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Section 1: 10-K (FAUQUIER BANKSHARES, INC FORM 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, 2017

or

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from _____________to_____________

Commission File 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 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, a smaller reporting company, or an emerging growth company.  See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer
Accelerated filer
Non-accelerated filer o (Do not check if smaller reporting company)
Smaller reporting company
 
Emerging growth company

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

Indicate by check mark 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 at June 30, 2017, was $67.9 million.  The registrant had 3,773,971 shares of common stock outstanding as of March 20, 2018.

DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement for the 2018 Annual Meeting of Shareholders 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
9
 
 
 
 
 
Item 6.
Selected Financial Data
10
 
 
 
 
 
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
11
       
 
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
24
 
 
 
 
 
Item 8.
Financial Statements and Supplementary Data
25
 
 
 
 
 
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
59
 
 
 
 
 
Item 9A.
Controls and Procedures
59
 
 
 
 
 
Item 9B.
Other Information
59
 
 
 
 
PART III
 
 
 
 
 
 
 
Item 10
Directors, Executive Officers and Corporate Governance
59
 
 
 
 
 
Item 11.
Executive Compensation
59
 
 
 
 
 
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
59
 
 
 
 
 
Item 13.
Certain Relationships and Related Transactions, and Director Independence
60
 
 
 
 
 
Item 14.
Principal Accounting Fees and Services
60
 
 
 
 
PART IV
 
 
 
 
 
 
 
Item 15.
Exhibits, Financial Statement Schedules
60
       
 
Item 16.
10-K Summary
62

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PART I

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 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. As of January 1, 2018, the Bank had 11 full service branch offices and approximately 12 automated teller machines (“ATM”) located throughout its market area.

The basic services offered by the Bank include: interest and noninterest-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, 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 deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (“FDIC”).  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, financial planning, 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 of Atlanta (“FHLB”). 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, 2017, the Company had total consolidated assets of $644.6 million, total consolidated loans net of allowance for loan losses of $497.7 million, total consolidated deposits of $570.0 million, and total consolidated shareholders’ equity of $56.1 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 net loans, at December 31, 2017, were $497.7 million, or 77.2% 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. Deteriorating economic conditions in Fauquier or Prince William Counties, as well as 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, 2017, approximately 92.0% of the loan portfolio consisted of loans secured by mortgages on real estate.

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LOANS SECURED BY REAL ESTATE
1- 4 FAMILY RESIDENTIAL REAL ESTATE. 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 utilizing amortization schedules of 30 years or less. As of December 31, 2017, the Bank’s 1-4 family residential loans amounted to $187.1 million, or 37.2% of the total loan portfolio. The majority of the Bank’s 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. The Bank’s home equity lines of credit loan portfolio primarily consists of conventional loans, generally with variable interest rates that are tied to the Wall Street Journal prime rate with 10 year terms. As of December 31, 2017, the Bank’s home equity loans amounted to $44.5 million, or 8.9% of the total loan portfolio. The majority of the Bank’s home equity lines of credit are 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. 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, 2017, the Bank’s construction and land loans totaled $54.2 million, or 10.8% of the total loan portfolio, which includes $17.1 million of commercial acquisition and development loans, $25.4 million of raw land loans and $1.3 million of agricultural land loans.

COMMERCIAL REAL ESTATE. Loans secured by commercial real estate comprised $176.8 million, or 35.2% of total loans at December 31, 2017, and consist principally of commercial loans for which real estate constitutes a source of collateral. Approximately $85.5 million or 48.4% of commercial real estate loans are owner-occupied. 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 92.7% of the Bank’s commercial loans, on a dollar-value basis, and the remaining 7.3% 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 the Bank's 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 $24.4 million or 4.9% of total loans at December 31, 2017.

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 $5.1 million or 1.0% of total loans at December 31, 2017.

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 $10.7 million or 2.1% of total loans at December 31, 2017.

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, and non-brokered time deposits under $100,000 to be core deposits. These accounts comprised approximately 93.0% of the Bank’s total deposits at December 31, 2017. 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 4.1% and 2.8%, respectively, of the Bank’s total deposits at December 31, 2017. During 2017, 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, 2017 were $17.3 million of brokered deposits, or 3.0% of total deposits. Of the brokered deposits, $12.9 million or 2.3% of total deposits represent a reciprocal arrangement for existing Bank customers who desire FDIC insurance for deposits above current limits.

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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 $72.2 million and $1.5 million, respectively, or 11.2% and 0.2% of total assets, respectively, at December 31, 2017.

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.

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 the SCC 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 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.

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”).

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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 2017 and 2016, the Company recorded expense of $312,000 and $489,000, 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, 2017, Tier 1 and total capital to risk-weighted assets ratios of the Bank were 11.4% and 12.4%, respectively, thus exceeding the minimum requirements. The common equity Tier 1 capital ratio and leverage ratio of the Bank were 11.4% and 9.2%, respectively, as of December 31, 2017, well above the minimum requirements. Based on management’s understanding and interpretation of the new capital rules, it believes that, as of December 31, 2017, 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.

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.

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Immediately upon becoming “undercapitalized,” a depository institution is 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, 2017.

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, which provides funding to their members for making housing loans as well as loans for affordable housing and community development lending. 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 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.

OFFICE OF FOREIGN ASSETS CONTROL. The U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) is responsible for administering and enforcing economic and trade sanctions against specified foreign parties, including countries and regimes, foreign individuals and other foreign organizations and entities. OFAC publishes lists of prohibited parties that are regularly consulted by the Company in the conduct of its business in order to assure compliance. The Company is responsible for, among other things, blocking accounts of, and transactions with, prohibited parties identified by OFAC, avoiding unlicensed trade and financial transactions with such parties and reporting blocked transactions after their occurrence. Failure to comply with OFAC requirements could have serious legal, financial and reputational consequences for the Company.

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, 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.

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CONSUMER LAWS AND REGULATIONS. The Bank is 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, 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.

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. Further, regulatory positions taken by the CFPB may influence how other regulatory agencies apply the subject consumer financial protection laws and regulations.

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.

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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. As of December 31, 2017, the Company is not aware of any instances of non-compliance with the guidance.
 
TAX REFORM. On December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act of 2017 (the “Tax Act”).  The legislation made key changes to the U.S. tax law, including the reduction of the U.S. federal corporate tax rate from 35% to 21%, effective January 1, 2018. As a result of the reduction in the U.S. corporate income tax rate from 35% to 21% under the Tax Act, the Company revalued its ending net deferred tax assets at December 31, 2017 and recognized a provisional $1.7 million tax expense in the Company’s consolidated statement of operations for the year ended December 31, 2017.  The Company is still analyzing certain aspects of the new law and refining its calculations, which could affect the measurement of these assets and liabilities or give rise to new deferred tax amounts.  The accounting is expected to be complete when the 2017 U.S. corporate income tax return is filed in 2018.

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.

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, 2017, the Company and the Bank employed 150 full-time equivalent employees.  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 the Company's secretary 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.

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ITEM 2. PROPERTIES
The Company, through its subsidiary bank, owns or leases buildings which are used in normal business operations.  The executive offices of the Company and the main office of the Bank are each located at 10 Courthouse Square, Warrenton, Virginia 20186. 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. See the Note 1 “Nature of Banking Activities and Significant Accounting Policies” and Note 9 “Commitments and Contingent Liabilities” in the “Notes to the Consolidated Financial Statements” contained in Item 8 of this Form 10-K for information with respect to the amounts at which the Company’s premises and equipment are carried and commitments under long-term leases.

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.

PART II

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 (“Nasdaq”) under the symbol “FBSS”. As of March 16, 2018, there were 3,773,603 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 16, 2018, the closing market price of the Company’s common stock was $21.75.

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.

 
 
2017
   
2016
   
Dividends per share
 
 
 
High
   
Low
   
High
   
Low
   
2017
   
2016
 
1st Quarter
 
$
19.88
   
$
16.20
   
$
15.96
   
$
14.38
   
$
0.12
   
$
0.12
 
2nd Quarter
 
$
19.60
   
$
17.62
   
$
15.75
   
$
14.47
   
$
0.12
   
$
0.12
 
3rd Quarter
 
$
20.18
   
$
17.24
   
$
14.95
   
$
14.13
   
$
0.12
   
$
0.12
 
4th Quarter
 
$
22.25
   
$
19.06
   
$
16.79
   
$
14.49
   
$
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.

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, 2018, the Board of Directors authorized the Company to repurchase up to 112,880 shares (3% of the shares of common stock outstanding on January 1, 2018) beginning January 1, 2018. During the year ended December 31, 2017, 382 shares of common stock were repurchased at an average price of $17.55 per share. No shares were repurchased during the fourth quarter of 2017.

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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.
 
 
 
For the Year Ended December 31,
 
(Dollars in thousands, except per share data)
 
2017
   
2016
   
2015
   
2014
   
2013
 
EARNINGS STATEMENT DATA:
                             
Interest income
 
$
23,320
   
$
21,574
   
$
21,694
   
$
21,935
   
$
23,045
 
Interest expense
   
2,049
     
1,843
     
1,962
     
2,564
     
3,062
 
Net interest income
   
21,271
     
19,731
     
19,732
     
19,371
     
19,983
 
Provision for (recovery of) loan losses
   
520
     
(508
)
   
8,000
     
     
1,800
 
Net interest income after provision for (recovery of) loan losses
   
20,751
     
20,239
     
11,732
     
19,371
     
18,183
 
Noninterest income
   
5,468
     
5,296
     
6,414
     
6,619
     
6,551
 
Gain on sale and call of securities
   
     
1
     
4
     
3
     
144
 
Noninterest expense
   
20,844
     
20,925
     
20,186
     
19,807
     
19,106
 
Income (loss) before income taxes
   
5,375
     
4,611
     
(2,036
)
   
6,186
     
5,772
 
Income taxes
   
2,879
     
937
     
(1,424
)
   
1,380
     
1,441
 
Net income (loss)
 
$
2,496
   
$
3,674
   
$
(612
)
 
$
4,806
   
$
4,331
 
PER SHARE DATA:
                                       
Net income (loss) per share, basic
 
$
0.66
   
$
0.98
   
$
(0.16
)
 
$
1.29
   
$
1.17
 
Net income (loss) per share, diluted
 
$
0.66
   
$
0.98
   
$
(0.16
)
 
$
1.28
   
$
1.16
 
Cash dividends
 
$
0.48
   
$
0.48
   
$
0.48
   
$
0.53
   
$
0.48
 
Average basic shares outstanding
   
3,764,690
     
3,753,757
     
3,742,725
     
3,728,316
     
3,710,802
 
Average diluted shares outstanding
   
3,773,010
     
3,763,929
     
3,742,725
     
3,747,247
     
3,727,886
 
Book value at period end
 
$
14.92
   
$
14.51
   
$
14.06
   
$
14.78
   
$
13.80
 
BALANCE SHEET DATA:
                                       
Total assets
 
$
644,613
   
$
624,445
   
$
601,400
   
$
606,286
   
$
615,774
 
Loans, net
   
497,705
     
458,608
     
442,669
     
435,070
     
444,710
 
Securities, including restricted investments
   
73,699
     
51,755
     
56,510
     
58,700
     
55,033
 
Deposits
   
570,023
     
546,157
     
524,294
     
525,215
     
540,204
 
Shareholders' equity
   
56,142
     
54,451
     
52,633
     
55,157
     
51,227
 
                                         
PERFORMANCE RATIOS:
                                       
Net interest margin(1)
   
3.66
%
   
3.50
%
   
3.62
%
   
3.55
%
   
3.64
%
Return (loss) on average assets
   
0.39
%
   
0.60
%
   
(0.10
%)
   
0.80
%
   
0.72
%
Return (loss) on average equity
   
4.44
%
   
6.82
%
   
(1.09
%)
   
8.98
%
   
8.89
%
Dividend payout
   
72.44
%
   
49.07
%
   
(293.79
%)
   
41.16
%
   
41.15
%
Efficiency ratio(2)
   
76.80
%
   
82.36
%
   
75.50
%
   
74.96
%
   
70.72
%
 
                                       
ASSET QUALITY RATIOS:
                                       
Allowance for loan losses to total loans
   
1.01
%
   
0.98
%
   
0.94
%
   
1.22
%
   
1.48
%
Allowance for loan losses to nonperforming loans
   
56.43
%
   
38.72
%
   
41.28
%
   
40.81
%
   
34.69
%
Nonperforming assets to total assets
   
1.61
%
   
2.09
%
   
1.91
%
   
2.41
%
   
4.00
%
Nonaccrual loans to total loans
   
0.63
%
   
0.76
%
   
0.41
%
   
0.28
%
   
0.48
%
Net charge-offs (recoveries) to average loans
   
(0.01
%)
   
(0.19
%)
   
2.04
%
   
0.29
%
   
0.31
%
 
                                       
CAPITAL RATIOS:
                                       
Leverage
   
9.17
%
   
9.23
%
   
9.13
%
   
9.83
%
   
9.24
%
Common equity Tier 1 capital ratio
   
11.43
%
   
12.22
%
   
11.64
%
 
NA
   
NA
 
Tier 1 capital ratio
   
11.43
%
   
12.22
%
   
11.64
%
   
14.05
%
   
13.28
%
Total capital ratio
   
12.41
%
   
13.17
%
   
12.53
%
   
15.30
%
   
14.54
%
(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 noninterest expense by the sum of fully taxable equivalent net interest income and fully taxable equivalent noninterest income.

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 the Company believes its plans, intentions and expectations reflected in these forward-looking statements are reasonable, the Company can give no assurance that these plans, intentions or expectations will be achieved. The Company's 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 the Company's 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 Company'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 the Company's allowance for loan losses, competition, demand for financial services in the Company's market area, the Company's plans to increase its market share, mergers, acquisitions and dispositions, and tax 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 of America (“GAAP”). The financial information contained within the Company's 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. The Company uses historical loss factors as one factor in determining the inherent loss that may be present in its loan portfolio. Actual losses could differ significantly from the historical factors that the Company uses in its 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 the recognition of 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 the Company's 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, nonperforming 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 twelve 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.
 
OTHER-THAN-TEMPORARY IMPAIRMENT (“OTTI”) FOR SECURITIES.  Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) the Company intends to sell the security or (ii) it is more-likely-than-not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more-likely-than-not that the Company will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no OTTI. If there is a credit loss, OTTI exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income (loss). For equity securities, impairment is considered to be other-than-temporary based on the Company's ability and intent to hold the investment until a recovery of fair value. OTTI of an equity security results in a write-down that must be included in net income. The Company regularly reviews each investment security for OTTI based on criteria that includes the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, the best estimate of the present value of cash flows expected to be collected from debt securities, the intention with regard to holding the security to maturity and the likelihood that the Company would be required to sell the security before recovery.
11

Table of Contents
 
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 the Company's 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's primary operating businesses are in commercial and retail lending, core deposit account relationships, and assets under WMS management.  The revenues of the Company are primarily derived from net interest income, 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 nonperforming 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 factored together, the uncertainty of future trends compounds. Based on management’s current projections, net interest income may increase in 2018 with the growth of average loans, but this may be offset in part or in whole by a possible contraction in the Company’s net interest margin resulting from the prolonged historically low levels in market interest rates. The Company 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.

For the year ended December 31, 2017, the Company’s return on average equity (“ROE”) and on average assets (“ROA”) were 4.44% and 0.39%, respectively, compared to 6.82% and 0.60%, respectively, for the year ended December 31, 2016.  Excluding the effect of the nonrecurring revaluation of the Company’s net deferred tax asset related to the Tax Act, for the year ended December 31, 2017, the Company’s adjusted ROE and adjusted ROA were 7.39% and 0.66%, respectively.  For reconciliation of the non-GAAP measures, refer to section “Non-GAAP Measures” included within this Item 7.

Total assets were $644.6 million on December 31, 2017 compared to $624.4 million on December 31, 2016. Net loans increased $39.1 million or 8.53% to $497.7 million on December 31, 2017 from $458.6 million on December 31, 2016. Total deposits were $570.0 million on December 31, 2017 compared to $546.2 million on December 31, 2016, respectively. Low cost transaction deposits (demand and interest checking accounts) were $361.2 million, an increase of $12.4 million from December 31, 2016.

The Company had net income of $2.5 million, or $0.66 per diluted share, in 2017 compared to $3.7 million, or $0.98 per diluted share for 2016.  Net interest margin was 3.66% for the year ended December 31, 2017 compared to 3.50% for the year ended December 31, 2016. Net interest income for the year ended December 31, 2017 increased $1.5 million to $21.3 million when compared to $19.7 million for the year ended December 31, 2016.  The decrease in net income was primarily due to the effect of the Tax Act, which was signed into law on December 22, 2017. Among other things, the Tax Act permanently lowers the federal corporate income tax rate to 21% from the maximum rate of 35% prior to the passage of the Tax Act, effective January 1, 2018. As a result of the reduction of the federal corporate income tax rate, GAAP requires companies to re-measure their deferred tax assets and deferred tax liabilities, including those accounted for in accumulated other comprehensive income, as of the date of the Tax Act’s enactment and record the corresponding effects in income tax expense.  As a result of the permanent reduction in the corporate income tax rate, the Company recognized a $1.7 million reduction in the value of its net deferred tax asset and recorded a corresponding incremental income tax expense of $1.7 million in the Company’s consolidated results of operations for the fourth quarter of 2017. 

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

 
 
Three Months Ended 2017
   
Three Months Ended 2016
 
(Dollars in thousands, except per share data)
 
December 31
   
September 30
   
June 30
   
March 31
   
December 31
   
September 30
   
June 30
   
March 31
 
Interest income
 
$
6,191
   
$
6,001
   
$
5,713
   
$
5,415
   
$
5,569
   
$
5,423
   
$
5,325
   
$
5,257
 
Interest expense
   
556
     
515
     
509
     
469
     
489
     
458
     
456
     
440
 
Net interest income
   
5,635
     
5,486
     
5,204
     
4,946
     
5,080
     
4,965
     
4,869
     
4,817
 
Provision for (recovery of) loan losses
   
125
     
110
     
235
     
50
     
     
425
     
(1,133
)
   
200
 
Net interest income after provision for (recovery of) loan losses
   
5,510
     
5,376
     
4,969
     
4,896
     
5,080
     
4,540
     
6,002
     
4,617
 
Other income
   
1,380
     
1,290
     
1,393
     
1,405
     
1,283
     
1,290
     
1,337
     
1,386
 
Gain on sale and call of securities
   
     
     
     
     
     
1
     
     
 
Other expense
   
5,288
     
4,998
     
5,150
     
5,408
     
5,357
     
5,017
     
5,215
     
5,336
 
Income before income taxes
   
1,602
     
1,668
     
1,212
     
893
     
1,006
     
814
     
2,124
     
667
 
Income tax expense
   
2,145
     
387
     
222
     
125
     
198
     
116
     
562
     
61
 
Net income (loss)
 
$
(543
)
 
$
1,281
   
$
990
   
$
768
   
$
808
   
$
698
   
$
1,562
   
$
606
 
 
                                                               
Net income (loss) per share, basic
 
$
(0.14
)
 
$
0.34
   
$
0.26
   
$
0.20
   
$
0.22
   
$
0.19
   
$
0.42
   
$
0.16
 
Net income (loss) per share, diluted
 
$
(0.14
)
 
$
0.34
   
$
0.26
   
$
0.20
   
$
0.22
   
$
0.19
   
$
0.42
   
$
0.16
 

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Table of Contents
RESULTS OF OPERATIONS

NET INTEREST INCOME AND EXPENSE

2017 COMPARED WITH 2016
Net interest income increased to $21.3 million for the year ended December 31, 2017 from $19.7 million for the same period of 2016. The net interest margin was 3.66% for the year ended December 31, 2017 compared to 3.50% for the same period in 2016.

The increase in interest income was the result of an overall increase in average earning assets from $568.9 million in 2016 to $587.7 million in 2017, a direct result of management's emphasis on growing the loan and securities portfolio and an increase in the interest rate environment during 2017.  These following factors contributed to an increase of 17 basis points (“bp”) in the average yield on assets from 3.83% in 2016 to 4.00% in 2017:
Average loans increased $18.3 million or 4.0% from $453.2 million in 2016 to $471.5 million in 2017. The tax-equivalent yield on loans increased to 4.49% in 2017 compared to 4.42% in 2016. Together, this resulted in a $1.2 million increase in interest and fee income from loans for 2017 compared with 2016.
Average securities increased $11.5 million from $52.2 million in 2016 to $63.6 million in 2017. The tax-equivalent yield on investments increased from 2.68% in 2016 to 2.86% in 2017.  Tax-equivalent interest and dividend income on securities increased $424,000 from 2016 to 2017.
Interest income on deposits at other banks increased from $338,000 in 2016 to $529,000 in 2017 due to the increase in the average yield from 0.53% in 2016 to 1.01% in 2017.

Total interest expense increased $206,000 or 11.2% from $1.84 million in 2016 to $2.05 million in 2017, resulting in the average rate on total interest-bearing liabilities increasing from 0.41% in 2016 to 0.45% in 2017, due primarily to the following:
Interest paid on deposits increased $280,000 or 21.2% from $1.3 million in 2016 to $1.6 million in 2017. Average NOW balances increased $2.8 million from 2016 to 2017 while the yield on NOW accounts increased 5 bp from 0.23% in 2016 to 0.28% in 2017, resulting in an increase in interest expense of $120,000 in 2017.  Average money market accounts decreased $851,000 from 2016 to 2017, while the yield remained at 0.21% for both respective years, resulting in relatively flat interest expense in 2017. Average savings accounts increased $2.1 million from 2016 to 2017, while the yield increased 3 bp from 0.10% in 2016 to 0.13% in 2017. Average time deposits increased $1.7 million from 2016 to 2017 while the yield increased 18 bp from 0.88% to 1.06%, resulting in an increase of $133,000 in interest expense from 2016 to 2017.
Interest expense on FHLB advances decreased $75,000 from 2016 to 2017 due to a $3.1 million decrease in average balances over the same time periods. 
The interest expense on junior subordinated debt remained relatively flat when comparing 2016 to 2017.

2016 COMPARED WITH 2015
Net interest income remained relatively flat at $19.7 million for the years 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 $121,000 or 0.56% to $21.6 million in 2016 from $21.7 million in 2015. This decrease was due to the 15 bp decrease in the average yield on assets, partially offset by the increase in total average earning assets of $18.0 million or 3.27%, 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 loans increased $1.5 million or 0.33% from $451.8 million in 2015 to $453.2 million in 2016. The tax-equivalent  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 securities decreased $5.5 million from $57.7 million in 2015 to $52.2 million in 2016. The tax-equivalent yield on securities decreased from 2.71% in 2015 to 2.68% in 2016. Together, interest and dividend income on securities 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 yield from 0.34% in 2015 to 0.53% in 2016.

Total interest expense decreased $119,000 or 6.1% from $2.0 million in 2015 to $1.8 million in 2016, resulting in a decrease in rate on total interest-bearing liabilities from 0.45% in 2015 to 0.41% 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 $1.4 million in 2015 to $1.3 million in 2016. Average NOW deposit balances increased $19.9 million from 2015 to 2016 while the yield increased from 0.21% during 2015 to 0.23% during 2016, resulting in $92,000 more interest expense in 2016. Average money market accounts increased $1.7 million from 2015 to 2016, and the yield remained at 0.21% for both respective years, resulting in $3,000 more interest expense in 2016. Average savings accounts increased $2.0 million from 2015 to 2016, and the yield on savings accounts remained at 0.10%, resulting in no interest expense change in 2016. Average time deposits decreased $6.0 million from 2015 to 2016 while the yield 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 advances decreased $1,000 due to $70,000 of amortization. 
The interest expense on junior subordinated debt increased from $199,000 in 2015 to $200,000 in 2016.

13

Table of Contents
The following table sets forth, on a tax-equivalent basis, information relating to the Company’s average balance sheet and reflects the average yield on assets and average cost of liabilities for the years ended December 31, 2017, 2016 and 2015 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.

(Dollars in thousands)
 
December 31, 2017
   
December 31, 2016
   
December 31, 2015
 
Assets
 
Average
Balances
   
Income/
Expense
   
Average
Rate
   
Average
Balances
   
Income/
Expense
   
Average
Rate
   
Average
Balances
   
Income/
Expense
   
Average
Rate
 
Loans
                                                     
Taxable
 
$
466,513
   
$
21,075
     
4.52
%
 
$
446,094
   
$
19,783
     
4.43
%
 
$
443,303
   
$
19,884
     
4.49
%
Tax-exempt (1)
   
2,068
     
108
     
5.24
%
   
4,716
     
253
     
5.36
%
   
6,007
     
338
     
5.63
%
Nonaccrual (2)
   
2,953
     
             
2,436
     
             
2,457
     
         
Total Loans
   
471,534
     
21,183
     
4.49
%
   
453,246
     
20,036
     
4.42
%
   
451,767
     
20,222
     
4.48
%
Securities
                                                                       
Taxable
   
51,824
     
1,303
     
2.52
%
   
46,501
     
1,076
     
2.32
%
   
51,722
     
1,230
     
2.38
%
Tax-exempt (1)
   
11,799
     
517
     
4.38
%
   
5,649
     
320
     
5.66
%
   
5,946
     
331
     
5.57
%
Total securities
   
63,623
     
1,820
     
2.86
%
   
52,150
     
1,396
     
2.68
%
   
57,668
     
1,561
     
2.71
%
Deposits in other banks
   
52,532
     
529
     
1.01
%
   
63,534
     
338
     
0.53
%
   
41,480
     
139
     
0.34
%
Federal funds sold
   
9
     
     
0.94
%
   
9
     
     
0.37
%
   
9
     
     
0.17
%
Total earning assets
   
587,698
     
23,532
     
4.00
%
   
568,939
     
21,770
     
3.83
%
   
550,924
     
21,922
     
3.98
%
Less: Allowance for loan losses
   
(4,534
)
                   
(4,695
)
                   
(5,730
)
               
Cash and due from banks
   
4,903
                     
4,728
                     
5,308
                 
Premises and equipment, net
   
18,979
                     
19,990
                     
20,807
                 
Other real estate owned, net
   
1,356
                     
1,384
                     
1,516
                 
Other assets
   
25,405
                     
26,447
                     
25,536
                 
Total Assets
 
$
633,807
                   
$
616,793
                   
$
598,361
                 
Liabilities & Shareholders’ Equity
                                                                       
Deposits
                                                                       
Demand
 
$
114,910
                   
$
102,403
                   
$
96,538
                 
Interest-bearing
                                                                       
NOW
   
233,963
     
655
     
0.28
%
   
231,142
     
535
     
0.23
%
   
211,273
     
443
     
0.21
%
Money market
   
53,660
     
112
     
0.21
%
   
54,511
     
115
     
0.21
%
   
52,787
     
112
     
0.21
%
Savings
   
86,806
     
115
     
0.13
%
   
84,660
     
85
     
0.10
%
   
82,626
     
85
     
0.10
%
Time
   
67,716
     
717
     
1.06
%
   
66,027
     
584
     
0.88
%
   
72,056
     
790
     
1.10
%
Total interest-bearing deposits
   
442,145
     
1,599
     
0.36
%
   
436,340
     
1,319
     
0.30
%
   
418,742
     
1,430
     
0.34
%
Federal  funds purchased
   
111
     
2
     
1.41
%
   
2
     
     
0.99
%
   
1,415
     
     
0.53
%
FHLB advances
   
9,829
     
249
     
2.54
%
   
12,971
     
324
     
2.50
%
   
13,041
     
325
     
2.49
%
Junior subordinated debt
   
4,124
     
199
     
4.83
%
   
4,124
     
200
     
4.84
%
   
4,124
     
199
     
4.83
%
Total interest-bearing liabilities
   
456,209
     
2,049
     
0.45
%
   
453,437
     
1,843
     
0.41
%
   
437,322
     
1,962
     
0.45
%
Other liabilities
   
6,467
                     
7,114
                     
8,543
                 
Shareholders' equity
   
56,221
                     
53,839
                     
55,958
                 
Total Liabilities & Shareholders' Equity
 
$
633,807
                   
$
616,793
                   
$
598,361
                 
Net interest income
           
21,483
     
3.55
%
           
19,927
     
3.42
%
           
19,960
     
3.53
%
Less: tax-equivalent adjustment
           
212
                     
196
                     
228
         
Net interest income
         
$
21,271
                   
$
19,731
                   
$
19,732
         
Interest expense as a percent of average earning assets
                   
0.35
%
                   
0.32
%
                   
0.36
%
Net interest margin
                   
3.66
%
                   
3.50
%
                   
3.62
%
(1)
Income and rates on non-taxable assets are computed on a tax-equivalent basis using a federal tax rate of 34%.
(2)
Nonaccrual loans are included in the average balance of total loans and total earning assets.

14

Table of Contents
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.

   
2017 Compared to 2016
   
2016 Compared to 2015
 
(Dollars in thousands)
 
Change
   
Due to Volume
   
Due to Rate
   
Change
   
Due to Volume
   
Due to Rate
 
Interest Income
                                   
Loans; taxable
 
$
1,292
   
$
906
   
$
386
   
$
(101
)
 
$
125
   
$
(226
)
Loans; tax-exempt (1)
   
(145
)
   
(142
)
   
(3
)
   
(85
)
   
(73
)
   
(12
)
Securities; taxable
   
227
     
123
     
104
     
(154
)
   
(124
)
   
(30
)
Securities; tax-exempt (1)
   
197
     
348
     
(151
)
   
(11
)
   
(16
)
   
5
 
Deposits in other banks
   
191
     
(59
)
   
250
     
199
     
74
     
125
 
Total Interest Income
   
1,762
     
1,176
     
586
     
(152
)
   
(14
)
   
(138
)
Interest Expense
                                               
NOW accounts
   
120
     
7
     
113
     
92
     
42
     
50
 
Money market accounts
   
(3
)
   
(2
)
   
(1
)
   
3
     
4
     
(1
)
Savings accounts
   
30
     
2
     
28
     
     
2
     
(2
)
Time deposits
   
133
     
15
     
118
     
(206
)
   
(66
)
   
(140
)
Federal funds purchased
   
2
     
     
2
     
(8
)
   
(8
)
   
 
FHLB advances
   
(75
)
   
(79
)
   
4
     
(1
)
   
(2
)
   
1
 
Junior subordinated debt
   
(1
)
   
     
(1
)
   
1
     
     
1
 
Total Interest Expense
   
206
     
(57
)
   
263
     
(119
)
   
(28
)
   
(91
)
Net Interest Income
 
$
1,556
   
$
1,233
   
$
323
   
$
(33
)
 
$
14
   
$
(47
)

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

ASSET QUALITY
GAAP requires that the impairment of loans that are 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 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.

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. Loans are placed on nonaccrual when principal or interest is delinquent for 90 days or more, unless the loans are well secured and 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. As is the case for all loans, charge-offs occur when the loan or portion of the loan is determined to be uncollectible.

Nonperforming assets, in most cases, consist of nonaccrual loans, troubled debt restructure (“TDR”) loans, other real estate owned (“OREO”), loans that are greater than 90 days past due and accruing interest, and investments that are considered OTTI. Management evaluates all loans and investments that are greater than 90 days past due, as well as borrowers that have suffered financial distress, to determine if they should be placed on nonaccrual.

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 unless the loan is identified as TDR.  In determining a TDR status, management assesses whether a borrower is experiencing financial difficulty and, if so, whether the Bank has granted a concession to the borrower by modifying the loan.  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.

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Table of Contents
The following table sets forth certain information with respect to the Company’s nonperforming assets:

 
 
At December 31,
 
(Dollars in thousands)
 
2017
   
2016
   
2015
   
2014
   
2013
 
Nonaccrual loans
 
$
3,180
   
$
3,523
   
$
1,849
   
$
1,227
   
$
2,184
 
Restructured loans still accruing
   
4,182
     
5,305
     
5,495
     
7,431
     
8,613
 
Student loans greater than 90 days past due and still accruing
   
1,616
     
2,538
     
2,814
     
4,551
     
7,917
 
Loans greater than 90 days past due and still accruing
   
49
     
321
     
     
     
506
 
Total nonperforming loans
   
9,027
     
11,687
     
10,158
     
13,209
     
19,220
 
Nonperforming corporate bond, at fair value
   
     
     
     
     
1,300
 
Other real estate owned, net
   
1,356
     
1,356
     
1,356
     
1,406
     
4,085
 
Total nonperforming assets
 
$
10,383
   
$
13,043
   
$
11,514
   
$
14,615
   
$
24,605
 
 
                                       
Allowance for loan losses to total loans
   
1.01
%
   
0.98
%
   
0.94
%
   
1.22
%
   
1.48
%
Nonaccrual loans to total loans
   
0.63
%
   
0.76
%
   
0.41
%
   
0.28
%
   
0.48
%
Allowance for loan losses to nonperforming loans
   
56.43
%
   
38.72
%
   
41.28
%
   
40.81
%
   
34.69
%
Nonperforming loans to total loans
   
1.46
%
   
2.52
%
   
2.27
%
   
3.00
%
   
4.26
%
Nonperforming assets to total assets
   
1.61
%
   
2.09
%
   
1.91
%
   
2.41
%
   
4.00
%

Nonperforming assets totaled $10.4 million or 1.61%, $13.0 million or 2.09% and $11.5 million or 1.91% of total assets at December 31, 2017, 2016 and 2015, respectively.  The ratio of allowance for loan losses as a percentage of nonperforming loans was 56.43%,  38.72% and 41.28% at December 31, 2017, 2016 and 2015, respectively.  Factors contributing to these changes are:
Nonaccrual loans were $3.2 million, $3.5 million and $1.8 million at December 31, 2017, 2016 and 2015, respectively.  The primary changes in nonaccrual loans during 2017 include the payoff of a $1.0 million, 1-4 family residential loan, the charge-off of one 1-4 family residential loan and one commercial real estate loan both totaling $615,000 that were previously on nonaccrual status at December 31, 2016, offset by the addition of $1.7 million in one commercial real estate loan and one 1-4 family residential loan totaling $1.7 million.
OREO remains at $1.36 million at December 31, 2017, consisting of one 47 acre tract of undeveloped property.
Student loans that were greater than 90 days past due and still accruing interest totaled $1.6 million, $2.5 million and $2.8 million at December 31, 2017, 2016 and 2015, respectively. These loans continue to accrue interest when past due because repayment of both principal and accrued interest are 98% guaranteed by the U.S. Department of Education.
Excluding student loans, loans that were 90 days past due and accruing interest totaled $49,000 and $321,000 at December 31, 2017 and 2016.  There were no loans, excluding student loans, that were greater than 90 days past due and accruing interest at December 31, 2015.
There are 10 loans in the portfolio totaling $5.6 million that have been identified as TDRs at December 31, 2017 compared to 12 loans at $6.9 million at December 31. 2016 and four loans at $4.2 million at December 31, 2015.  No loans were modified and identified as TDRs during 2017 and 2016.  At December 31, 2017, six of the TDR loans were current and performing in accordance with the modified terms. Three of the TDRs, totaling $1.3 million to a single borrower, were in nonaccrual status due to prior irregular payments, but were paying in accordance with a bankruptcy plan.

LOAN PORTFOLIO
At December 31, 2017, 2016 and 2015, net loans accounted for 77.2%, 73.4% and 73.6% 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.

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Table of Contents
Total loans on the balance sheet are comprised of the following classifications:

 
 
December 31,
 
(Dollars in thousands)
 
2017
   
2016
   
2015
   
2014
   
2013
 
Loans secured by real estate:
                             
Construction and land
 
$
54,162
   
$
49,777
   
$
49,855
   
$
39,085
   
$
32,807
 
Residential real estate
   
187,104
     
162,383
     
150,575
     
143,477
     
142,256
 
Home equity lines of credit
   
44,548
     
43,861
     
44,013
     
42,732
     
43,476
 
Commercial real estate
   
176,827
     
165,271
     
160,036
     
165,528
     
176,320
 
Commercial and industrial loans
   
24,413
     
25,735
     
23,705
     
26,924
     
24,746
 
Consumer
   
5,068
     
3,100
     
3,160
     
3,015
     
3,810
 
Student
   
10,677
     
13,006
     
15,518
     
19,700
     
27,962
 
Total loans
 
$
502,799
   
$
463,133
   
$
446,862
   
$
440,461
   
$
451,377
 

At December 31, 2017, no concentration of loans to commercial borrowers engaged in similar activities exceeded 10% of total loans. The largest industry concentration at December 31, 2017 was approximately $16.8 million or 3.3% 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) concentrations above 300% for permanent investor real estate loans. As of December 31, 2017, construction and land loans are $38.1 million or 59.2% of the concentration limit, while permanent investor real estate loans (by NAICS code) are $129.3 million or 200.9% of the concentration level.

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 concentrations, trends in historical loan loss experience, 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 (recovery of) loan losses on the Company’s statements of operations, are made as needed to maintain the allowance at an appropriate level based on management’s analysis. The amount of the provision is a function of the level of loans outstanding, the level and nature of impaired and nonperforming 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.

The allowance for loan losses was $5.1 million or 1.01% of total loans at December 31, 2017, compared to $4.5 million or 0.98% of total loans and $4.2 million or 0.94% of total loans at December 31, 2016 and 2015, respectively.  The provision for loan losses was  $520,000 and $8.0 million during the years ended December 31, 2017 and 2015, respectively, and a recovery of loan losses of $508,000 during 2016.  Changes in provision expense for 2017 was primarily due to portfolio growth and changes in historical loss rates, adjustments to qualitative factors based on management's ongoing analysis of economic and environmental factors, partially offset by improvements in asset quality from reductions in classified and nonaccrual loans. The recovery of loan losses during 2016 was the result of a $1.4 million recovery received on loans charged-off in previous years.  Management believes that adequate reserves existed on nonperforming loans as of December 31, 2017.

The increase in the allowance is due, in part, to the increase in impaired loans from $8.5 million at December 31, 2016 to $10.9 at December 31, 2017 and adjustments to reflect management's perception of portfolio risk based on the Company's analysis of external and internal qualitative factors of the loan portfolio.  There were 17 loans totaling $10.9 million at December 31, 2017 that were considered impaired and were allocated $912,000 of loan loss reserves. This included eight loans totaling $7.7 million that were performing and accruing interest at December 31, 2017. Additionally, there were nine loans totaling $3.2 million that were nonaccrual. 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.

The amount of the provision for loan loss for 2017, 2016 and 2015 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 nonperforming 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 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.

17

Table of Contents
The following table summarizes the Bank’s loan loss experience for each of the years presented:

 
 
Years ended December 31,
 
(Dollars in thousands)
 
2017
   
2016
   
2015
   
2014
   
2013
 
Allowance for loan losses, January 1,
 
$
4,525
   
$
4,193
   
$
5,391
   
$
6,667
   
$
6,258
 
Charged-off loans:
                                       
Secured by real estate:
                                       
Construction and land
   
     
     
17
     
313
     
 
1-4 family residential
   
51
     
36
     
167
     
172
     
284
 
Home equity lines of credit
   
     
     
50
     
91
     
174
 
Commercial real estate
   
476
     
380
     
568
     
560
     
686
 
Commercial and industrial
   
19
     
226
     
8,525
     
171
     
257
 
Student
   
31
     
36
     
50
     
139
     
 
Consumer
   
114
     
46
     
10
     
18
     
104
 
Total loans charged-off
   
691
     
724
     
9,387
     
1,464
     
1,505
 
Recoveries:
                                       
Secured by real estate:
                                       
Construction and land
   
     
     
     
65
     
 
1-4 family residential
   
6
     
     
52
     
22
     
2
 
Home equity lines of credit
   
3
     
3
     
21
     
5
     
11
 
Commercial real estate
   
575
     
24
     
     
     
 
Commercial and industrial
   
154
     
1,527
     
102
     
86
     
76
 
Student
   
     
     
     
     
 
Consumer
   
2
     
10
     
14
     
10
     
25
 
Total loans recoveries
   
740
     
1,564
     
189
     
188
     
114
 
Net charge-offs (recoveries)
   
(49
)
   
(840
)
   
9,198
     
1,276
     
1,391
 
Provision for (recovery of)  loan losses
   
520
     
(508
)
   
8,000
     
     
1,800
 
Allowance for loan losses, December 31,
 
$
5,094
   
$
4,525
   
$
4,193
   
$
5,391
   
$
6,667
 
 
                                       
Ratio of net charge-offs (recoveries) to average loans
   
(0.01
%)
   
(0.19
%)
   
2.04
%
   
0.29
%
   
0.31
%

The following table allocates the allowance for loan losses at December 31, 2017, 2016, 2015, 2014 and 2013 to each loan category. The allowance has been allocated according to the amount deemed to be reasonably necessary to provide for the possibility of losses being incurred, although the entire allowance balance is available to absorb any actual charge-offs that may occur.
 
 
 
2017
   
2016
   
2015
 
(Dollars in thousands)
 
Allowance
for Loan
Losses
   
Percentage
of Total
Loans
   
Allowance
for Loan
Losses
   
Percentage
of Total
Loans
   
Allowance
for Loan
Losses
   
Percentage
of Total
Loans
 
Secured by real estate:
                                   
Construction and land
 
$
879
     
10.77
%
 
$
661
     
10.75
%
 
$
924
     
11.16
%
1-4 family residential
   
1,174
     
37.21
%
   
943
     
35.06
%
   
886
     
33.70
%
Home equity lines of credit
   
387
     
8.86
%
   
307
     
9.47
%
   
356
     
9.85
%
Commercial real estate
   
1,609
     
35.17
%
   
1,569
     
35.69
%
   
1,162
     
35.81
%
Commercial and industrial
   
518
     
4.86
%
   
561
     
5.56
%
   
526
     
5.30
%
Student
   
72
     
2.11
%
   
76
     
2.81
%
   
117
     
3.47
%
Consumer
   
105
     
1.01
%
   
21
     
0.67
%
   
13
     
0.71
%
Unallocated
   
350
     
     
387
     
     
209
     
 
 
 
$
5,094
     
100.00
%
 
$
4,525
     
100.00
%
 
$
4,193
     
100.00
%

 
 
2014
   
2013
 
 
 
Allowance
for Loan
Losses
   
Percentage
of Total
Loans
   
Allowance
for Loan
Losses
   
Percentage
of Total
Loans
 
Secured by real estate:
                       
Construction
 
$
699
     
8.87
%
 
$
412
     
7.27
%
1-4 family residential
   
1,424
     
32.58
%
   
1,261
     
31.52
%
Home equity lines of credit
   
296
     
9.70
%
   
1,314
     
9.63
%
Commercial real estate
   
1,943
     
37.58
%
   
2,320
     
39.06
%
Commercial and industrial
   
516
     
6.11
%
   
964
     
5.48
%
Student
   
72
     
4.47
%
   
196
     
6.20
%
Consumer
   
37
     
0.69
%
   
18
     
0.84
%
Unallocated
   
404
     
     
182
     
 
 
 
$
5,391
     
100.00
%
 
$
6,667
     
100.00
%

18

Table of Contents
NONINTEREST INCOME

2017 COMPARED WITH 2016
Total noninterest income increased by $171,000 or 3.2% from $5.30 million in 2016 to $5.47 million in 2017.  The following are the primary components of noninterest income:
Trust and estate income increased $119,000 or 8.4% from 2016 to 2017.
Brokerage income decreased $14,000 or 7.6% from 2016 to 2017.
Service charges on deposit accounts decreased $182,000 or 8.6% to $1.9 million for 2017, compared with $2.1 million for 2016. The reason for the change may be linked to the continued growth in mobile banking usage, combined with improved personal cash flow as economic conditions continue to improve.
ATM fee income, net, totaled $1.3 million and $1.1 million for 2017 and 2016, respectively.
Bank-owned life insurance (“BOLI”) income was $362,000 in 2017, relatively unchanged from 2016.
Other service charges, commissions and fees decreased $68,000 or 18.5% from $367,000 in 2016 to $299,000 in 2017.
The recognition of passive losses within community development tax credit investments was $126,000 in 2017 compared with $267,000 in 2016, a $141,000 decrease. These passive losses will be more than offset in future periods by federal tax credits related to low/moderate income housing and/or buildings of historical significance.

2016 COMPARED WITH 2015
Total noninterest income decreased by $1.1 million or 17.5% from $6.4 million in 2015 to $5.3 million in 2016.  The following are the primary components of noninterest income:
Trust and estate income decreased $530,000 or 27.3% from 2015 to 2016, primarily due to the decline in production from the loss of personnel.
Brokerage income decreased $65,000 primarily due to the loss of personnel, as well as a shift from transaction based fees to assets under management.
Service charges on deposit accounts decreased $228,000 or 9.8% to $2.1 million in 2016, compared to $2.3 million in 2015. This decrease is attributable to growth in mobile banking combined with improved personal cash flow as economic conditions continue to improve.
ATM income, net, totaled $1.1 million and $1.2 million in 2016 and 2015, respectively.  This decline is associated with increased expense required for the production and issuance of chip enabled quipped debit cards.
BOLI income decreased from $796,000 in 2015 to $361,000 in 2016. Approximately $433,000 of BOLI income was in tax-free death benefits in excess of surrender value in 2015.
Other service charges, commissions and fees increased $13,000 or 3.7% to $367,000 from $354,000.
The recognition of passive losses within community development tax credit investments decreased $215,000.

NONINTEREST EXPENSE

2017 COMPARED WITH 2016
Total noninterest expense decreased $81,000 or 0.4% in 2017 compared with 2016. The primary components of noninterest expense are:
Salary and benefit expenses increased $323,000, or 3.0% in 2017 compared with 2016, primarily reflecting the increase in salary expense, merit salary increases, incentive pay and production based commissions.  The Company expects personnel costs, consisting primarily of salary and benefits, to continue to be its largest noninterest expense.
Net occupancy expense remained relatively unchanged from 2016 to 2017.  Furniture and equipment decreased $97,000 as a result of improved management of expenses for the period.
Marketing expense decreased $58,000 or 10.9% from 2016 to 2017 reflecting expense reductions to various areas such as advertising, promotional items and business development overhead.
Consulting expense, which includes legal and auditing fees, decreased $140,000 or 11.7% in 2017 compared with 2016.  This decline was primarily related to reduced expenses for troubled loan workouts in 2017 compared with 2016.
Data processing expense remained relatively unchanged from 2016 to 2017.  The Company outsources most of its data processing to third-party vendors.
The FDIC deposit insurance expense decreased $177,000 or 36.2% from $489,000 in 2016 to $312,000 for 2017, primarily due to the recent changes to the assessment calculations.
Other operating expenses increased $71,000 or 2.3% from 2016 to 2017. This was primarily due to operating expenses related to the Company's newly established business line for the origination and sale of mortgage loans on the secondary market.

2016 COMPARED WITH 2015
Total noninterest expense increased $739,000 or 3.7% in 2016 compared to 2015. The primary components of noninterest expense are:
Salary and benefit expenses increased $796,000, or 8.0%, primarily reflecting the increase in salary expense, merit salary increases and incentive pay.
Net occupancy expense increased $2,000 or 0.1%, and furniture and equipment expense increased $14,000 or 1.1%, from 2015 to 2016.
Marketing expense decreased $90,000 or 14.4% from 2015 to 2016 reflecting expense reductions to various areas such as advertising, promotional items and business development overhead.
Legal, audit and consulting expense increased $24,000 or 2.0% in 2016 compared with 2015.  An increase of $179,000 for continued legal expenses for troubled loan workouts in 2016 compared with 2015 was mostly offset by a decrease of $136,000 in consulting expenses during the same time period. The decrease in consulting expense was due to reduced expenses related to the chief executive officer succession planning in 2016 compared to 2015.
Data processing expense decreased $55,000 or 4.2% in 2016 compared with 2015 due to management’s expense reduction initiative.
The FDIC deposit insurance expense increased $103,000 or 26.7% from $386,000 for 2015 to $489,000 for 2016, primarily due to the  carryforward impact of 2015 charge-offs and their weight in FDIC assessment calculations.
Other operating expenses decreased $70,000 or 2.2% from 2015 to 2016. This was primarily due to a $124,000 decrease in non-loan charge-offs, with the largest portion related to debit card fraud. Retail debit/credit data breaches that plagued 2015 were infrequent during 2016, leading to less expense.

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INCOME TAXES
The provision for income taxes is based upon the results of operations, adjusted for the effect of certain tax-exempt income and non-deductible expenses. In addition, certain items of income and expense are reported in different periods for financial reporting and tax return purposes. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit. Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the applicable enacted marginal tax rate.

On December 22, 2017, the Tax Act was signed into law. Among other things, the Tax Act permanently reduced the corporate tax rate to 21% from the prior maximum rate of 35%, effective for tax years including or commencing January 1, 2018. As a result of the reduction of the corporate tax rate to 21%, companies were required to revalue their deferred tax assets and liabilities as of the date of enactment, with resulting tax effects accounted for in the fourth quarter of 2017. The Company continues to evaluate the impact on its 2017 tax expense of the revaluation required by the lower corporate tax rate implemented by the Tax Act, which management has estimated to be approximately $1.7 million. During the fourth quarter of 2017, the Company recorded $1.7 million in additional tax expense based on the Company's preliminary analysis of the impact of the Tax Act. The Company's preliminary estimate of the impact of the Tax Act is based on currently available information and interpretation of its provisions. The actual results may differ from the current estimate due to, among other things, further guidance that may be issued by U.S. tax authorities or regulatory bodies and/or changes in interpretations and assumptions that the Company has preliminarily made. The Company's evaluation of the impact of the Tax Act is subject to refinement for up to one year after enactment per the guidance under ASC 740, Accounting for Income Taxes, and Staff Accounting Bulletin No. 118.

The income tax expense was $2.9 million for the year ended December 31, 2017 compared with an income tax expense of $937,000 for the year ended December 31, 2016 and an income tax benefit of $1.4 million for the year ended December 31, 2015. The effective tax rate was 53.6% for 2017, as compared to 20.3% for 2016, and a tax rate benefit of 69.9% for 2015. The increase in the effective tax rate in 2017 compared to prior years was primarily related to the impact of the Tax Act.

COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2017 AND DECEMBER 31, 2016

ASSETS
Total assets were $644.6 million at December 31, 2017, an increase of 3.2% or $20.2 million from $624.4 million at December 31, 2016. Balance sheet categories reflecting significant changes in assets were:
Interest-bearing deposits in other banks decreased from $62.3 million at December 31, 2016 to $23.4 million at December 31, 2017. The decrease in interest-bearing deposits in other banks was primarily the result of lower deposits at the Federal Reserve Bank of Richmond due to excess funds being deployed to fund loan and securities growth.
Securities available for sale were $72.2 million at December 31, 2017, reflecting an increase of $22.32 million from $50.0 million at December 31, 2016.  See Note 2 “Securities” of the Notes to Consolidated Financial Statements for further discussion on the Company’s investment securities.