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Section 1: 10-K (10-K)

20191231 10K_Taxonomy2019



UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-K

  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2019

  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from__________ to___________

Commission file number 001-38884

FRANKLIN FINANCIAL SERVICES CORPORATION

(Exact name of registrant as specified in its charter)



 

 

 



PENNSYLVANIA

25-1440803

 



(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)

 



 

 

 



20 South Main Street,  Chambersburg,  PA

17201-0819

 



(Address of principal executive offices)

(Zip Code)

 

(717)  264-6116

(Registrant's telephone number, including area code)

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

NONE

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

Common Stock, par value $1.00 per share

(Title of class)

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

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes   No  

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes    No   

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).  Yes     No   

Indicate by check mark whether the registrant  is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.





 

 

 

Large accelerated filer

Accelerated filer    

Non-accelerated filer

Smaller reporting company



 

 

Emerging growth company



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



 

 



 

 



 

 

Title of class

Symbol

Name of exchange on which registered

Common stock

FRAF

Nasdaq Capital Market



If an emerging growth company, indicate by check mark if the registrant has elected not to use the 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 whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act)  Yes  No

The aggregate market value of the 4,005,752 shares of the Registrant's common stock held by nonaffiliates of the Registrant as of June 30, 2019 based on the price of such shares was $153,179,956.

There were 4,360,363 outstanding shares of the Registrant's common stock as of February 29, 2020.



DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive annual proxy statement to be filed, pursuant to Reg. 14A within 120 days after December 31, 2019, are incorporated into Part III.

 

 


 

FRANKLIN FINANCIAL SERVICES CORPORATION

FORM 10-K

INDEX



 

 

Part I

 

Page

Item 1.

Business

Item 1A.

Risk Factors

Item 1B.

Unresolved Staff Comments

11 

Item 2.

Properties

12 

Item 3.

Legal Proceedings

12 

Item 4.

Mine Safety Disclosures

12 

Part II

 

 

Item 5. 

Market for Registrant's Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities

12 

Item 6.

Selected Financial Data

16 

Item 7.

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

17 

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

37 

Item 8.

Financial Statements and Supplementary Data

40 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

83 

Item 9A.

Controls and Procedures

83 

Item 9B.

Other Information

83 

Part III

 

 

Item 10.

Directors, Executive Officer and Corporate Governance

83 

Item 11.

Executive Compensation

84 

Item 12.

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

84 

Item 13.

Certain Relationships and Related Transaction, and Director Independence

84 

Item 14.

Principal Accountant Fees and Services

84 

Part IV

 

 

Item 15.

Exhibits, Financial Statement Schedules

84 

Index of Exhibits

 

86 

Signatures 

 

87 








 

Table of Contents

 

Part I

Item 1. Business



General

Franklin Financial Services Corporation (the “Corporation”) was organized as a Pennsylvania business corporation on June 1, 1983 and is a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHCA”).  On January 16, 1984, pursuant to a plan of reorganization approved by the shareholders of Farmers and Merchants Trust Company of Chambersburg (“F&M Trust” or “the Bank”) and the appropriate regulatory agencies, the Corporation acquired all the shares of F&M Trust and issued its own shares to former F&M Trust shareholders on a share-for-share basis.



The Corporation’s common stock is listed under the symbol “FRAF” on the Nasdaq Capital MarketThe Corporation’s internet address is www.franklinfin.com.  Electronic copies of the Corporation’s 2019 Annual Report on Form 10-K are available free of charge by visiting the “Investor Information” section of www.franklinfin.com.  Electronic copies of quarterly reports on Form 10-Q and current reports on Form 8-K are also available at this internet address.  These reports are posted as soon as reasonably practicable after they are electronically filed with the Securities and Exchange Commission (SEC).



The Corporation conducts substantially all of its business through its direct banking subsidiary, F&M Trust, which is wholly owned. F&M Trust, established in 1906, is a full-service, Pennsylvania-chartered commercial bank and trust company, which is not a member of the Federal Reserve System. F&M Trust operates twenty-two community banking offices in Franklin, Cumberland, Fulton and Huntingdon Counties, Pennsylvania. The Bank engages in general commercial, retail banking and trust services normally associated with community banks and its deposits are insured (up to applicable legal limits) by the Federal Deposit Insurance Corporation (the “FDIC”). F&M Trust offers a wide variety of banking services to businesses, individuals, and governmental entities.  These services include, but are not necessarily limited to, accepting and maintaining checking, savings, and time deposit accounts, providing investment and trust services, making loans and providing safe deposit facilities. Franklin Future Fund Inc., a direct subsidiary of the Corporation, is a non-bank investment company that makes venture capital investments, limited to 5% or less of the outstanding shares of any class of voting securities of any company, within the Corporation’s primary market area. Franklin Financial Properties Corp. is a “qualified real estate subsidiary,” a wholly owned subsidiary of F&M Trust, and was established to hold real estate assets used by F&M Trust in its banking operations.



F&M Trust is not dependent upon a single customer or a few customers for a material part of its business.  Thus, the loss of any customer or identifiable group of customers would not materially affect the business of the Corporation or the Bank in an adverse manner.  Also, none of the Bank’s business is seasonal.  The Bank’s lending activities consist primarily of commercial real estate, construction and land development, agricultural, commercial and industrial loans, installment and revolving loans to consumers and residential mortgage loans.  Secured and unsecured commercial and industrial loans, including accounts receivable and inventory financing, and commercial equipment financing, are made to small and medium-sized businesses, individuals, governmental entities, and non-profit organizations. 



The Bank classifies loans in this report by the type of collateral, primarily residential or commercial and agricultural real estate. Loans secured by residential real estate loans may be further broken down into consumer or commercial purposes. Consumer purpose residential real estate loans represent traditional residential mortgages and home equity products. Both of these products are underwritten in generally the same manner; however, home equity products may present greater risk since many of these loans are secured by a second lien position where the Bank may or may not hold the first lien position. Commercial purpose residential real estate loans represent loans made to businesses, but are secured by residential real estate.  These loans are underwritten as commercial loans and the repayment ability may be dependent on the business operation, despite the residential collateral. In addition to the real estate collateral, it is possible that personal guarantees or UCC filings on business assets provide additional security.  In certain situations, the Bank acquires properties through foreclosure on delinquent loans.  The Bank initially records these properties at the estimated fair value less cost to sell with subsequent adjustments to fair value recorded as needed.



Commercial and agricultural real estate loans are secured by properties such as hotels, office buildings, apartment buildings, retail sites, and farmland or agricultural related properties. These loans are highly dependent on the business operations for repayment. Compared to residential real estate, this collateral may be more difficult to sell in the event of a default.  



Construction loans are made to finance the purchase of land and the construction of residential and commercial buildings, and are secured by mortgages on real estate.  These loans are primarily comprised of loans to consumers to build a home, and loans to contractors and developers to construct residential properties for resale or rental. Construction loans present various risks that include, but are not limited to:  schedule delays, cost overruns, changes in economic conditions during the construction period, and the inability to sell or rent the property upon completion. 



Commercial loans are made to businesses and government municipalities of various sizes for a variety of purposes including operations, property, plant and equipment, and working capital. These loans are highly dependent on the business operations for repayment and are generally secured by business assets and personal guarantees. As such, this collateral may be more difficult to sell

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in the event of a delinquency.  Commercial lending, including commercial real estate, is concentrated in the Bank’s primary market, but also includes purchased loan participations originated primarily in south-central Pennsylvania. 



Consumer loans are comprised of unsecured personal lines of credit and installment loans.  While some of these loans are secured, the collateral behind the loans is often comprised of assets that lose value quickly (e.g. automobiles) and if repossessed, may not fully satisfy the loan in the event of default. Repayment of these loans is highly dependent on the borrowers’ financial condition that can be affected by economic factors beyond their control and personal circumstances.



F&M Trust’s Investment and Trust Services Department offers all of the personal and corporate trust services normally associated with community bank trust departments including: estate planning and administration, corporate and personal trust fund management, pension, profit sharing and other employee benefit funds management, and custodial services.  F&M Trust through licensed members of its Investment and Trust Services Department sells mutual funds, annuities and selected insurance products.



Competition



The Corporation and its banking subsidiary operate in a highly competitive environment. The principal market of F&M Trust is in south central Pennsylvania, primarily the counties of Franklin, Cumberland, Fulton and Huntingdon. There are 24 competing commercial banks that have offices within the Corporation’s primary market area. These banks range from large regional banks to independent community banks.  In addition, credit unions, savings and loan associations, mortgage banks, brokerage firms and other on-line competitors compete within the market.



The following table shows the Bank’s market share in its primary market as reported on the June 30, 2019 FDIC Summary of Deposits Report:







 

 

 

 

 

 

 

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 



 

F&M Trust

 

 

 

 

 

County

 

# of Locations

 

 

Deposits

 

Market Deposits

 

Market Share

Franklin

 

12 

 

$

757,427 

 

$

2,222,323 

 

34% 

Cumberland

 

 

 

263,273 

 

 

9,027,357 

 

3% 

Fulton

 

 

 

74,208 

 

 

214,567 

 

35% 

Huntingdon

 

 

 

18,220 

 

 

620,935 

 

3% 



 

22 

 

$

1,113,128 

 

$

12,085,182 

 

9% 





Because of increasing competition, profit margins in the traditional banking business of lending and gathering deposits have been flat and many nonbanking institutions offer services similar to those offered by the Bank. Some competitors may have access to resources (e.g., financial and technological) sooner than they are available to the Bank, or that may be unavailable to the Bank, thereby creating a competitive disadvantage for the Bank in terms of product, service pricing and delivery.  In addition, credit unions increasingly compete with banks for deposits. The Bank utilizes various strategies including its long history of local customer service and convenience as part of a relationship management culture, a wide variety of products and services and, to a lesser extent, the pricing of loans and deposits, to compete.  F&M Trust is the largest financial institution headquartered in Franklin County and had total assets of approximately $1.3 billion on December 31, 2019.



Staff



As of December 31, 2019, the Corporation and its banking subsidiary had 283 full-time equivalent employees.  The officers of the Corporation are employees of the Bank.  The Bank offers a 401(k) plan, employee stock purchase plan and incentive compensation plans.  Employees are also provided with group life and health insurance.  Management considers employee relations to be excellent.



Supervision and Regulation



Various requirements and restrictions under the laws of the United States and under Pennsylvania law affect the Corporation and its subsidiaries.



General



The Corporation is registered as a bank holding company and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System under the Bank Holding Act of 1956, as amended.  The Corporation has also made an effective election to be treated as a "financial holding company."  Financial holding companies are bank holding companies that meet certain minimum capital and other standards and are therefore entitled to engage in financially related activities on an expedited basis as further

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discussed below.  Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve.  The Federal Reserve has issued regulations under the Bank Holding Company Act that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks.  As a result, the Federal Reserve, pursuant to such regulations, may require the Corporation to stand ready to use its resources to provide adequate capital funds to its Bank subsidiary during periods of financial stress or adversity. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.



The Bank Holding Company Act prohibits the Corporation from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock, or substantially all of the assets of any bank, or from merging or consolidating with another bank holding company, without prior approval of the Federal Reserve Board.  Additionally, the Bank Holding Company Act prohibits the Corporation from engaging in or from acquiring ownership or control of more than 5% of the outstanding shares of any class of voting stock of any company engaged in a non‑banking business, unless such business is determined by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto.  Federal law and Pennsylvania law also require persons or entities desiring to acquire certain levels of share ownership (generally, 10% or more, or 5% or more for another bank holding company) of the Corporation to first obtain prior approval from the Federal Reserve and the Pennsylvania Department of Banking and Securities. 



As a Pennsylvania bank holding company for purposes of the Pennsylvania Banking Code, the Corporation is also subject to regulation and examination by the Pennsylvania Department of Banking and Securities.



The Bank is a state chartered bank that is not a member of the Federal Reserve System, and its deposits are insured (up to applicable legal limits) by the Federal Deposit Insurance Corporation (FDIC).  Accordingly, the Bank's primary federal regulator is the FDIC, and the Bank is subject to extensive regulation and examination by the FDIC and the Pennsylvania Department of Banking and Securities.  The Bank is also subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered.  The Bank is subject to extensive regulation and reporting requirements in a variety of areas, including helping to prevent money laundering, to preserve financial privacy, and to properly report late payments, defaults, and denials of loan applications. 



Dodd-Frank Wall Street Reform and Consumer Protection Act



In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) became law.  Dodd-Frank is intended to affect a fundamental restructuring of federal banking regulation.  Among other things, Dodd-Frank creates a new Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms.  Dodd-Frank additionally creates a new independent federal regulator to administer federal consumer protection laws.  Dodd-Frank is expected to have a significant impact on our business operations as its provisions take effect.  Among the provisions that are likely to affect the Corporation are the following:



FDIC Insurance. The insurance limit was increased to $250,000 per depositor.  In addition, the assessment base was changed from a deposit-based calculation to an asset-based calculation. Dodd-Frank also eliminated the federal statutory prohibition against the payment of interest on business checking accounts.



Compensation.  At least once every three years, companies must conduct a non-binding shareholder vote (say-on-pay) to approve the compensation of the CEO and the company’s “named executive officers.”  At least once every 6 years, shareholders must also vote on whether to hold the non-binding vote on executive compensation every 1, 2, or 3 years.  Additionally, banking regulators have established guidance that prohibits incentive-based compensation arrangements that encourage inappropriate risks that could lead to material financial loss to the institution.



Consumer Financial Protection Bureau.  Dodd-Frank created a new, independent federal agency called the Consumer Financial Protection Bureau (CFPB), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes.  The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets.  Smaller institutions are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for consumer compliance purposes.  The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products.  Dodd-Frank authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay.  In addition, Dodd-Frank will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB.  Dodd-Frank permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

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Most of the Dodd-Frank rules and regulations have been implemented.  These new rules and regulations have and will continue to significantly change the current bank regulatory structure and affect the lending, deposit and operating activities of financial institutions, including the Corporation.  It remains difficult to anticipate or predict the overall future financial impact the Dodd-Frank Act will have on the Corporation, our customers, our financial condition and results of operations.  The Corporation continues to monitor and implement rules and regulations as they are adopted and modified, and to evaluate their application to our current and future operations.



Community Reinvestment Act



The Community Reinvestment Act (CRA) requires the Bank to help meet the credit needs of the entire community where the Bank operates, including low and moderate-income neighborhoods.  The Bank's rating under the Community Reinvestment Act, assigned by the FDIC pursuant to an examination of the Bank, is important in determining whether the bank may receive approval for, or utilize certain streamlined procedures in applications to engage in new activities.  The Bank’s present CRA rating is “satisfactory.”  Various consumer laws and regulations also affect the operations of the Bank. 



Capital Adequacy Guidelines



The Corporation, as a bank holding company, is required to comply with the capital adequacy standards established by Federal Reserve Board.  The Bank is required to comply with capital adequacy standards established by the FDIC. In addition, the Pennsylvania Department of Banking and Securities also requires state chartered banks to maintain minimum capital ratios, defined substantially the same as the federal regulations.



In July 2013, Federal banking regulators approved the final rules from the Basel Committee on Banking Supervision for the regulation of capital requirements for bank holding companies and U.S banks, generally referred to as “Basel III.” The Basel III standards were effective for the Corporation and the Bank, effective January 1, 2015 (subject to a phase-in period for certain provisions).  Basel III imposes significantly higher capital requirements and more restrictive leverage and liquidity ratios than those previously in place.  The capital ratios to be considered “well capitalized” under Basel III are: (1) Common Equity Tier 1 (CET1) of 6.5%, (2) Tier 1 Leverage of 5%, (3) Tier 1 Risk-Based Capital of 8%, and (4) Total Risk-Based Capital of 10%.  The rules also include changes in the risk weights of certain assets to better reflect credit and other risk exposures. In addition, a capital conservation buffer of 1.875% for 2018 and 2.50% for 2019 and thereafter, was added. The capital conservation buffer is applicable to all of the capital ratios except for the Tier1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum (“adequately capitalized”) for each respective capital measurement.   The Bank’s capital conservation buffer at December 31, 2019 was 7.87% (total risk-based capital 15.87% less 8.00%) compared to the 2019 regulatory buffer of 2.50%. Compliance with the capital conservation buffer is required in order to avoid limitations on certain capital distributions, especially dividends.  As of December 31, 2019, the Bank was “well capitalized’ under the Basel III requirements.   The minimum capital ratios (shown as “adequately capitalized”) and the “well capitalized” capital ratios are reported in Note 2 of the accompanying financial statements. 



In 2019, the federal banking agencies issued a final rule to provide an optional simplified measure of capital adequacy for qualifying community banking organizations, including the community bank leverage ratio (“CBLR”) framework.  Generally, under the CBLR framework, qualifying community banking organizations with total assets of less than $10 billion, and limited amounts of off-balance-sheet exposures and trading assets and liabilities, may elect whether to be subject to the CBLR framework if they have a CBLR of greater than 9%.  Qualifying community banking organizations that elect to be subject to the CBLR framework and continue to meet all requirements under the framework would not be subject to risk-based or other leverage capital requirements and, in the case of an insured depository institution, would be considered to have met the well capitalized ratio requirements for purposes of the FDIC’s Prompt Corrective Action framework.  The CBLR framework will be available for banks to use in their March 31, 2020 Call Report.  The Corporation expects that it will not opt into the CBLR framework. 

Prompt Corrective Action Rules



The federal banking agencies have regulations defining the levels at which an insured institution would be considered "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized."  The applicable federal bank regulator for a depository institution could, under certain circumstances, reclassify a "well‑capitalized" institution as "adequately capitalized" or require an "adequately capitalized" or "undercapitalized" institution to comply with supervisory actions as if it were in the next lower category.  Such a reclassification could be made if the regulatory agency determines that the institution is in an unsafe or unsound condition (which could include unsatisfactory examination ratings).  At December 31, 2019, the Bank satisfied the criteria to be classified as "well capitalized" within the meaning of applicable regulations.



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Regulatory Restrictions on Dividends



Dividend payments by the Bank to the Corporation are subject to the Pennsylvania Banking Code, the Federal Deposit Insurance Act, and the regulations of the FDIC.  Under the Banking Code, no dividends may be paid except from "accumulated net earnings" (generally, retained earnings).  The Federal Reserve and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions.  The Prompt Corrective Action Rules and the Basel III rules, described above, may further limit the ability of banks to pay dividends or make capital distributions if regulatory capital requirements are not met. There are currently no restrictions on the payments of dividends by either the Bank or the Corporation.



Volker Rule



In December 2013, Federal banking regulators issued rules for complying with the Volker Rule provision of the Dodd-Frank Act. The Bank does not engage in, or expect to engage in, any transactions that are considered “covered activities” as defined by the Volker Rule. Therefore, the Bank does not have any compliance obligations under the Volker Rule.



Consumer Laws and Regulations



The Consumer Financial Protection Bureau (“CFPB”) was created under the Dodd-Frank Act to centralize responsibility for consumer financial protection with broad rulemaking, supervision, and enforcement authority for a wide range of consumer protection laws that would apply to all banks and thrifts, including the Equal Credit Opportunity Act, Truth in Lending Act (“TILA”), Real Estate Settlement Procedures Act (“RESPA”), Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act, and certain other statues. Violations of consumer protection laws may result in litigation and liability from consumers and regulators.   It is likely that future CFPB rulemaking action will affect the Bank.  Banks with total assets less than $10 billion are not subject to examination by the CFPB.  However, the CFPB can require any bank to submit reports it deems necessary to fulfill its mission and it can request to be part of any bank examination.



Ability to Repay / Qualified Mortgages



In July 2013, the Consumer Finance Protection Bureau adopted the final rules that implement the Ability to Repay (ATR) / Qualified Mortgages (QM) provisions of the Dodd-Frank Act. Regulators believe that the ATR/QM rules will prevent many of the loose underwriting practices that contributed to the mortgage crisis in 2008.  The ATR/QM rule applies to almost all closed-end consumer credit transactions secured by a dwelling. The ATR rule provides eight specific factors that must be considered during the underwriting process. QMs generally have three types of requirements: restrictions on loan features, points and fees, and underwriting criteria.  A QM is presumed to comply with the ATR requirements. The ATR/QM rule was effective January 10, 2014. 



Commercial Real Estate Guidance



In December 2015, the federal banking agencies released a “Statement on Prudent Risk Management for Commercial Real Estate Lending” (the “CRE Statement”).  The agencies stated that financial institutions should review their policies and practices related to CRE lending and should maintain risk management practices and capital levels commensurate with the level and nature of their CRE concentration risk, including maintaining underwriting discipline and exercising prudent risk management practices that identify, measure, monitor and manage the risks arising from their CRE lending activity.  Financial institutions were directed to review the interagency guidance on “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” issued in 2006 providing that a financial institution is potentially exposed to significant CRE concentration risk, and should employ enhanced risk management practices where (1) total CRE loans represent 300% or more of total capital, and (2) the outstanding balance the CRE loan portfolio has increased by 50% or more during the prior 36 months.  The agencies state in the CRE statement that they will focus on those financial institutions that have recently experienced, or whose lending strategy plans for, substantial growth in CRE lending activity, or that operate in markets or loan segments with increasing growth or risk fundamentals.



Pennsylvania Regulation and Supervision



In December 2012, the “Banking Law Modernization Package” became effective.  The law permits banks to disclose formal enforcement actions initiated by the Pennsylvania Department of Banking and Securities, clarifies that the Department has examination and enforcement authority over subsidiaries as well as affiliates of regulated banks, and bolsters the Department’s enforcement authority over its regulated institutions by clarifying its ability to remove directors, officers and employees from institutions for violations of laws or orders or for any unsafe or unsound practice or breach of fiduciary duty.  The Department also may assess civil money penalties of up to $25,000 per violation.



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FDIC Insurance



The Bank is a member of the Deposit Insurance Fund (DIF), which is administered by the FDIC. The FDIC insures deposit accounts at the Bank, generally up to a maximum of $250,000 for each separately insured depositor. The FDIC charges a premium to depository institutions for deposit insurance. This rate is based on the risk category of the institution and the total premium is based on average total assets less average tangible equity.  As of December 31, 2019, the Bank was considered well capitalized and its assessment rate was approximately 3 basis points of the assessment base.



Insurance of deposits may be terminated by the FDIC upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not currently know of any practice, condition or violation that might lead to termination of our deposit insurance.



In addition to the FDIC assessments, the Financing Corporation (“FICO”) is authorized to impose and collect, with the approval of the Federal Deposit Insurance Corporation, assessments for anticipated payments, issuance costs and custodial fees on bonds issued by the FICO in the 1980s to recapitalize the former Federal Savings and Loan Insurance Corporation. The bonds issued by the FICO matured in 2019. The Bank’s FICO assessment was approximately $3 thousand in 2019 and was included in FDIC insurance expense.



New Legislation



Congress is often considering new financial industry legislation, and the federal banking agencies routinely propose new regulations.  The Corporation cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business in the future. 



Tax Reform



On December 22, 2017 the Tax Cuts and Jobs Act (the Act) was signed into law.  This comprehensive tax legislation provides for significant changes to the U.S. Internal Revenue Code of 1986, as amended, that impact corporate taxation such as the reduction in the federal corporate income tax rate from 35% to 21% effective January 1, 2018.  The Act repeals the corporate alternative minimum tax, provides for earlier recognition of certain revenue, accelerates expensing of investments in tangible property and limits several deductions such as FDIC premiums, certain executive compensation and meals and entertainment expenses. 



Selected Statistical Information



Certain statistical information is included in this report as part of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Item 1A. Risk Factors



The following is a summary of the primary risks associated with the Corporation’s business, financial condition and results of operations, and common stock.



Risk Factors Relating to the Corporation



Real estate related loans are a significant portion of our loan portfolio.



The Bank offers a variety of loan products, including residential mortgage, consumer, construction and commercial loans.  The Bank requires real estate as collateral for many of its loans. At December 31, 2019, approximately 75% ($698.1 million) of its loans were secured by real estate.  Loans secured by real estate and the percent of the loan portfolio are reported in Table 14.  These real estate loans are located primarily in the Bank’s market area of south central Pennsylvania.  Real estate values tend to follow changes in general economic cycles. If a loan becomes delinquent as the result of an economic downturn and the Bank becomes dependent on the real estate collateral as a source of repayment, it is likely that the value of the real estate collateral has also declined.  A decline in real estate values means it is possible that the real estate collateral may be insufficient to cover the outstanding balance of a delinquent or foreclosed loan, resulting in a loss to the Bank. In addition, the real estate collateral is concentrated in a small market area of south central Pennsylvania. Localized events such as plant closures or layoffs may affect real estate prices and collateral values and could have a more negative affect on the Bank as compared to other competitors with a more geographically diverse portfolio.   As the Bank grows, it is expected that real estate secured loans will continue to comprise a significant part of its balance sheet. Risk of loan default is unavoidable in the banking industry, and Management tries to limit exposure to this risk by carefully monitoring the amount of loans in specific industries and by exercising prudent lending practices and securing appropriate collateral.  However, this risk cannot be eliminated and substantial credit losses could result in reduced earnings or losses.

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Commercial loans are a significant portion of our loan portfolio.



The Bank continues to grow its commercial loan portfolio.  Commercial purpose loans account for 86% ($796.0 million) of the total loan portfolio.  These loans are made to businesses for a variety of commercial purposes and may include fixed and variable rate loans, term loans, and lines of credit. Commercial purpose loans may be secured by real estate, business assets and equipment, personal guarantees, or non-real estate collateral.  Commercial purpose loans secured by real estate were $556.8 million at December 31, 2019 and account for 70% of the total commercial loan portfolio.   These loans contain all the risks associated with real estate lending as discussed above. In addition, commercial real estate collateral may be more difficult to liquidate for repayment purposes than residential real estate. The repayment of commercial loans is highly dependent upon the success of the business activity and as such maybe more susceptible to risk of loss during a downturn in the economy. Because the Bank’s commercial loan portfolio is concentrated in south-central Pennsylvania, the ability to repay these loans could be affected by deterioration of the economy in this region.  As commercial lending continues to be the primary drive of loan growth, these new loans may present additional risk due to a lack of repayment history with the Bank.  The Bank attempts to mitigate these risks through its underwriting and loan review process; however, this risk cannot be eliminated and substantial credit losses could result in reduced earnings or losses.     



The allowance for loan losses may prove to be insufficient to absorb inherent losses in our loan portfolio.



The Bank maintains an allowance for loan losses that Management believes is appropriate to provide for any inherent losses in the loan portfolio.  The amount of the allowance is determined through a periodic review and consideration of several factors, including an ongoing review of the quality, size and diversity of our loan portfolio; evaluation of nonperforming loans; historical loan loss experience; and the amount and quality of collateral, including guarantees, securing the loan.



Although Management believes the loan loss allowance is adequate to absorb inherent losses in the loan portfolio, such losses cannot be predicted and the allowance may not be adequate.  Excessive loan losses could have a material adverse effect on the Bank’s financial condition and results of operations.



The Bank’s lending limit is smaller than many of our competitors, which affects the size of the loans it can offer customers.



The Bank’s lending limit is approximately $20.3 million.  Accordingly, the size of the loans that can be offered to customers is less than the size of loans that many of our competitors, with larger lending limits, can offer.  This limit affects the Bank’s ability to seek relationships with larger businesses in its market area.  Loan amounts in excess of the lending limits can be accommodated through the sale of participations in such loans to other banks.  However, there can be no assurance that the Bank will be successful in attracting or maintaining customers seeking larger loans or that it will be able to engage in participation of such loans or on terms favorable to the Bank.



There is strong competition in the Bank’s primary market areas and its geographic diversification is limited.



The Bank encounters strong competition from other financial institutions in its primary market area, which consists of Franklin, Cumberland, Fulton and Huntingdon Counties, Pennsylvania.  In addition, established financial institutions not already operating in the Bank’s primary market area may open branches there at future dates or can compete in the market via the Internet.  In the conduct of certain aspects of banking business, the Bank also competes with savings institutions, credit unions, mortgage banking companies, consumer finance companies, insurance companies and other institutions, some of which are not subject to the same degree of regulation or restrictions as are imposed upon the Bank.  Many of these competitors have substantially greater resources and lending limits and can offer services that the Bank does not provide.  In addition, many of these competitors have numerous branch offices located throughout their extended market areas that provide them with a competitive advantage.  No assurance can be given that such competition will not have an adverse effect on the Bank’s financial condition and results of operations.



Changes in interest rates could have an adverse impact upon our results of operations.



The Bank’s profitability is in part a function of the spread between interest rates earned on investments, loans and other interest-earning assets and the interest rates paid on deposits and other interest-bearing liabilities. Interest rates are highly sensitive to many factors that are beyond the Bank’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, will influence not only the interest received on loans and investment securities and the amount of interest we pay on deposits and borrowings, but will also affect the Bank’s ability to originate loans and obtain deposits and the value of our investment portfolio.  If the rate of interest paid on deposits and other borrowings increases more than the rate of interest earned on loans and other investments, the Bank’s net interest income, and therefore earnings, could be adversely affected.  Likewise, the Bank currently has a very low cost of funds that it may be unable to maintain in a raising rate environment.  Earnings could also be adversely affected if the rates on loans and other investments fall more quickly than those on deposits and other borrowings.  While Management takes measures to guard against interest rate risk, there can be no assurance that such measures will be effective in minimizing the exposure to interest rate risk.



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Uncertainty about the future of LIBOR may adversely affect our business.



LIBOR and certain other interest rate “benchmarks” are the subject of recent national, international, and other regulatory guidance and proposals for reform.  These reforms may cause such benchmarks to perform differently than in the past or have other consequences which cannot be predicted.  On July 27, 2017, the United Kingdom’s Financial Conduct Authority, which regulates LIBOR, publicly announced that it intends to stop persuading or compelling banks to submit information to the administrator of LIBOR after 2021.  The announcement indicates that the continuation of LIBOR on the current basis cannot be guaranteed after 2021.  While there is no consensus on what rate or rates may become accepted alternatives to LIBOR, a group of market participants convened by the Federal Reserve, the Alternative Reference Rate Committee, has selected the Secured Overnight Financing Rate as its recommended alternative to LIBOR.  The Federal Reserve Bank of New York started to publish the Secured Overnight Financing Rate in April 2018.  The Secured Overnight Financing Rate is a broad measure of the cost of overnight borrowings collateralized by Treasury securities that was selected by the Alternative Reference Rate Committee due to the depth and robustness of the U.S. Treasury repurchase market.  At this time, it is impossible to predict whether the Secured Overnight Financing Rate will become an accepted alternative to LIBOR.  The market transition away from LIBOR to an alternative reference rate, such as the Secured Overnight Financing Rate, is complex and could have a range of adverse effects on our business, financial condition and results of operations. Management has formed a work group to review the Bank’s exposure to LIBOR, study replacement options and customer communication about the LIBOR change.



The Alternative Reference Rates Committee ("ARRC") has proposed that the Secured Overnight Funding Rate ("SOFR") replace USD-LIBOR. ARRC has proposed that the transition to SOFR from USD-LIBOR will take place by the end of 2021. The Company has material contracts that are indexed to USD-LIBOR. Industry organizations are currently working on the transition plan. The Corporation is currently monitoring this activity and evaluating the risks involved.



Our operational or security systems may experience interruption or breach in security, including cyber-attacks.



We rely heavily on communications and information systems to conduct our business.  These systems include our internal network and data systems, as well as those of third party vendors.  Any failure, interruption or breach in security or these systems, including a cyber-attack, could result in the disclosure or misuse of confidential or proprietary information.  Cyber security risks for financial institutions have significantly increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists and other external parties, including foreign state actors.  Financial services institutions have been subject to, and are likely to continue to be the target of, cyber-attacks, including computer viruses, malicious or destructive code, phishing attacks, denial of service or information or other security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of confidential, proprietary and other information of the institution, its employees or customers or of third parties, or otherwise materially disrupt network access or business operations.  Cyber threats could result in unauthorized access, loss or destruction of customer data, unavailability, degradation or denial of service, introduction of computer viruses and other adverse events, causing the Corporation to incur additional costs (such as repairing systems or adding new personnel or protection technologies). Cyber threats may also subject the Corporation to regulatory investigations, litigation or enforcement, require the payment of regulatory fines or penalties or undertaking costly remediation efforts.  While we have systems, policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of client business, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operations.



A large component of fee income is dependent on stock market values.



Fee income from the Bank’s Investment and Trust Services Department comprises a large percentage of total noninterest income.  Fee income from Investment and Trust Services is comprised primarily of asset management fees as measured by the market value of assets under management.  As such, the market values are directly related to stock market values.  Therefore, any significant change in the value of assets under management due to stock market fluctuations could greatly affect fee income.



A large component of fee income is dependent on two deposit services.



Fee income from the Bank’s debit card is a significant contributor of fee income.  As technology changes and consumer payment preferences change it is possible that debit card income does not continue to grow or may decline. The Bank’s overdraft protection program has also been a significant contributor of fee income. It is possible that the usage of this product slows or that regulatory changes effect the fees that can be charged for such services.



A large percentage of certificates of deposit have short-term maturities.



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Seventy percent ($62.3 million) of the Bank’s certificates of deposit are scheduled to mature within one year. If the Bank is unable to retain these deposits, it may require the Bank to access other sources of liquidity that may carry a higher cost. However, these deposits only account for 7.9% of total deposits.



A large percentage of deposits may be highly sensitive to changes in interest rates.    



Thirty-eight percent ($429.2 million) of all deposits are in the Bank’s money management product.  The interest rate on these deposits generally follows market rates. A large or continuous increase in market rates could result in a rapid increase in the interest expense of these deposits.  While the interest rate on this product generally follows market rates, the product is not indexed to a market rate, thereby giving the Bank more control over any rate increases. 



Liquidity contingency funding is highly concentrated. 



The Bank is a member of the Federal Home Loan Bank of Pittsburgh (FHLB). Access to funding through the FHLB is the largest component of the Bank’s liquidity stress testing and contingency funding plans. The ability to access funding from FHLB may be critical if a funding need arises. However, there can be no assurance that the FHLB will be able to provide funding when needed, nor can there be assurance that the FHLB will provide funds to the Bank if its financial condition deteriorates. The inability to access FHLB funding, through a restriction on credit or the failure of the FHLB, could have a materially adverse effect on the Bank’s liquidity management.



Our business and financial results could be impacted materially by adverse results in legal proceedings.



The nature of the Corporation’s business generates a certain amount of litigation involving matters arising in the ordinary course of business (and, in some cases, from the activities of companies we have acquired).  These legal proceedings, whether founded or unfounded, could result in reputation damage and have an adverse effect on our financial condition and results of operation if they are not resolved in a manner favorable to the Corporation.  Although we establish legal accruals for legal proceedings when information related to the loss contingencies represented by these matters indicates that both a loss is probable and that the amount of the loss can be reasonably estimated, we do not have accruals for all legal proceedings where we face a risk of loss.  In addition, due to the inherent subjectivity of the assessments and unpredictability of outcomes of legal proceedings, any amounts that may be accrued or included in estimates of possible losses or ranges of possible losses may not represent the actual loss to the Corporation.  We discuss these matters further in Part I Item 3 Legal Proceedings and in Note 20 Commitments and Contingencies in the Notes to Consolidated Financial Statements in Part II Item 8 of this Report.



Risk Factors Relating to the Common Stock



The market price of the Corporation’s common stock may be subject to volatility.

The Corporation’s common stock trades on the Nasdaq Capital Market under the symbol “FRAF”.  The market price of the stock may be subject to fluctuations due to the performance of the Corporation and by fluctuations beyond our control such as general economic or political conditions.  Trading volume of the Corporation’s shares is less than that of larger companies and lower trading volume may affect the price. 



The Bank's ability to pay dividends to the Corporation is subject to regulatory limitations that may affect the Corporation’s ability to pay dividends to its shareholders.



As a holding company, the Corporation is a separate legal entity from the Bank and does not have significant operations of its own. It currently depends upon the Bank's cash and liquidity to pay dividends to its shareholders.  The Corporation cannot assure you that in the future the Bank will have the capacity to pay dividends to the Corporation. Various statutes and regulations limit the availability of dividends from the Bank. It is possible; depending upon the Bank's financial condition and other factors, that the Bank’s regulators could assert that payment of dividends by the Bank to the Corporation would constitute an unsafe or unsound practice.  In the event that the Bank is unable to pay dividends to the Corporation, the Corporation may not be able to pay dividends to its shareholders.

 

Item 1B. Unresolved Staff Comments



None

 

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Item 2.  Properties



The Corporation’s headquarters is located in the main office of F&M Trust at 20 South Main Street, Chambersburg, Pennsylvania.  This location also houses a community banking office as well as operational support services for the Bank. The Corporation owns or leases thirty-seven properties in Franklin, Cumberland, Fulton and Huntingdon Counties, Pennsylvania, for banking operations, as described below:







 

 

 

 

Property

 

Owned

 

Leased

Facilities used in Banking Operations

 

17 

 

Remote ATM Sites

 

 

Other Properties

 

 —

 



Included in Other Properties is a property leased for future use.

 

Item 3.  Legal Proceedings



The nature of the Corporation’s business generates a certain amount of litigation.



We establish accruals for legal proceedings when information related to the loss contingencies represented by those matters indicates both that a loss is probably and the amount of the loss can be reasonably estimated.  When we are able to do so, we also determine estimates of possible losses, whether in excess of any accrued liability or where there is no accrued liability.



These assessments are based on our analysis of currently available information and are subject to significant judgment and a variety of assumptions and uncertainties.  As new information is obtained, we may change our assessments and, as a result, take or adjust the amounts of our accruals and change our estimates of possible losses or ranges of possible losses.  Due to the inherent subjectivity of the assessments and the unpredictability of outcomes of legal proceedings, any amounts that may be accrued or included in estimates of possible losses or ranges of possible losses may not represent the actual loss to the Corporation from any legal proceeding.  Our exposure and ultimate losses may be higher, possibly significantly higher, than amounts we may accrue or amounts we may estimate.



In management’s opinion, we do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of all litigation to which the Corporation is a party will have a material adverse effect on our financial position.  We cannot now determine, however, whether or not any claim asserted against us will have a material adverse effect on our results of operations in any future reporting period, which will depend on, amount other things, the amount of loss resulting from the claim and the amount of income otherwise reported for the reporting period.  Thus, at December  31, 2019, we are unable to provide an evaluation of the likelihood of an unfavorable outcome or an estimate of the amount or range of potential loss with respect to such other matters and, accordingly, have not yet established any specific accrual for such other matters.



No material proceedings are pending or are known to be threatened or contemplated against us by governmental authorities.



In management’s opinion, there are no other proceedings pending to which the Corporation is a party or to which its property is subject which, if determined adversely to the Corporation, would be material.  No material proceedings are pending or are known to be threatened or contemplated against us by any governmental authorities.

 

Item 4.  Mine Safety Disclosures



Not Applicable 



Part II



Item 5.  Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities



Market and Dividend Information



The Corporation had 1,675 shareholders of record as of December 31, 2019.



 Restrictions on the Payment of Dividends



For limitations on the Corporation’s ability to pay dividends, see “Supervision and Regulation – Regulatory Restrictions on Dividends” in Item 1 above.



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Securities Authorized for Issuance under Equity Compensation Plans



The information related to equity compensation plans is incorporated by reference to the materials set forth under the heading “Executive Compensation – Compensation Tables” in the Corporation’s Proxy Statement for the 2019 Annual Meeting of Shareholders.



Common Stock Repurchases



The Board of Directors, from time to time, authorizes the repurchase of the Corporation’s $1.00 par value common stock. The repurchased shares will be held as Treasury shares available for issuance in connection with future stock dividends and stock splits, employee benefit plans, executive compensation plans, the Dividend Reinvestment Plan and other appropriate corporate purposes. 



The following table shows stock repurchase activity under approved plans:







 

 

 

 

 

 

 

 

 

 

 

(Dollars in thousands, except per share)

 

 

 

 

 

 

 

 

 

 

 

Period

 

Number of Shares Purchased as Part of Publicly Announced Program

 

 

Weighted Average Price Paid per Share

 

 

Dollar Amount of Shares Purchased as Part of Publicly Announced Program

 

 

Shares Yet To Be Purchased Under Program

October 2019

 

 —

 

 

 —

 

 

 —

 

 

147,022

November 2019

 

100 

 

 

35.13 

 

 

 

 

146,922

December 2019

 

 —

 

 

 —

 

 

 —

 

 

146,922



 

100 

 

 

 

 

$

 

 

 







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Performance Graph



The following graph compares the cumulative total return to shareholders of Franklin Financial with selected market indices and a bank peer group, consisting of Mid-Atlantic Banks with assets between $1 billion - $2 billion as of September 30, 2019; for the five year period ended December 31, 2019, in each case assuming an initial investment of $100 on December 31, 2014 and the reinvestment of all dividends. Information is provided by S&P Global Market Intelligence.



Picture 2





 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

Period Ending

Index

12/31/14

 

12/31/15

 

12/31/16

 

12/31/17

 

12/31/18

 

12/31/19

Franklin Financial Services Corporation

$

100.00 

 

$

110.22 

 

$

138.90 

 

$

186.66 

 

$

162.14 

 

$

205.60 

NASDAQ Composite

$

100.00 

 

$

106.96 

 

$

116.45 

 

$

15.96 

 

$

146.67 

 

$

200.49 

SNL Mid-Atlantic Bank

$

100.00 

 

$

103.75 

 

$

131.87 

 

$

161.62 

 

$

138.10 

 

$

196.39 

SNL Mid-Atlantic Bank $1B - $2B

$

100.00 

 

$

107.55 

 

$

134.73 

 

$

156.01 

 

$

150.92 

 

$

174.21 



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Shareholders’ Information



Dividend Reinvestment Plan:



Franklin Financial Services Corporation offers a dividend reinvestment program whereby shareholders of the Corporation’s common stock may reinvest their dividend, or make optional cash payment, to purchase additional shares of the Corporation.  Beneficial owners of shares of the Corporation’s common stock may participate in the program by making appropriate arrangements through their bank, broker or other nominee. Information concerning this optional program is available by contacting the Corporate Secretary at 20 South Main Street, P.O. Box 6010, Chambersburg, PA 17201-6010, telephone 717-264-6116.



Dividend Direct Deposit Program:



Franklin Financial Services Corporation offers a dividend direct deposit program whereby shareholders of the Corporation’s common stock may choose to have their dividends deposited directly into the bank account of their choice on the dividend payment date.  Information concerning this optional program is available by contacting the Corporate Secretary at 20 South Main Street, P.O. Box 6010, Chambersburg, PA  17201-6010, telephone 717-264-6116.



Annual Meeting:



The Annual Shareholders’ Meeting will be held on Tuesday, April 28, 2020, at the Orchard Restaurant & Banquet Facility, 1580 Orchard Drive, Chambersburg, PA.  The Business Meeting will begin at 9:00 a.m. with breakfast provided prior to the meeting.



Websites:



Franklin Financial Services Corporation:        www.franklinfin.com

Farmers & Merchants Trust Company:           www.fmtrust.bank



Stock Information:



The Corporation’s common stock is traded on the Nasdaq Capital Market under the symbol “FRAF”.





 

The registrar and transfer agent for Franklin Financial Services Corporation is:

Computershare



P.O. Box 30170



College Station, TX 77842-3170



1-800-368-5948

 



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Item 6. Selected Financial Data



Item

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

Summary of Selected Financial Data as of and for the Year Ended December 31



 

2019

 

2018

 

2017

 

2016

 

2015

(Dollars in thousands, except per share)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Highlights

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,269,157 

 

$

1,209,587 

 

$

1,179,813 

 

$

1,127,443 

 

$

1,035,295 

Investment and equity securities

 

 

187,873 

 

 

131,846 

 

 

127,336 

 

 

143,875 

 

 

159,473 

Loans, net

 

 

922,609 

 

 

960,960 

 

 

931,908 

 

 

882,798 

 

 

771,930 

Deposits

 

 

1,125,392 

 

 

1,082,629 

 

 

1,047,181 

 

 

982,120 

 

 

918,512 

Shareholders' equity

 

 

127,528 

 

 

118,396 

 

 

115,144 

 

 

116,493 

 

 

111,376 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Summary of Operations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

49,235 

 

$

44,868 

 

$

39,885 

 

$

36,979 

 

$

34,615 

Interest expense

 

 

7,113 

 

 

4,214 

 

 

2,491 

 

 

2,245 

 

 

2,371 

Net interest income

 

 

42,122 

 

 

40,654 

 

 

37,394 

 

 

34,734 

 

 

32,244 

Provision for loan losses

 

 

237 

 

 

9,954 

 

 

670 

 

 

3,775 

 

 

1,285 

Net interest income after provision for loan losses

 

 

41,885 

 

 

30,700 

 

 

36,724 

 

 

30,959 

 

 

30,959 

Noninterest income

 

 

15,424 

 

 

12,629 

 

 

12,189 

 

 

11,605 

 

 

12,652 

Noninterest expense

 

 

38,314 

 

 

37,369 

 

 

43,172 

 

 

33,175 

 

 

31,136 

Income before income taxes

 

 

18,995 

 

 

5,960 

 

 

5,741 

 

 

9,389 

 

 

12,475 

Federal income tax expense (benefit)

 

 

2,880 

 

 

(165)

 

 

3,565 

 

 

1,302 

 

 

2,271 

Net income

 

$

16,115 

 

$

6,125 

 

$

2,176 

 

$

8,087 

 

$

10,204 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Performance Measurements

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Return on average assets

 

 

1.29% 

 

 

0.52% 

 

 

0.19% 

 

 

0.74% 

 

 

1.00% 

Return on average equity

 

 

13.17% 

 

 

5.34% 

 

 

1.80% 

 

 

7.04% 

 

 

9.52% 

Return on average tangible assets (1)

 

 

1.30% 

 

 

0.52% 

 

 

0.19% 

 

 

0.75% 

 

 

1.02% 

Return on average tangible equity (1)

 

 

14.22% 

 

 

5.80% 

 

 

1.94% 

 

 

7.64% 

 

 

10.52% 

Efficiency ratio (1)

 

 

65.36% 

 

 

68.27% 

 

 

82.59% 

 

 

68.26% 

 

 

67.39% 

Net interest margin, fully tax equivalent

 

 

3.68% 

 

 

3.78% 

 

 

3.72% 

 

 

3.62% 

 

 

3.59% 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shareholders' Value (per common share)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

3.67 

 

$

1.39 

 

$

0.50 

 

$

1.88 

 

$

2.40 

Basic earnings per share

 

 

3.68 

 

 

1.40 

 

 

0.50 

 

 

1.88 

 

 

2.40 

Regular cash dividends paid

 

 

1.17 

 

 

1.05 

 

 

0.93 

 

 

0.82 

 

 

0.74 

Book value

 

 

29.30 

 

 

26.85 

 

 

26.44 

 

 

26.99 

 

 

26.05 

Tangible book value (1)

 

 

27.23 

 

 

24.81 

 

 

24.37 

 

 

24.90 

 

 

23.94 

Market value**

 

 

38.69 

 

 

31.50 

 

 

37.36 

 

 

28.60 

 

 

23.50 

Market value/book value ratio

 

 

132.05% 

 

 

117.32% 

 

 

141.30% 

 

 

105.97% 

 

 

90.21% 

Market value/tangible book value ratio

 

 

142.11% 

 

 

126.97% 

 

 

153.30% 

 

 

114.88% 

 

 

98.16% 

Price/earnings multiple year-to-date

 

 

10.54 

 

 

22.66 

 

 

74.72 

 

 

15.21 

 

 

9.79 

Current quarter dividend yield*

 

 

3.10% 

 

 

3.43% 

 

 

2.49% 

 

 

2.94% 

 

 

3.23% 

Dividend payout ratio

 

 

31.74% 

 

 

75.07% 

 

 

185.25% 

 

 

43.56% 

 

 

30.76% 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Safety and Soundness

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average equity/average assets

 

 

9.78% 

 

 

9.73% 

 

 

10.62% 

 

 

10.56% 

 

 

10.49% 

Risk-based capital ratio (Total)

 

 

16.08% 

 

 

15.21% 

 

 

15.31% 

 

 

15.67% 

 

 

16.03% 

Leverage ratio (Tier 1)

 

 

9.72% 

 

 

9.78% 

 

 

9.73% 

 

 

10.11% 

 

 

10.38% 

Common equity ratio (Tier 1)

 

 

14.82% 

 

 

13.96% 

 

 

14.06% 

 

 

14.41% 

 

 

14.77% 

Nonperforming loans/gross loans

 

 

0.42% 

 

 

0.27% 

 

 

0.28% 

 

 

0.61% 

 

 

0.73% 

Nonperforming assets/total assets

 

 

0.31% 

 

 

0.44% 

 

 

0.45% 

 

 

0.92% 

 

 

1.18% 

Allowance for loan loss/loans

 

 

1.28% 

 

 

1.28% 

 

 

1.25% 

 

 

1.24% 

 

 

1.29% 

Net loans charged-off (recovered)/average loans

 

 

0.07% 

 

 

0.97% 

 

 

-0.01%

 

 

0.33% 

 

 

0.04% 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Assets under Management 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Trust and Investment Services (fair value)

 

$

790,949 

 

$

684,825 

 

$

686,941 

 

$

622,630 

 

$

586,664 

Held at third-party brokers (fair value)

 

 

127,976 

 

 

122,213 

 

 

158,145 

 

 

142,676 

 

 

122,010 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

*Annualized

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

** Based on the closing price of FRAF as quoted on the Nasdaq Capital Market for 2019 and the OTCQX for all prior periods

(1) See the section titled "GAAP versus Non-GAAP Presentation" that follows.

 

 

 

 

 

 

 

 

 

16


 

Table of Contents

 

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations



Application of Critical Accounting Policies:



Disclosure of the Corporation’s significant accounting policies is included in Note 1 to the consolidated financial statements.  These policies are particularly sensitive requiring significant judgments, estimates and assumptions to be made by Management.  Senior management has discussed the development of such estimates, and related Management Discussion and Analysis disclosure, with the Audit Committee of the Board of Directors.



The following accounting policy is identified by management to be critical to the results of operations: Allowance for Loan Losses.



GAAP versus non-GAAP PresentationsThe Corporation supplements its traditional GAAP measurements with certain non-GAAP measurements to evaluate its performance and to eliminate the effect of intangible assets.  By eliminating intangible assets, the Corporation believes it presents a measurement that is comparable to companies that have no intangible assets or to companies that have eliminated intangible assets in similar calculations. However, not all companies may use the same calculation method for each measurement. The Efficiency Ratio measures the cost to generate one dollar of revenue. The non-GAAP measurements are not intended to be used as a substitute for the related GAAP measurements. The following table shows the calculation of the non-GAAP measurements.







 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(Dollars in thousands, except per share)

 

For the Year Ended December 31



 

2019

 

2018

 

2017

 

2016

 

2015

Return on Average Tangible Assets (non-GAAP)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

16,115 

 

$

6,125 

 

$

2,176 

 

$

8,087 

 

$

10,204 

Plus intangible amortization (net of tax)

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

119 

Net income (non-GAAP)

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

10,323 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average assets

 

 

1,251,655 

 

 

1,178,302 

 

 

1,139,703 

 

 

1,088,047 

 

 

1,021,275 

Less average intangible assets

 

 

(9,016)

 

 

(9,016)

 

 

(9,016)

 

 

(9,016)

 

 

(9,066)

Average assets (non-GAAP)

 

 

1,242,639 

 

 

1,169,286 

 

 

1,130,687 

 

 

1,079,031 

 

 

1,012,209 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Return on average tangible assets (non-GAAP)

 

 

1.30% 

 

 

0.52% 

 

 

0.19% 

 

 

0.75% 

 

 

1.02% 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Return on Average Tangible Equity (non-GAAP)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

16,115 

 

$

6,125 

 

$

2,176 

 

$

8,087 

 

$

10,204 

Plus intangible amortization (net of tax)

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

119 

Net income (non-GAAP)

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

10,323 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average shareholders' equity

 

 

122,377 

 

 

114,625 

 

 

120,993 

 

 

114,884 

 

 

107,175 

Less average intangible assets

 

 

(9,016)

 

 

(9,016)

 

 

(9,016)

 

 

(9,016)

 

 

(9,066)

Average shareholders' equity (non-GAAP)

 

 

113,361 

 

 

105,609 

 

 

111,977 

 

 

105,868 

 

 

98,109 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Return on average tangible equity (non-GAAP)

 

 

14.22% 

 

 

5.80% 

 

 

1.94% 

 

 

7.64% 

 

 

10.52% 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Tangible Book Value (per share) (non-GAAP)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shareholders' equity

 

$

127,528 

 

$

118,396 

 

$

115,144 

 

$

116,493 

 

$

111,376 

Less intangible assets

 

 

(9,016)

 

 

(9,016)

 

 

(9,016)

 

 

(9,016)

 

 

(9,016)

Shareholders' equity (non-GAAP)

 

 

118,512 

 

 

109,380 

 

 

106,128 

 

 

107,477 

 

 

102,360 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares outstanding (in thousands)

 

 

4,353 

 

 

4,409 

 

 

4,355 

 

 

4,317 

 

 

4,276 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Tangible book value (non-GAAP)

 

 

27.23 

 

 

24.81 

 

 

24.37 

 

 

24.90 

 

 

23.94 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Efficiency Ratio (non-GAAP)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Noninterest expense

 

$

38,314 

 

$

37,369 

 

$

43,172 

 

$

33,175 

 

$

31,136 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income  

 

 

42,122 

 

 

40,654 

 

 

37,394 

 

 

34,734 

 

 

32,244 

Plus tax equivalent adjustment to net interest income

 

 

1,393 

 

 

1,522 

 

 

2,690 

 

 

2,246 

 

 

2,203 

Plus noninterest income, net of securities transactions

 

 

15,102 

 

 

12,564 

 

 

12,186 

 

 

11,623 

 

 

11,756 

Total revenue

 

 

58,617 

 

 

54,740 

 

 

52,270 

 

 

48,603 

 

 

46,203 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Efficiency ratio (non-GAAP)

 

 

65.36% 

 

 

68.27% 

 

 

82.59% 

 

 

68.26% 

 

 

67.39% 





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Results of Operations:



Management’s Overview



The following discussion and analysis is intended to assist the reader in reviewing the financial information presented and should be read in conjunction with the consolidated financial statements and other financial data presented elsewhere herein.



Summary

Reported net income of $16.1 million ($3.67 per diluted share) for the year ended 2019, compared to $6.1 million ($1.39 per diluted share) for the year ended 2018. 

·

2019 net interest income increased $1.5 million to $42.1 million compared to $40.7 million in 2018. Average interest-earning assets for 2019 increased $66.5 million over 2018. The average balance of the loan portfolio increased $5.1 million due to a lesser dependence on purchased loan participations and slower loan demand. The average balance of the investment portfolio and interest-bearing cash increased $61.5 million and accounted for most of the growth in interest-earning assets. The yield on earning assets increased 13 basis points over 2018 due to short-term market rate increases during the year, with the yield on the loan portfolio increasing 26 basis points year-over-year. These changes resulted in a $4.4 million increase in interest income. This increase was partially offset by an increase in interest expense of $2.9 million driven by an increase of $53.8 million in average interest-bearing balances and an increase of 29 basis points on the cost of these funds from 0.49% in 2018 to 0.78% in 2019. For 2019, the net interest margin was 3.68% compared to 3.78% in 2018.

·

The provision for loan loss expense decreased $9.7 million compared to prior year.  The provision expense for the year-ended 2018 was affected by the impairment charges on a loan participation initially reported in our current report on Form 8-K filed May 31, 2018. 

·

Noninterest income increased $2.8 million driven primarily by an increase in fees from Investment and Trust services, gains from the sale of debt securities and an increase in fees from originating mortgages for the secondary market. In addition, noninterest income was boosted by gains on the sale of property owned by the Corporation ($597 thousand) and a gain on the sale of OREO property ($557 thousand).

·

Noninterest expense increased by $945 thousand,  mainly the result of an increase in salaries and incentive plans, increases in data processing expenses from increased mobile offerings and the cost of a building feasibility study.  These increases were offset by the $2.4 million off-balance sheet reserve expense in 2018.



The balance sheet grew by $59.6 million, ending the year at $1.269 billion, a 4.9% increase from the 2018 year-end balance of $1.210 million.

·

Interest-bearing deposits in other banks and Investments increased $39.6 million and $56.0 million, respectively, to offset cash generated by pay-offs in the loan portfolio and increased deposits.

·

The loan portfolio decreased by 4.0%, or $38.8 million, to $934.6 million, primarily due to several large commercial participation payoffs of approximately $32 million, as the Bank continues to move away from purely loan transactions without business relationships.

·

A lease liability and a right-of-use asset of $6.2 million were initially recognized in 2019.

·

Deposits increased by $42.8 million primarily in interest-bearing commercial and municipal deposits.

·

Shareholders’ equity increased $9.1 million primarily due to an increase in retained earnings.   

Other key performance measurements are presented in Item 6, of this report.



A more detailed discussion of the areas that had the greatest effect on the reported results follows.     



Net Interest Income



The most important source of the Corporation’s earnings is net interest income, which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities.  For the purpose of this discussion, balance sheet items refer to the average balance for the year and net interest income is adjusted to a fully taxable-equivalent basis.  This tax-equivalent adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Corporation’s 21% Federal statutory rate.  The components of net interest income are detailed in Tables 1, 2 and 3. 



2019 versus 2018



Tax equivalent net interest income increased 3.2%, or $1.3 million, in 2019.   The increase was driven by a $4.2 million increase in interest income, primarily from a higher yield on earning assets, partially offset by a $2.9 million increase in interest expense due to

18


 

Table of Contents

 

higher rates in 2019.  The yield on earning assets (Table 3) improved from 4.16% for 2018 to 4.29% for 2019, driven by the increase in the yield on portfolio loans.  The benefit provided by tax-exempt income decreased from 2018 to 2019 as a result of a smaller tax-free asset portfolio.  Table 2 shows the affect volume and rate had on the change in tax equivalent net interest income in 2019.



Table 1. Net Interest Income







 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

Change

(Dollars in thousands)

 

2019

 

2018

 

$

 

%

Interest income

 

$

49,235 

 

$

44,868 

 

$

4,367 

 

9.7 

Interest expense

 

 

7,113 

 

 

4,214 

 

 

2,899 

 

68.8 

Net interest income

 

 

42,122 

 

 

40,654 

 

 

1,468 

 

3.6 

Tax equivalent adjustment

 

 

1,393 

 

 

1,522 

 

 

(129)

 

 

Tax equivalent net interest income

 

$

43,515 

 

$

42,176 

 

$

1,339 

 

3.2 



Table 2 identifies increases and decreases in tax equivalent net interest income to either changes in average volume or to changes in average rates for interest-earning assets and interest-bearing liabilities.  Numerous and simultaneous balance and rate changes occur during the year.  The amount of change that is not due solely to volume or rate is allocated proportionally to both.



Table 2. Rate-Volume Analysis of Tax Equivalent Net Interest Income







 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

2019 Compared to 2018

 

2018 Compared to 2017

Increase (Decrease) due to:

 

 Increase (Decrease) due to:

 

 Increase (Decrease) due to:

(Dollars in thousands)

 

Volume

 

Rate

 

Net

 

Volume

 

Rate

 

Net

Interest earned on:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing obligations in other banks

 

$

1,062 

 

$

47 

 

$

1,109 

 

$

(83)

 

$

171 

 

$

88 

Investment securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Taxable

 

 

548 

 

 

91 

 

 

639 

 

 

(200)

 

 

223 

 

 

23 

Nontaxable

 

 

(332)

 

 

117 

 

 

(215)

 

 

108 

 

 

(314)

 

 

(206)

Loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial, industrial and agriculture

 

 

363 

 

 

2,190 

 

 

2,553 

 

 

2,505 

 

 

1,448 

 

 

3,953 

Residential mortgage

 

 

(11)

 

 

128 

 

 

117 

 

 

(187)

 

 

111 

 

 

(76)

Home equity loans and lines

 

 

(181)

 

 

168 

 

 

(13)

 

 

(171)

 

 

160 

 

 

(11)

Consumer

 

 

50 

 

 

(2)

 

 

48 

 

 

17 

 

 

27 

 

 

44 

Loans

 

 

221 

 

 

2,484 

 

 

2,705 

 

 

2,164 

 

 

1,746 

 

 

3,910 

Total net change in interest income

 

 

1,499 

 

 

2,739 

 

 

4,238 

 

 

1,989 

 

 

1,826 

 

 

3,815 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense on:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing checking

 

 

84 

 

 

322 

 

 

406 

 

 

39 

 

 

471 

 

 

510 

Money management

 

 

48 

 

 

1,620 

 

 

1,668 

 

 

(10)

 

 

956 

 

 

946 

Savings

 

 

 

 

59 

 

 

64 

 

 

 

 

181 

 

 

187 

Time deposits

 

 

165 

 

 

584 

 

 

749 

 

 

(39)

 

 

111 

 

 

72 

Short-term borrowings

 

 

 

 

 

 

12 

 

 

(10)

 

 

18 

 

 

Total net change in interest expense

 

 

309 

 

 

2,590 

 

 

2,899 

 

 

(14)

 

 

1,737 

 

 

1,723 

Change in tax equivalent net interest income

 

$

1,190 

 

$

149 

 

$

1,339 

 

$

2,003 

 

$

89 

 

$

2,092 

 

19


 

Table of Contents

 

The following table presents average balances, tax-equivalent (T/E) interest income and expense, and yields earned or rates paid on the assets or liabilities.  Nonaccrual loans are included in the average loan balances.



Table 3. Analysis of Net Interest Income







 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



2019

 

2018

 



Average

 

Income or

 

Average

 

Average

 

Income or

 

Average

 

(Dollars in thousands)

balance

 

expense

 

yield/rate

 

balance

 

expense

 

yield/rate

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-earning assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing obligations of other

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

banks and federal funds sold

$

75,570 

 

$

1,598 

 

2.11% 

 

$

25,187 

 

$

489 

 

1.94% 

 

Investment securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Taxable

 

104,614