled 128.4% of non-accrual loans at December 31, 2016 compared with 226.8% and 439.4% at December 31, 2015 and 2014, respectively.

The following table summarizes the Bank's loan loss experience for each of the years ended December 31, 2016, 2015, 2014, 2013, and 2012, respectively:

Analysis of Allowance for Loan Losses
 
 
 
Years ended December 31,
 
(Dollars in thousands)
 
2016
   
2015
   
2014
   
2013
   
2012
 
 
                             
Allowance for loan losses, January 1,
 
$
4,193
   
$
5,391
   
$
6,667
   
$
6,258
   
$
6,728
 
 
                                       
Secured by real estate:
                                       
Construction and land
   
-
     
17
     
313
     
-
     
-
 
1-4 family residential
   
36
     
167
     
172
     
284
     
126
 
Home equity line of credit
   
-
     
50
     
91
     
174
     
536
 
Commercial real estate
   
380
     
568
     
560
     
686
     
5,004
 
Commercial and industrial
   
226
     
8,525
     
171
     
257
     
526
 
Student
   
36
     
50
     
139
     
-
     
-
 
Consumer
   
46
     
10
     
18
     
104
     
117
 
Total loans charged-off
   
724
     
9,387
     
1,464
     
1,505
     
6,309
 
 
                                       
Secured by real estate:
                                       
Construction and land
   
-
     
-
     
65
     
-
     
-
 
1-4 family residential
   
-
     
52
     
22
     
2
     
2
 
Home equity line of credit
   
3
     
21
     
5
     
11
     
-
 
Commercial real estate
   
24
     
-