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Section 1: 10-K (10-K)

fbss-10k_20181231.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

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

 

For the fiscal year ended December 31, 2018

 

or

 

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

For the transition period from                to             

 

Commission File 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 every Interactive Data File required to be submitted 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 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

o

 

 

Accelerated filer

Non-accelerated filer

o

 

 

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 nonaffiliates of the registrant at June 30, 2018, was $76.6 million. The registrant had 3,785,454 shares of common stock outstanding as of March 11, 2019.

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement for the 2019 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

10

 

 

 

 

 

Item 1B.

Unresolved Staff Comments

16

 

 

 

 

 

Item 2.

Properties

16

 

 

 

 

 

Item 3.

Legal Proceedings

17

 

 

 

 

 

Item 4.

Mine Safety Disclosures

17

 

 

 

 

PART II

 

 

 

 

 

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

18

 

 

 

 

 

Item 6.

Selected Financial Data

19

 

 

 

 

 

Item 7.

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

20

 

 

 

 

 

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

34

 

 

 

 

 

Item 8.

Financial Statements and Supplementary Data

34

 

 

 

 

 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

73

 

 

 

 

 

Item 9A.

Controls and Procedures

73

 

 

 

 

 

Item 9B.

Other Information

73

 

 

 

 

PART III

 

 

 

 

 

 

 

Item 10

Directors, Executive Officers and Corporate Governance

74

 

 

 

 

 

Item 11.

Executive Compensation

74

 

 

 

 

 

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

74

 

 

 

 

 

Item 13.

Certain Relationships and Related Transactions, and Director Independence

74

 

 

 

 

 

Item 14.

Principal Accounting Fees and Services

74

 

 

 

 

PART IV

 

 

 

 

 

 

 

Item 15.

Exhibits, Financial Statement Schedules

75

 

 

 

 

 

Item 16.

10-K Summary

76

 

 

 

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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 full range of financial services, including internet banking, mobile banking, commercial, retail, insurance, wealth management, and financial planning services through eleven banking offices throughout Fauquier and Prince William counties in Virginia.

 

The Bank provides retail banking services to individuals and businesses. These services include various types of interest and noninterest-bearing checking accounts, money market and savings accounts, and time deposits.  In addition, the Bank provides secured and unsecured commercial and real estate loans, standby letters of credit, secured and unsecured lines of credit, personal loans, residential mortgages and home equity loans, automobile and other types of consumer financing.

 

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 offers a full range of 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, and Bankers Title Shenandoah, LLC, a title insurance company which are owned by a consortium of Virginia community banks.  Fauquier Bank Services, Inc. also, previously had an equity ownership interest in Infinex Investments, Inc., a full service broker/dealer, owned by banks and banking associations in various states, whose ownership was sold by Fauquier Bank Services, Inc. in January 2019.

 

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 securities.  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 and WMS related services. 

 

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 majority of the Bank’s loans are made on a secured basis. 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, subprime 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 loan portfolio includes the following segments: commercial and industrial loans, commercial real estate loans, construction and land loans, consumer and student loans, residential real estate loans and home equity lines of credit.  

 

COMMERCIAL AND INDUSTRIAL LOANS

The Bank’s commercial loans include loans for working capital, equipment purchases, and various other business purposes. Business assets are the primary collateral for the Bank’s commercial loan portfolio.  Commercial loans have variable or fixed rates of interest.

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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 based on 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 and changes in economic and industry conditions.  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, including the debtors’ cash flow as the source of repayment and secondarily 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.

 

COMMERCIAL REAL ESTATE LOANS

Loans secured by commercial real estate consist principally of commercial loans for which real estate constitutes the primary source of collateral. 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.

 

CONSTRUCTION AND LAND LOANS

The majority of the Bank’s construction and land loans are made to individuals to construct a primary residence. Such loans have a maximum term of twelve months, a fixed rate of interest, and loan-to-value ratios of 80% or less of the appraised value upon completion. The Bank requires that permanent financing, with the Bank or some other lender, be in place prior to closing any construction loan. Construction loans are generally considered to involve a higher degree of credit risk than single-family residential mortgage loans. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion. The Bank also provides construction loans and lines of credit to developers. Such loans generally have maximum loan-to-value ratios of 80% of the appraised value upon completion. The loans are made with a fixed rate of interest. The majority of these 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.

 

CONSUMER AND STUDENT LOANS

The Bank’s consumer loans include loans to individuals such as auto loans, credit card loans and overdraft loans. The Bank also has U.S. Government guaranteed student loans, which were purchased through and serviced by a third-party and have a variable rate of interest.

 

RESIDENTIAL REAL ESTATE LOANS

The Bank’s 1-4 family residential real estate loan portfolio primarily consists of conventional loans, generally with fixed interest rates with 15 or 30-year terms, and balloon loans with fixed interest rates, and 3, 5, 7, or 10 year maturities utilizing amortization schedules of 30 years or less. The majority of the Bank’s 1-4 family residential mortgage loans are secured by properties located in the Bank’s market area.

 

HOME EQUITY LINES OF CREDIT

The Bank’s home equity lines of credit consist of conventional loans, generally with variable interest rates that are tied to the Wall Street Journal prime rate with 10 year terms. 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.

 

DEPOSIT ACTIVITIES

Deposits are the major source of the Bank’s funds for lending and other investment activities. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the Federal Deposit Insurance Corporation (“FDIC”).  The Bank considers its interest and noninterest-bearing checking accounts, savings and money market accounts, and nonbrokered time deposits under $100,000 to be core deposits.  Generally, the Bank attempts to maintain the rates paid on its deposits at a competitive level.  The Bank 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.  

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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, and mutual funds. 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 restricted investments include holdings of FHLB stock and stock of the Federal Reserve Bank of Richmond (the “Reserve Bank”).  

 

GOVERNMENT SUPERVISION AND REGULATION

Bank holding companies and banks are extensively regulated under both federal and state law. The following summary 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 Board of Governors of the Federal Reserve System (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 (“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 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 and is a member of the Federal Reserve System.  The Bank is subject to comprehensive regulation, examination and supervision by the Federal Reserve and the Virginia State Corporation Commission (“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 FDIC insures the deposits of the Bank’s customers to the maximum extent provided by law and, as a result, the Bank is also subject to regulation by the FDIC.  The Bank’s regulators have 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.

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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. Each of the Bank’s depository accounts is insured by the FDIC against loss to the depositor to the maximum extent permitted by applicable law, and federal law and regulatory policy impose a number of obligations and restrictions on the Company and the Bank to reduce potential loss exposure to depositors and to the DIF.  The deposit insurance assessment is based on average total assets minus average tangible equity, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

 

The FDIC utilizes a “financial ratios method” based on the 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 reflect 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.

 

During 2016, the FDIC raised the DIF’s minimum reserve ratio from 1.15% to 1.35%, as required by the Dodd-Frank Act.  The FDIC imposed a 4.5 basis point annual surcharge on insured depository institutions with total consolidated assets of $10 billion or more. The rule granted credits to smaller banks, such as the Bank, for the portion of their regular assessments that contribute to increasing the reserve ratio from 1.15% to 1.35%.  The minimum reserve ratio reached 1.35% in the third quarter of 2018.  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.  Federal bank regulators have issued substantially similar guidelines requiring banks and bank holding companies to maintain capital at certain levels.  In addition, regulators may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth.  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 condition and results of operations.

 

The Federal Reserve and the FDIC have adopted rules to implement the Basel III capital framework as outlined by the Basel Committee on Banking Supervision (the “Basel Committee”) and certain provisions of the Dodd-Frank Act (the “Basel III Capital Rules”). For the purposes of the Basel III Capital Rules, (i) common equity tier 1 capital consists principally of common stock (including surplus) and retained earnings; (ii) Tier 1 capital consists principally of common equity Tier 1 capital plus noncumulative preferred stock and related surplus, and certain grandfathered cumulative preferred stocks and trust preferred securities; and (iii) Tier 2 capital consists principally of Tier 1 capital plus qualifying subordinated debt and preferred stock, and limited amounts of an institution’s allowance for loan losses.  Each regulatory capital classification is subject to certain adjustments and limitations, as implemented by the Basel III Capital Rules.  The Basel III Capital Rules also establish risk weightings that are applied to many classes of assets held by community banks, including applying higher risk weightings to certain commercial real estate loans.

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The Basel III Capital Rules require banks and bank holding companies to comply with the following minimum capital ratios: (i) a ratio of common equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7%); (ii) a ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum Tier 1 capital ratio of 8.5%); (iii) a ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum total capital ratio of 10.5%); and (iv) a leverage ratio of 4%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).  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 it was fully implemented at 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress.  Banking organizations with a ratio of common equity Tier 1 capital to risk-weighted assets above the minimum but below the conservation buffer face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall.

 

In December 2017, the Basel Committee published standards that it described as the finalization of the Basel III post-crisis regulatory reforms (the standards are commonly referred to as “Basel IV”).  Among other things, these standards revise the standardized approach for credit risk (including by recalibrating risk weights and introducing new capital requirements for certain “unconditionally cancellable commitments,” such as unused credit card lines of credit) and provide a new standardized approach for operational risk capital.  Under the proposed framework, these standards will generally be effective on January 1, 2022, with an aggregate output floor phasing-in through January 1, 2027.  Under the current capital rules, operational risk capital requirements and a capital floor apply only to advanced approaches institutions, and not to the Company.  The impact of Basel IV on the Company and the Bank will depend on the manner in which it is implemented by the federal bank regulatory agencies.

 

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 (the “SBHC Policy Statement”). On August 28, 2018, the Federal Reserve issued an interim final rule required by the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018, which was signed into law on May 24, 2018 (the “EGRRCPA”), that expands the applicability of the SBHC Policy Statement to bank holding companies with total consolidated assets of less than $3 billion (up from the prior $1 billion threshold).  Under the SBHC Policy Statement, qualifying bank holding companies, such as the Company, have additional flexibility in the amount of debt they can issue and are also exempt from the Basel III Capital Rules.  The SBHC Policy Statement does not apply to the Bank and the Bank must comply with the Basel III Capital Rules.  The Bank must also comply with the capital requirements set forth in the “prompt corrective action” regulations pursuant to Section 38 of the Federal Deposit Insurance Act, as described below.

 

On November 21, 2018, the federal bank regulators jointly issued a proposed rule required by the EGRRCPA that would permit qualifying banks and bank holding companies that have less than $10 billion in consolidated assets to elect to be subject to a 9% leverage ratio that would be applied using less complex leverage calculations (commonly referred to as the community bank leverage ratio or “CBLR”). Under the proposed rule, banks and bank holding companies that opt into the CBLR framework and maintain a CBLR of greater than 9% would not be subject to other risk-based and leverage capital requirements under the Basel III Capital Rules and would be deemed to have met the well capitalized ratio requirements under the “prompt corrective action” framework.  The rule is in proposed form so the content and scope of the final rule, and its impact on the Company and the Bank (if any), cannot be determined.

 

PROMPT CORRECTIVE ACTION. Federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” These terms are defined under uniform regulations issued by each of the federal banking agencies regulating these institutions. An insured depository institution which is less than adequately capitalized must adopt an acceptable capital restoration plan, is subject to increased regulatory oversight and is increasingly restricted in the scope of its permissible activities.

 

To be well capitalized under these regulations, a bank must have the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of at least 6.5%; (ii) a Tier 1 capital to risk-weighted assets ratio of at least 8.0%; (iii) a total capital to risk-weighted assets ratio of at least 10.0%; and (iv) a leverage ratio of at least 5.0%.  As of December 31, 2018, the Bank was considered “well capitalized.”

 

As described above, on November 21, 2018, the federal bank regulators jointly issued a proposed rule required by the EGRRCPA that would permit qualifying banks and bank holding companies that have less than $10 billion in consolidated assets elect to opt into the CBLR framework.  Banks opting into the CBLR framework and maintaining a CBLR of greater than 9% would be deemed to have met the well capitalized ratio requirements under the “prompt corrective action” framework.  The rule is in proposed form so the content and scope of the final rule, and its impact on the Company and the Bank (if any), cannot be determined.

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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 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.

 

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.

 

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The Dodd-Frank Act centralized responsibility for consumer financial protection by creating 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. 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.

 

ABILITY-TO-REPAY AND QUALIFIED MORTGAGE RULE. The Dodd-Frank Act authorized the CFPB to establish certain minimum standards for the origination of residential mortgages, including a determination of the borrower's ability-to-repay, and allows borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the Dodd-Frank Act and CFPB regulations. 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.

 

LOANS TO INSIDERS. The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks. Specifically, 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. Loans exceeding these amounts are prohibited, 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). Loans to directors, executive officers and principal shareholders are required to be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.

 

CYBERSECURITY. Federal banking agencies have adopted guidelines for establishing information security standards and cybersecurity programs for implementing safeguards under the supervision of a financial institution’s board of directors. These guidelines, along with related regulatory materials, increasingly focus on risk management and processes related to information technology and the use of third parties in the provision of financial products and services. The federal banking agencies expect financial institutions to establish lines of defense and ensure that their risk management processes also address the risk posed by compromised customer credentials, and also expect financial institutions to maintain sufficient business continuity planning processes to ensure rapid recovery, resumption and maintenance of the institution’s operations after a cyber-attack. If the financial institution fails to meet the expectations set forth in this regulatory guidance, the institution could be subject to various regulatory actions, including financial penalties, and any remediation efforts may require significant resources.

 

INCENTIVE COMPENSATION. Federal bank regulatory agencies issued regulatory guidance intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Bank, that are not “large, complex banking organizations.” The findings will be included in reports of examination, and deficiencies will be incorporated into the organization’s supervisory ratings. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies. As of December 31, 2018, the Company is not aware of any instances of noncompliance with the guidance.

 

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

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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, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking companies, financial technology 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 nonbank 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 financial institutions tend to compete primarily on price and personal service.

 

EMPLOYEES

As of December 31, 2018, the Company and the Bank employed approximately 142 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 .  The Company’s website is https://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.

 


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ITEM 1A. RISK FACTORS

 

The Company is subject to interest rate risk and fluctuations in interest rates may negatively affect its financial performance.

The Company’s profitability depends, in part, on its net interest margin, which is the difference between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits and borrowings divided by total interest-earning assets. Changes in interest rates will affect the Company’s net interest margin in diverse ways, including the pricing of loans and deposits, the levels of prepayments and asset quality. The Company is unable to predict actual fluctuations of market interest rates because many factors influencing interest rates are beyond the Company’s control. Management believes that the Company’s current interest rate exposure is manageable and does not indicate any significant exposure to interest rate changes.  Based on modest increases in the federal funds rates in 2018, as initiated by the Federal Open Market Committee, the Company expects continued pressure on its net interest margin due to continued low market rates and intense competition for loans and deposits from both local and national financial institutions.  Continued pressure on net interest margin could adversely affect the Company’s results of operations.

 

The Company’s business is subject to various lending and other economic risks that could adversely affect its results of operations and financial condition.

The Company’s business is directly affected by general economic and market conditions; broad trends in industry and finance; legislative and regulatory changes; changes in governmental monetary and fiscal policies; and inflation, all of which are beyond the Company’s control. A deterioration in economic conditions, in particular a prolonged economic slowdown within the Company’s geographic region, could result in the following consequences which could adversely affect the Company’s business: an increase in loan delinquencies; an increase in problem assets and foreclosures; a decline in demand for products and services; and a deterioration in the value of collateral for loans.  

 

Adverse changes in economic conditions in the Company’s market areas or adverse conditions in industries on which such markets are dependent could adversely affect the Company’s results of operations and financial condition.

The Company provides full service banking and other financial services in Fauquier and Prince William counties in Virginia. The Company’s loan and deposit activities are directly affected by economic conditions within these markets, as well as conditions in the industries on which those markets are economically dependent. A deterioration in local economic conditions or in the condition of an industry on which a local market depends could adversely affect such factors as unemployment rates, business formations and expansions and housing market conditions. Adverse developments in any of these factors could result in, among other things, a decline in loan demand, a reduction in the number of creditworthy borrowers seeking loans, an increase in delinquencies, defaults and foreclosures, an increase in classified and nonaccrual loans, a decrease in the value of loan collateral, and a decline in the financial condition of borrowers and guarantors, any of which could adversely affect the Company’s financial condition or operations.

 

The Company’s focus on lending to small to mid-sized community-based businesses may increase its credit risk.

Most of the Company’s commercial business and commercial real estate loans are made to small business or middle market customers.  These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and have a heightened vulnerability to economic conditions.  Additionally, these loans may increase concentration risk as to industry or collateral securing the loans.  If general economic conditions in the market areas in which the Company operates negatively impact this important customer sector, the Company’s results of operations and financial condition may be adversely affected.  Moreover, a portion of these loans have been made by the Company in recent years and the borrowers may not have experienced a complete business or economic cycle.  The deterioration of the borrowers’ businesses may hinder their ability to repay their loans with the Company, which could have a material adverse effect on the Company’s financial condition and results of operations.

 

The Company’s risk management framework may not be effective in mitigating risk and loss.

The Company maintains an enterprise risk management program that is designed to identify, quantify, monitor, report and control the risks it faces. These risks include, but are not limited to, interest rate, credit, liquidity, operational, reputation, legal, compliance, economic and litigation risk. Although the risk management program is assessed on an ongoing basis, the Company gives no assurance that the risk management framework and related controls will effectively mitigate the risks listed above or limit losses that may occur. If the Company’s risk management program or controls do not function effectively, the Company’s results of operations or financial condition may be adversely affected.

 

Competition from other financial institutions and financial intermediaries may adversely affect the Company’s profitability.

The Company faces competition in originating loans and in attracting deposits principally from other banks, mortgage banking companies, consumer finance companies, savings associations, credit unions, brokerage firms, insurance companies, financial technology companies and other institutional lenders and purchasers of loans. Additionally, banks and other financial institutions with larger capitalization and

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financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger clients. These institutions may be able to offer the same loan products and services that the Company offers at more competitive rates and prices. Increased competition could require the Company to increase the rates paid on deposits or lower the rates offered on loans, which could adversely affect profitability.

 

The Bank may be required to transition from the use of the London Interbank Offered Rate (“LIBOR”) index in the future.

The Bank has certain loans indexed to LIBOR to calculate the loan interest rate. The continued availability of the LIBOR index is not guaranteed after 2021. It is impossible to predict whether and to what extent banks will continue to provide LIBOR submissions to the administrator of LIBOR or whether any additional reforms to LIBOR may be enacted. At this time, no consensus exists as to what rate or rates may become acceptable alternatives to LIBOR. The implementation of a substitute index or indices for the calculation of interest rates under the Bank’s loan agreements with borrowers may cause the Bank to incur significant expenses in effecting the transition, may result in reduced loan balances if borrowers do not accept the substitute index or indices, and may result in disputes or litigation with customers over the appropriateness or comparability to LIBOR of the substitute index or indices, which could have a material adverse effect on the Bank’s results of operations.

 

Weakness in the secondary residential mortgage loan markets will adversely affect noninterest income.

One of the components of the Company’s strategic plan is to generate noninterest income from loans originated for sale into the secondary market.  Interest rates, low housing inventory, cash buyers, new mortgage lending regulations and other market conditions could have an adverse effect on loan originations across the industry which would reduce our noninterest income.

 

The Company’s credit standards and on-going credit assessment processes might not protect it from significant credit losses.

The Company takes credit risk by virtue of making loans and extending loan commitments and letters of credit. Credit risk is managed through a program of underwriting standards, the review of certain credit decisions and an ongoing process of assessment of the quality of the credit already extended. In addition, the Company’s credit administration function employs risk management techniques intended to promptly identify problem loans. While these procedures are designed to provide the Company with the information needed to implement policy adjustments where necessary and to take appropriate corrective actions, there can be no assurance that such measures will be effective in avoiding future undue credit risk, and credit losses may occur in the future.

 

If the Company’s allowance for loan losses becomes inadequate, results of operations may be adversely affected.

Making loans is an essential element of the Company’s business. The risk of nonpayment is affected by a number of factors, including but not limited to: the duration of the credit; credit risks of a particular customer; changes in economic and industry conditions; and, in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral. Although the Company seeks to mitigate risks inherent in lending by adhering to specific underwriting practices, loans may not be repaid. The Company attempts to maintain an appropriate allowance for loan losses to provide for losses in the loan portfolio. The allowance for loan losses is determined by analyzing numerous factors about the loan portfolio including historical loan losses for relevant periods of time, current trends in delinquencies and charge-offs, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, changes in the size and composition of the loan portfolio and industry information. Also included are qualitative considerations with respect to the effect of potential economic events, the outcomes of which are uncertain.

 

Because any estimate of loan losses is subjective and the accuracy depends on the outcome of future events, charge-offs in future periods may exceed the allowance for loan losses and additional increases in the allowance for loan losses may be required. Additions to the allowance for loan losses would result in a decrease of profitability. Although management believes the allowance for loan losses is adequate to absorb losses that are inherent in the loan portfolio, the Company cannot predict such losses or that the allowance will be adequate in the future.

 

The Financial Accounting Standards Board (“FASB”) has adopted a new accounting standard that will be effective for the Company for the fiscal year beginning January 1, 2020. This standard, referred to as Current Expected Credit Loss (“CECL”) will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit loss in its allowance for loan losses. This will change the current method of providing an allowance for loan losses that are inherent in the loan portfolio, which may require an increase in the allowance for loan losses, and to greatly increase the types of data needed to collect and review to determine the appropriate level of the allowance for loan losses. The Company has established a committee that is in the process of gathering historical data and evaluating appropriate portfolio segmentation and modeling methods. Any increase in the Company’s allowance for loan losses or expenses incurred to determine the appropriate level of the allowance for loan losses may have a material adverse effect on the Company’s financial condition and results of operations.

 

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Nonperforming assets take significant time to resolve and adversely affect the Company’s results of operations and financial condition.

Nonperforming assets adversely affect net income in various ways. The Company does not record interest income on nonaccruing loans, which adversely affects income and increases credit administration costs. When the Company receives collateral through foreclosures and similar proceedings, it is required to mark the related loan to the then fair market value of the collateral less estimated selling costs, which may result in a loss. An increased level of nonperforming assets also increases the Company’s risk profile and may impact the capital levels regulators believe are appropriate in light of such risks. The Company utilizes various techniques such as workouts, restructurings and loan sales to manage problem assets. Increases in, or negative adjustments in, the value of these problem assets, the underlying collateral, or in the borrowers’ performance or financial condition, could adversely affect the Company’s business, results of operations and financial condition. In addition, the resolution of nonperforming assets requires significant commitments of time from management and staff, which can be detrimental to the performance of their other responsibilities, including generation of new loans. There can be no assurance that the Company will avoid increases in nonperforming loans in the future.

 

The Company’s real estate lending business can result in increased costs associated with other real estate owned (“OREO”).  

Because the Company originates loans secured by real estate, the Company may have to foreclose on the collateral property and may thereafter own and operate such property.  The amount that may be realized after a default is dependent upon factors outside of the Company’s control, including, but not limited to, general or local economic conditions, environmental cleanup liability, neighborhood values, interest rates, real estate tax rates, operating expenses of the mortgaged properties, and supply of and demand for properties. Certain expenditures associated with the ownership of income-producing real estate, principally real estate taxes and maintenance costs, may adversely affect the net cash flows generated by the real estate. Therefore, the cost of operating income-producing real property may exceed the rental income earned from such property, and the Company may have to advance funds in order to protect its investment or may be required to dispose of the real property at a loss.

 

The Company’s deposit insurance premiums could increase in the future, which may adversely affect future financial performance.

The FDIC insures deposits at FDIC insured financial institutions, including the Bank.  The FDIC charges insured financial institutions premiums to maintain the DIF at a certain level.  Economic conditions that began with the financial crisis of 2008 increased the rate of bank failures through 2014, requiring the FDIC to make payments for insured deposits from the DIF and prepare for future payments from the DIF.  A depository institution’s deposit insurance assessment is calculated based on the institution’s total assets less tangible equity, rather than the previous base of total deposits.  The Bank’s FDIC insurance premiums could increase in future periods if the Bank’s asset size increases, if the FDIC raises base assessment rates, or if the FDIC takes other actions to replenish the DIF.

 

The Company relies on deposits obtained from customers in the Company’s market area to provide liquidity and to support growth.

The Company’s business strategies are based on access to funding from local customer deposits. Deposit levels may be affected by a number of factors, including interest rates paid by competitors, general interest rate levels, returns available to customers on alternative investments and general economic conditions. If deposit levels fall, the Company could lose a relatively low-cost source of funding and interest expense would likely increase as alternative funding to replace lost deposits may be necessary. If local customer deposits are not sufficient to fund the Company’s normal operations and growth, the Company will look to outside sources, such as borrowings from the FHLB, which is a secured funding source. The Company’s ability to access borrowings from the FHLB will be dependent upon whether and the extent to which collateral to secure FHLB borrowings can be provided. The Company may also look to federal funds purchased and brokered deposits, although the use of brokered deposits may be limited or discouraged by banking regulators.  The Company may also seek to raise funds through the issuance of shares of its common stock, or other equity or equity-related securities, or debt securities including subordinated notes as additional sources of liquidity. If the Company is unable to access funding sufficient to support business operations and growth strategies or is only able to access such funding on unattractive terms, the Company may not be able to implement its business strategies which may negatively affect financial performance.

 

The Company is subject to security and operational risks relating to the use of technology that could damage the Company’s reputation.

In the ordinary course of business, the Company collects and stores sensitive data, including proprietary business information and personally identifiable information of customers and employees, in systems and on networks. The secure processing, maintenance and use of this information is critical to operations and the Company’s business strategy. The Company has invested in information security technologies and continually reviews processes and practices that are designed to protect its networks, computers and data from damage or unauthorized access. Despite these security measures, computer systems and infrastructures may be vulnerable to attacks by hackers or breaches due to employee error, malfeasance or other disruptions. Security breaches, including cyber incidents and hacking events, have

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been experienced by several of the world’s largest financial institutions that utilize sophisticated security tools to prevent such breaches, incidents and events.  Any security breach could result in exposure to possible liability and reputational damage. The Company places reliance on standard security systems and procedures to provide the security and authentication necessary to effect secure collection, transmission and storage of sensitive data. These systems and procedures include but are not limited to (i) regular penetration testing of the network perimeter, (ii) regular employee training programs on sound security practices, (iii) deployment of tools to monitor the network including intrusion/exfiltration prevention and detection systems, electronic mail spam filters, anti-virus and anti-malware, resource logging and patch management, (iv) multifactor authentication for customers, where applicable, and (v) enforcement of security policies and procedures for the additions and maintenance of user access and rights to resources.

 

While most of the Company’s core data processing is conducted internally, certain key applications are outsourced to third-party providers. If the Company’s third-party providers encounter difficulties or if the Company has difficulty in communicating with such third-parties, the ability to adequately process and account for customer transactions, could affect the Company’s operations and reputation.  Additionally, in recent years banking regulators have focused on the responsibilities of financial institutions to supervise vendors and other third-party service providers.  The Company may have to dedicate significant resources to manage risks and regulatory burdens, including the Company’s data processing and cybersecurity service providers.

 

Business counterparties, over which the Company may have limited or no control, may experience disruptions that could adversely affect the Company.

Multiple major U.S. retailers and a major consumer credit reporting agency have experienced data systems incursions in recent years reportedly resulting in the thefts of credit and debit card information, online account information, and other personal and financial data of hundreds of millions of individuals.  Retailer incursions may affect debit cards issued and deposit accounts maintained by many banks.  Although the Company is not aware of any instance in which the Bank’s systems have been breached in a retailer incursion, these events can cause the Bank to reissue a significant number of cards and take other costly steps to avoid significant theft loss to the Bank and its customers.  In some cases, the Bank may be required to reimburse customers for losses they incur.  Credit reporting agency intrusions affect the Bank’s customers and can require these customers and the Bank to increase monitoring and take remedial action to prevent unauthorized account activity or access.  Other possible points of intrusion or disruption outside the Company’s control include internet service providers, electronic mail portal providers, social media portals, distant-server (or “cloud”) service providers, electronic data security providers, telecommunications companies and smart phone manufacturers.

 

The Company is technology dependent and an inability to invest in technological improvements may adversely affect results of operations and financial condition.

The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services, which may require substantial capital expenditures to modify or adapt existing products and services. In addition to enhancing customer service, the effective use of technology increases efficiency and results in reduced costs, although a financial institution’s initial investment in a technology product or service may represent a significant incremental cost. The Company’s future success will depend, in part, upon the ability to create synergies in operations through the use of technology and to facilitate the ability of customers to engage in financial transactions in a manner that enhances the customer experience. The Company cannot assure that technological improvements will increase operational efficiency or that the Company will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to customers, which may cause the Company to lose market share or incur additional expense.

 

Failure to maintain effective systems of internal and disclosure control could have a material adverse effect on the Company’s results of operation and financial condition.

Effective internal and disclosure controls are necessary for the Company to provide reliable financial reports and effectively prevent fraud and to operate successfully as a public company.  As part of the Company’s ongoing monitoring of internal control, it may discover material weaknesses or significant deficiencies in its internal control that require remediation.  A “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis.  Any failure to maintain effective controls or to timely effect any necessary improvement of the Company’s internal and disclosure controls could, among other things, result in losses from fraud or error, harm the Company’s reputation or cause investors to lose confidence in the Company’s reported financial information, all of which could have a material adverse effect on the Company’s results of operation and financial condition.

 

 

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Changes in accounting standards and management’s selection of accounting methods, including assumptions and estimates, could materially affect the Company’s financial statements.

From time to time, the SEC and FASB change the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. These changes can be hard to predict and can materially affect how the Company records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial results, or a cumulative charge to retained earnings. In addition, management is required to use certain assumptions and estimates in preparing financial statements, including determining the fair value of certain assets and liabilities, among other items. If the assumptions or estimates are incorrect, the Company may experience unexpected material consequences.

 

The Company relies heavily on its management team and the unexpected loss of key officers may adversely affect operations.

The Company believes that growth and future success will depend in large part on the skills and experience of its executive officers and on their relationships with the communities it serves. The loss of the services of one or more of these officers could disrupt operations and impair the Company’s ability to implement its business strategy, which could adversely affect the Company’s financial condition and results of operations.

 

The success of the Company’s business strategies depends on its ability to identify and recruit individuals with experience and relationships in its primary markets.

The successful implementation of the Company’s business strategy will require the Company to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships as well as new financial products and services. The market for qualified management personnel is competitive. In addition, the process of identifying and recruiting individuals with the combination of skills and attributes required to carry out the Company’s strategy is often lengthy, and the Company may not be able to effectively integrate these individuals into its operations. The Company’s inability to identify, recruit and retain talented personnel to manage its operations effectively and in a timely manner could limit growth, which could materially adversely affect the Company’s business.

 

The Company’s corporate culture has contributed to its success, and if the Company cannot maintain this culture, the Company could lose the beneficial aspects fostered by this culture, which could harm business.

The Company believes that a critical contributor to its success has been its corporate culture, which focuses on building personal relationships with its customers. As the Company grows, and more complex organizational management structures are required, the Company may find it increasingly difficult to maintain the beneficial aspects of this corporate culture, which could negatively affect the Company’s future success.

 

Compliance with laws, regulations and supervisory guidance, both new and existing, may adversely affect the Company’s business, financial condition and results of operations.

The Company is subject to numerous laws, regulations and supervision from both federal and state agencies. Failure to comply with these laws and regulations could result in financial, structural and operational penalties, including receivership. In addition, establishing systems and processes to achieve compliance with these laws and regulations may increase costs and/or place limits on pursuing certain business opportunities.

 

The legislative and regulatory environment is beyond the Company’s control, may change rapidly and unpredictably and may negatively influence profitability and capital levels. The Company’s success depends on its ability to maintain compliance with both existing and new laws and regulations.

 

Future legislation, regulation and government policy could affect the banking industry as a whole, including the Company’s results of operations, in ways that are difficult to predict. In addition, the Company’s results of operations could be adversely affected by changes in the way in which existing statutes and regulations are interpreted or applied by courts and government agencies.

 

The Dodd-Frank Act could continue to increase the Company’s regulatory compliance burden and associated costs, place restrictions on certain products and services, and limit future capital raising strategies.

The Dodd-Frank Act represents a sweeping overhaul of the financial services regulatory environment within the United States and implements significant changes in the financial regulatory landscape. The Dodd-Frank Act has increased and will likely continue to increase the Company’s regulatory compliance burden and may have a material adverse effect on the Company by increasing the costs associated with regulatory examinations and compliance measures. The federal regulatory agencies, and particularly bank regulatory agencies, have been given significant discretion in drafting the Dodd-Frank Act’s implementing rules and regulations, some of which have

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not been finalized. Consequently, the complete effect of the Dodd-Frank Act on the Company’s business, financial condition or results of operations will depend on the final implementing rules and regulations.

 

The Dodd-Frank Act increases regulatory supervision and examination of bank holding companies and their banking and nonbanking subsidiaries, which could increase the Company’s regulatory compliance burden and costs and restrict its ability to generate revenues from nonbanking operations. The Dodd-Frank Act imposes more stringent capital requirements on bank holding companies, which when considered in connection with the Basel III Capital Rules and related regulatory capital rules could significantly limit the Company’s future capital strategies. The Dodd-Frank Act also increases regulation of derivatives and hedging transactions, which could limit the Company’s ability to enter into, or increase the costs associated with, interest rate hedging transactions.

 

The CFPB may increase the Company’s regulatory compliance burden and could affect consumer financial products and services that the Company offers.

The CFPB is reshaping the consumer financial laws through rulemaking and enforcement of the Dodd-Frank Act’s prohibitions against unfair, deceptive and abusive consumer finance products or practices, which are directly affecting the business operations of financial institutions offering consumer financial products or services.  This agency’s broad rulemaking authority includes identifying practices or acts that are unfair, deceptive or abusive in connection with any consumer financial transaction, financial product or service.  Although the CFPB has jurisdiction over banks with $10 billion or greater in assets, rules, regulations and policies issued by the CFPB may also apply to the Company by virtue of the adoption of such policies and best practices by the Federal Reserve and the FDIC.  Further, the CFPB may include its own examiners in regulatory examinations by the Company’s primary regulators. The total costs and limitations related to this additional regulatory agency and the limitations and restrictions that will be placed upon the Company with respect to consumer products and services have yet to be determined in their entirety.  However, these costs, limitations and restrictions are producing, and may continue to produce, significant, material effects on the Company’s business, financial condition and results of operations.

 

Recently enacted capital standards, including the Basel III Capital Rules, may require the Company and the Bank to maintain higher levels of capital and liquid assets, which could adversely affect the Company’s profitability and return on equity.

The Basel III Capital Rules and related changes to the standardized calculations of risk-weighted assets are complex and created additional compliance burdens, especially for community banks. The Basel III Final Rules require bank holding companies and their subsidiaries to maintain significantly more capital as a result of higher required capital levels and more demanding regulatory capital risk weightings and calculations.  While the Company is exempt from these capital requirements under the SBHC Policy Statement, the Bank is not exempt and must comply.  The Bank must also comply with the capital requirements set forth in the “prompt corrective action” regulations pursuant to Section 38 of the Federal Deposit Insurance Act.  Satisfying capital requirements may require the Company or the Bank to limit its banking operations, retain net income or reduce dividends to improve regulatory capital levels, which could negatively affect its business, financial condition and results of operations.  The EGRRCPA, which became effective May 24, 2018, amended the Dodd-Frank Act to, among other things, provide relief from certain of these requirements.  Although the EGRRCPA is still being implemented, the Company does not expect the EGRRCPA and the related rulemakings to materially reduce the impact of capital requirements on its business.

 

The Company’s earnings are significantly affected by the fiscal and monetary policies of the federal government and its agencies.

The policies of the Federal Reserve affect the Company significantly. The Federal Reserve regulates the supply of money and credit in the United States. Its policies directly and indirectly influence the rate of interest earned on loans and paid on borrowings and interest-bearing deposits and can also affect the value of financial instruments. Those policies determine, to a significant extent, the cost of funds for lending and investing. Changes in those policies are beyond the Company’s control and are difficult to predict. Federal Reserve policies can also affect the Company’s borrowers, potentially increasing the risk that they may fail to repay their loans. This could adversely affect the borrower’s earnings and ability to repay a loan, which could have a material adverse effect on the Company’s financial condition and results of operations.

   

The Company’s common stock price may be volatile, which could result in losses to investors.

The Company’s common stock price has been volatile in the past, and several factors could cause the price to fluctuate in the future. These factors include, but are not limited to, actual or anticipated variations in earnings, changes in analysts’ recommendations or projections, operations and stock performance of other peer companies, and reports of trends and concerns and other issues related to the financial services industry. Fluctuations in the Company’s common stock price may be unrelated to performance. General market declines or market volatility in the future, especially in the financial institutions sector, could adversely affect the price of the Company’s common stock, and the current market price may not be indicative of future market prices.

 

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Future sales of the Company’s common stock by shareholders or the perception that those sales could occur may cause the Company’s common stock price to decline.

Although the Company’s common stock is listed for trading on Nasdaq Capital Select Market, the trading volume may be lower than that of other larger financial institutions. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Company has no control. Given the potential for lower relative trading volume, significant sales of the common stock in the public market, or the perception that those sales may occur, could cause the trading price of the Company’s common stock to decline or to be lower than it otherwise might be in the absence of these sales or perceptions.

 

Future issuances of the Company’s common stock could adversely affect the market price and could be dilutive.

The Company may issue additional shares of common stock or securities that are convertible into or exchangeable for, or that represent the right to receive, shares of the Company’s common stock. Issuances of a substantial number of shares of common stock, or the expectation that such issuances might occur, could adversely affect the market price of the shares of common stock and could be dilutive to shareholders. Any decision the Company makes to issue common stock in the future will depend on market conditions and other factors, and the Company cannot predict or estimate the amount, timing, or nature of possible future issuances.  Accordingly, the Company’s shareholders bear the risk that future issuances could reduce the market price of the common stock and dilute their stock holdings in the Company.

 

The Company relies on dividends from the Bank for substantially all of its revenue.

The Company is a bank holding company that conducts substantially all of its operations through the Bank. As a result, the Company relies on dividends from the Bank for substantially all of its revenues. There are various regulatory restrictions on the ability of the Bank to pay dividends or make other payments to the Company, and the Company’s right to participate in a distribution of assets upon the Bank’s liquidation or reorganization is subject to the prior claims of the Bank’s creditors. If the Bank is unable to pay dividends to the Company, the Company may not be able to service its outstanding borrowings and other debt, pay its other obligations or pay a cash dividend to the holders of the Company’s common stock, and the Company’s business, financial condition and results of operations may be adversely affected. Further, although the Company has historically paid cash dividends to holders of its common stock, these holders are not entitled to receive dividends and regulatory or economic factors may cause the Company’s Board of Directors to consider, among other actions, the reduction of dividends paid on the Company’s common stock even if the Bank continues to pay dividends to the Company.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. PROPERTIES

The following describes the location and general character of the physical properties of the Company.

 

The Bank owns two buildings located in the Town of Warrenton at 10 Courthouse Square, Warrenton, Virginia.  These buildings house the Company’s executive offices and the Bank’s main office, loan operations, information technology and the Wealth Management division.

 

The Bank owns a building located in the Town of Warrenton at 87 W. Lee Highway, Warrenton, Virginia which houses a retail banking branch and the Bank’s deposit operations department.

 

The Bank owns four other retail banking branches located in Fauquier County:  6464 Main Street, The Plains, Virginia; 5119 Lee Highway, New Baltimore, Virginia; 3543 Catlett Road, Catlett, Virginia; and 6207 Station Drive, Bealeton, Virginia.

 

The Bank owns two other retail banking branches located in Prince William County:  7485 Limestone Drive, Gainesville, Virginia; 8780 Centreville Road, Manassas, Virginia.  

 

The Bank leases three retail banking branches located in Prince William County:  15240 Washington Street, Haymarket, Virginia; 10260 Bristow Center Drive, Bristow, Virginia; and 8091 Sudley Road, Manassas, Virginia.

 

All of the Company’s properties are in good operating condition and are adequate for the Company’s present and anticipated future needs.

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ITEM 3. LEGAL PROCEEDINGS

In the ordinary course of business, 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.

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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 11, 2019, there were 3,785,454 shares outstanding of the Company’s common stock, which is the Company’s only class of stock outstanding. These shares were held by approximately 340 holders of record. As of March 11, 2019, the market price of the Company’s common stock was $21.55.

 

The Company paid quarterly cash dividends of $0.12 per share during 2018.

 

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 17, 2019, the Board of Directors authorized the Company to repurchase up to 113,215 shares (3% of the shares of common stock outstanding on January 1, 2019) beginning January 1, 2019. During the year ended December 31, 2018, 368 shares of common stock were repurchased at an average price of $21.47 per share. No shares were repurchased during the fourth quarter of 2018.

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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)

 

2018

 

 

2017

 

 

2016

 

 

2015

 

 

2014

 

EARNINGS STATEMENT DATA:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

26,698

 

 

$

23,320

 

 

$

21,574

 

 

$

21,694

 

 

$

21,935

 

Interest expense

 

 

3,233

 

 

 

2,049

 

 

 

1,843

 

 

 

1,962

 

 

 

2,564

 

Net interest income

 

 

23,465

 

 

 

21,271

 

 

 

19,731

 

 

 

19,732

 

 

 

19,371

 

Provision for (recovery of) loan losses

 

 

507

 

 

 

520

 

 

 

(508

)

 

 

8,000

 

 

 

-

 

Net interest income after provision for (recovery of) loan losses

 

 

22,958

 

 

 

20,751

 

 

 

20,239

 

 

 

11,732

 

 

 

19,371

 

Noninterest income

 

 

5,236

 

 

 

5,468

 

 

 

5,296

 

 

 

6,414

 

 

 

6,619

 

Gain on sale and call of securities

 

 

838

 

 

 

-

 

 

 

1

 

 

 

4

 

 

 

3

 

Noninterest expense

 

 

22,151

 

 

 

20,844

 

 

 

20,925

 

 

 

20,186

 

 

 

19,807

 

Income (loss) before income taxes

 

 

6,881

 

 

 

5,375

 

 

 

4,611

 

 

 

(2,036

)

 

 

6,186

 

Income taxes

 

 

746

 

 

 

2,879

 

 

 

937

 

 

 

(1,424

)

 

 

1,380

 

Net income (loss)

 

$

6,135

 

 

$

2,496

 

 

$

3,674

 

 

$

(612

)

 

$

4,806

 

PER SHARE DATA:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share, basic

 

$

1.63

 

 

$

0.66

 

 

$

0.98

 

 

$

(0.16

)

 

$

1.29

 

Net income (loss) per share, diluted

 

$

1.62

 

 

$

0.66

 

 

$

0.98

 

 

$

(0.16

)

 

$

1.28

 

Cash dividends

 

$

0.48

 

 

$

0.48

 

 

$

0.48

 

 

$

0.48

 

 

$

0.53

 

Weighted average shares outstanding, basic

 

 

3,772,421

 

 

 

3,764,690

 

 

 

3,753,757

 

 

 

3,742,725

 

 

 

3,728,316

 

Weighted average shares outstanding, diluted

 

 

3,779,366

 

 

 

3,773,010

 

 

 

3,763,929

 

 

 

3,742,725

 

 

 

3,747,247

 

Book value

 

$

15.90

 

 

$

14.92

 

 

$

14.51

 

 

$

14.06

 

 

$

14.78

 

BALANCE SHEET DATA:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

730,805

 

 

$

644,613

 

 

$

624,445

 

 

$

601,400

 

 

$

606,286

 

Loans, net

 

 

544,188

 

 

 

497,705

 

 

 

458,608

 

 

 

442,669

 

 

 

435,070

 

Securities, including restricted investments

 

 

74,124

 

 

 

73,699

 

 

 

51,755

 

 

 

56,510

 

 

 

58,700

 

Deposits

 

 

635,638

 

 

 

570,023

 

 

 

546,157

 

 

 

524,294

 

 

 

525,215

 

Shareholders' equity

 

 

60,007

 

 

 

56,142

 

 

 

54,451

 

 

 

52,633

 

 

 

55,157

 

PERFORMANCE RATIOS:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest margin(1)

 

 

3.81

%

 

3.66%

 

 

3.50%

 

 

3.62%

 

 

 

3.55

%

Return (loss) on average assets

 

 

0.92

%

 

0.39%

 

 

0.60%

 

 

(0.10%)

 

 

 

0.80

%

Return (loss) on average equity

 

 

10.64

%

 

4.44%

 

 

6.82%

 

 

(1.09%)

 

 

 

8.98

%

Dividend payout

 

 

29.63

%

 

72.44%

 

 

49.07%

 

 

(293.79%)

 

 

 

41.16

%

Efficiency ratio(2)

 

 

76.68

%

 

76.80%

 

 

82.36%

 

 

75.50%

 

 

 

74.96

%

ASSET QUALITY RATIOS:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Allowance for loan losses to total loans

 

 

0.94

%

 

1.01%

 

 

0.98%

 

 

0.94%

 

 

 

1.22

%

Allowance for loan losses to nonperforming loans

 

 

78.65

%

 

56.43%

 

 

38.72%

 

 

41.28%

 

 

 

40.81

%

Nonperforming assets to total assets

 

 

1.09

%

 

1.61%

 

 

2.09%

 

 

1.91%

 

 

 

2.41

%

Nonaccrual loans to total loans

 

 

0.36

%

 

0.63%

 

 

0.76%

 

 

0.41%

 

 

 

0.28

%

Net charge-offs (recoveries) to average loans

 

 

0.08

%

 

(0.01%)

 

 

(0.19%)

 

 

2.04%

 

 

 

0.29

%

CAPITAL RATIOS:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Leverage

 

 

9.39

%

 

9.17%

 

 

9.23%

 

 

9.13%

 

 

 

9.83

%

Common equity Tier 1 capital ratio

 

 

11.89

%

 

11.43%

 

 

12.22%

 

 

11.64%

 

 

NA

 

Tier 1 capital ratio

 

 

11.89

%

 

11.43%

 

 

12.22%

 

 

11.64%

 

 

 

14.05

%

Total capital ratio

 

 

12.85

%

 

12.41%

 

 

13.17%

 

 

12.53%

 

 

 

15.30

%

 

(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 the Company’s 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 Company establishes the allowance for loan losses through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when it is believed that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in management’s judgment, will be adequate to absorb probable losses inherent in the loan portfolio. Management’s judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs for relevant periods of time, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available.  Note 1 to the Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, of the 2018 Form 10-K, provides additional information related to the allowance for loan losses.

 

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

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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.

 

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 Company’s primary financial objectives are to maximize earnings and to deploy capital in profitable growth initiatives that will enhance long-term shareholder value. The Company monitors the following financial performance metrics towards achieving these goals: (i) return on average assets (“ROA”), (ii) return on average equity (“ROE”), and (iii) growth in earnings.  The Company also actively manages capital through growth and dividends, while considering the need to maintain a strong regulatory capital position.

 

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 2019 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, 2018, the Company’s ROE and ROA were 10.64% and 0.92%, respectively, compared to 4.44% and 0.39%, respectively, for the year ended December 31, 2017. Excluding the effect of the nonrecurring revaluation of the Company’s net deferred tax asset related to the Tax Cuts and Jobs Act (the “Tax Act”), for the year ended December 31, 2017, the Company’s adjusted ROE and 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 $730.8 million on December 31, 2018 compared to $644.6 million on December 31, 2017. Net loans increased $46.5 million or 9.3% to $544.2 million on December 31, 2018 from $497.7 million on December 31, 2017. Total deposits were $635.6 million on December 31, 2018 compared to $570.0 million on December 31, 2017, respectively. Low cost transaction deposits (demand and interest checking accounts) increased to $392.6 million on December 31, 2018, from $361.2 on December 31, 2017.

 

The Company had net income of $6.1 million, or $1.62 per diluted share, in 2018 compared to $2.5 million, or $0.66 per diluted share for 2017. Net interest margin was 3.81% for the year ended December 31, 2018 compared to 3.66% for the year ended December 31, 2017. Net interest income for the year ended December 31, 2018 increased $2.2 million to $23.5 million when compared to $21.3 million for the year ended December 31, 2017. The results for 2017 included the effect of the Tax Act, which was signed into law on December 22, 2017. As a result of the permanent reduction in the federal corporate income tax rate, the Company recorded a one-time remeasurement adjustment to its net federal deferred tax asset of $1.7 million, which was recognized in income tax expense. Excluding the one-time effects of the Tax Act, adjusted net income for 2017 was $4.2 million, or $1.10 per share assuming dilution.

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

 

 

 

For the Quarter Ended

 

 

For the Quarter Ended

 

(Dollars in thousands, except per share data)

 

December 31,

2018

 

 

September 30,

2018

 

 

June 30,

2018

 

 

March 31,

2018

 

 

December 31,

2017

 

 

September 30,

2017

 

 

June 30,

2017

 

 

March 31,

2017

 

Interest income

 

$

7,094

 

 

$

6,694

 

 

$

6,540

 

 

$

6,370

 

 

$

6,191

 

 

$

6,001

 

 

$

5,713

 

 

$

5,415

 

Interest expense

 

 

1,042

 

 

 

853

 

 

 

686

 

 

 

652

 

 

 

556

 

 

 

515

 

 

 

509

 

 

 

469

 

Net interest income

 

 

6,052

 

 

 

5,841

 

 

 

5,854

 

 

 

5,718

 

 

 

5,635

 

 

 

5,486

 

 

 

5,204

 

 

 

4,946

 

Provision for loan losses

 

 

-

 

 

 

195

 

 

 

12

 

 

 

300

 

 

 

125

 

 

 

110

 

 

 

235

 

 

 

50

 

Net interest income after provision for loan losses

 

 

6,052

 

 

 

5,646

 

 

 

5,842

 

 

 

5,418

 

 

 

5,510

 

 

 

5,376

 

 

 

4,969

 

 

 

4,896

 

Noninterest income

 

 

1,263

 

 

 

1,324

 

 

 

1,624

 

 

 

1,863

 

 

 

1,380

 

 

 

1,290

 

 

 

1,393

 

 

 

1,405

 

Noninterest expense

 

 

5,612

 

 

 

5,484

 

 

 

5,574

 

 

 

5,481

 

 

 

5,288

 

 

 

4,998

 

 

 

5,150

 

 

 

5,408

 

Income before income taxes

 

 

1,703

 

 

 

1,486

 

 

 

1,892

 

 

 

1,800

 

 

 

1,602

 

 

 

1,668

 

 

 

1,212

 

 

 

893

 

Income tax expense

 

 

130

 

 

 

169

 

 

 

233

 

 

 

214

 

 

 

2,145

 

 

 

387

 

 

 

222

 

 

 

125

 

Net income (loss)

 

$

1,573

 

 

$

1,317

 

 

$

1,659

 

 

$

1,586

 

 

$

(543

)

 

$

1,281

 

 

$

990

 

 

$

768

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share, basic

 

$

0.42

 

 

$

0.35

 

 

$

0.44

 

 

$

0.42

 

 

$

(0.14

)

 

$

0.34

 

 

$

0.26

 

 

$

0.20

 

Net income (loss) per share, diluted

 

$

0.42

 

 

$

0.35

 

 

$

0.44

 

 

$

0.42

 

 

$

(0.14

)

 

$

0.34

 

 

$

0.26

 

 

$

0.20

 

 

RESULTS OF OPERATIONS

 

NET INTEREST INCOME AND EXPENSE

 

2018 COMPARED WITH 2017

Net interest income increased to $23.5 million for the year ended December 31, 2018 from $21.3 million for the same period of 2017. The net interest margin was 3.81% for the year ended December 31, 2018 compared to 3.66% for the same period in 2017.

 

Interest income increased as the result of an overall increase in average earning assets from $587.7 million in 2017 to $619.1 million in 2018, a direct result of management’s emphasis on growing the loan and securities portfolio and the increase in the interest rate environment during 2018 and 2017. The increase of 33 basis points (“bp”) in the average yield on assets from 4.00% in 2017 to 4.33% in 2018 was primarily the result of:

 

Average loans increased $46.2 million from $471.5 million in 2017 to $517.7 million in 2018. The tax-equivalent yield on loans increased to 4.69% in 2018 compared to 4.49% in 2017. Together, interest and fee income from loans increased $3.2 million for 2018 compared with 2017.

 

Average securities increased $11.0 million from $63.6 million in 2017 to $74.6 million in 2018. The tax-equivalent yield on investments decreased from 2.86% in 2017 to 2.81% in 2018. Tax-equivalent interest and dividend income on securities increased $276,000 from 2017 to 2018.

 

Total interest expense increased $1.2 million from $2.0 million in 2017 to $3.2 million in 2018, resulting in the average rate on total interest-bearing liabilities increasing from 0.45% in 2017 to 0.67% in 2018, due primarily to the following:

 

Average interest-bearing deposits increased $11.9 million from $442.1 million in 2017 to $454.0 million in 2018.  The average rate paid on interest-bearing deposits increased from 0.36% in 2017 to 0.54% in 2018.  This resulted in an increase in interest paid on deposits of $848,000 from $1.6 million in 2017 to $2.4 million in 2018.

 

Average FHLB advances increased $13.5 million from $9.8 million in 2017 to $23.3 million in 2018.  Interest expense on FHLB advances increased $292,000 from $249,000 in 2017 to $541,000 in 2018.  

 

The Company believes that it will be challenging to maintain the net interest margin at its current level, even with projected loan growth during 2019.  The recent increases in the federal funds rate may provide stimulus for higher costing deposits, which may reprice faster than loans and investments.

 

22


Table of Contents

 

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. The increase of 17 bp in the average yield on assets from 3.83% in 2016 to 4.00% in 2017 was primarily the result of:

 

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.

 

Total interest expense increased $206,000 or 11.2% from $1.8 million in 2016 to $2.1 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:

 

Average interest-bearing deposits increased $5.8 million from $436.3 million in 2016 to $442.1 million in 2017.  The average rate paid on interest-bearing deposits increased from 0.30% in 2016 to 0.36% in 2017.  This resulted in an increase in interest paid on deposits of $280,000 from $1.3 million in 2016 to $1.6 million in 2017.

 

Average FHLB advances decreased $3.1 million from $13.0 million in 2016 to $9.8 million in 2017.  Interest expense on FHLB advances decreased $75,000 from $324,000 in 2016 to $249,000 in 2017.  

23


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, 2018, 2017 and 2016 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.

 

 

 

December 31, 2018

 

 

December 31, 2017

 

 

December 31, 2016

 

(Dollars in thousands)

 

Average

 

 

Income/

 

 

Average

 

 

Average

 

 

Income/

 

 

Average

 

 

Average

 

 

Income/

 

 

Average

 

Assets

 

Balances

 

 

Expense

 

 

Rate

 

 

Balances

 

 

Expense

 

 

Rate

 

 

Balances

 

 

Expense

 

 

Rate

 

Loans

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Taxable

 

$

514,958

 

 

$

24,291

 

 

 

4.72

%

 

$

466,513

 

 

$

21,075

 

 

 

4.52

%

 

$

446,094

 

 

$

19,783

 

 

 

4.43

%

Tax-exempt (1)

 

 

-

 

 

 

-

 

 

 

-

 

 

 

2,068

 

 

 

108

 

 

 

5.24

%

 

 

4,716

 

 

 

253

 

 

 

5.36

%

Nonaccrual (2)

 

 

2,770

 

 

 

-

 

 

 

-

 

 

 

2,953

 

 

 

-

 

 

 

-

 

 

 

2,436

 

 

 

-

 

 

 

-

 

Total loans

 

 

517,728

 

 

 

24,291

 

 

 

4.69

%

 

 

471,534

 

 

 

21,183

 

 

 

4.49

%

 

 

453,246

 

 

 

20,036

 

 

 

4.42

%

Securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Taxable

 

 

60,560

 

 

 

1,622

 

 

 

2.68

%

 

 

51,824

 

 

 

1,303

 

 

 

2.52

%

 

 

46,501

 

 

 

1,076

 

 

 

2.32

%

Tax-exempt (1)

 

 

14,059

 

 

 

474

 

 

 

3.37

%

 

 

11,799

 

 

 

517

 

 

 

4.38

%

 

 

5,649

 

 

 

320

 

 

 

5.66

%

Total securities

 

 

74,619

 

 

 

2,096

 

 

 

2.81

%

 

 

63,623

 

 

 

1,820

 

 

 

2.86

%

 

 

52,150

 

 

 

1,396

 

 

 

2.68

%

Deposits in other banks

 

 

26,777

 

 

 

410

 

 

 

1.53

%

 

 

52,532

 

 

 

529

 

 

 

1.01

%

 

 

63,534

 

 

 

338

 

 

 

0.53

%

Federal funds sold

 

 

14

 

 

 

-

 

 

 

1.59

%

 

 

9

 

 

 

-

 

 

 

0.94

%

 

 

9

 

 

 

-

 

 

 

0.37

%

Total earning assets

 

 

619,138

 

 

 

26,797

 

 

 

4.33

%

 

 

587,698

 

 

 

23,532

 

 

 

4.00

%

 

 

568,939

 

 

 

21,770

 

 

 

3.83

%

Less: Allowance for loan losses

 

 

(5,317

)

 

 

 

 

 

 

 

 

 

 

(4,534

)

 

 

 

 

 

 

 

 

 

 

(4,695

)

 

 

 

 

 

 

 

 

Total nonearning assets

 

 

50,848

 

 

 

 

 

 

 

 

 

 

 

50,643

 

 

 

 

 

 

 

 

 

 

 

52,549

 

 

 

 

 

 

 

 

 

Total Assets

 

$

664,669

 

 

 

 

 

 

 

 

 

 

$

633,807