LOAN LOSS ALLOWANCE

The allowance for loan losses is maintained at a level considered adequate to provide for our estimate of probable credit losses inherent in the loan portfolio. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. Loans are charged against the allowance for loan losses when we believe that collectability is unlikely. While we use the best information available to make our evaluation, future adjustments may be necessary if there are significant changes in conditions.

The allowance is comprised of four distinct reserve components: (1) specific reserves related to loans individually evaluated, (2) quantitative reserves related to loans collectively evaluated (3) qualitative reserves related to loans collectively evaluated and (4) a temporal estimate is made for incurred loss emergence period for each loan category within the collectively evaluated pools.

A summary of the methodology we employ on a quarterly basis with respect to each of these components in order to evaluate the overall adequacy of our allowance for loan losses is as follows:

Specific Reserve for Loans Individually Evaluated

First, we identify loan relationships having aggregate balances in excess of $150 thousand and that may also have credit weaknesses. Such loan relationships are identified primarily through our analysis of internal loan evaluations, past due loan reports and loans adversely classified internally or by regulatory authorities. Each loan so identified is then individually evaluated to determine whether it is impaired- that is, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the underlying loan agreement. Substantially all of our impaired loans historically have been collateral dependent, meaning repayment of the loan is expected or is considered to be provided solely from the sale of the loan's underlying collateral. For such loans, we measure impairment based on the fair value of the loan's collateral, which is generally determined utilizing current appraisals. A specific reserve is established in an amount equal to the excess, if any, of the recorded investment in each impaired loan over the fair value of its underlying collateral, less estimated costs to sell. Our policy is to re-evaluate the fair value of collateral dependent loans at least every twelve months unless there is a known deterioration in the collateral's value, in which case a new appraisal is obtained.

Purchase credit impaired (“PCI”) loans are collectively evaluated, but are not included in the general reserve as described below. The evaluation of the PCI loans requires continued quarterly assessment of key assumptions and estimates similar to the initial fair value estimate, including changes in the severity of loss, timing and speed of payments, collateral value changes, expected cash flows and other relevant factors. The quarterly assessment is compared to the initial fair value estimate and a determination is made if an adjustment to the allowance for loan loss is deemed necessary.

Quantitative Reserve for Loans Collectively Evaluated

Second, we stratify loan portfolio into two general business loan pools: substandard (7 risk rated) and pass-rated (0 to 6 rated) by loan type. The Company utilizes historical loss rates for commercial real estate and commercial and industrial loans that are assessed by internal risk rating. Historical loss rates on residential real estate and consumer loans are not risk graded. Residential restate and consumer loans are considered as part of the pass-rated portfolio unless removed due to specific reserve evaluation based on past due status and/or other indications of credit deterioration. Quantitative reserves relative to each loan pool are established as follows: for all loan segments an allocation equaling 100% of the respective pool's average 3 year historical net loan charge-off rate (determined based upon the most recent 9 quarters ) is applied to the aggregate recorded investment in the pool of loans. Purchased performing loans are collectively evaluated as their own separate category within each loan pool.

Qualitative Reserve for Loans Collectively Evaluated

Third, we consider the necessity to adjust our average historical net loan charge-off rates relative to each of the above two loan pools for potential risks factors that could result in actual losses deviating from prior loss experience. Such qualitative risk factors considered are: (1) lending policies and procedures, (2) business conditions, (3) volume and nature of the loan portfolio, (4) experience, ability and depth of lending management, (5) problem loan trends, (6) quality of the Bank’s loan review system, (7) concentrations in the portfolio, (8) competition, legal, and regulatory environment and (9) collateral coverage and loan-to-value.

Loss Emergence Period for Loans Collectively Evaluated

Fourth, the general allowance related to loans collectively evaluated includes an estimate of incurred losses over an estimated loss emergence period ("LEP"). The LEP was generated utilizing a charge-off look-back analysis, which studied the time from the first indication of elevated risk of repayment (or other early event indicating a problem) to eventual charge-off to support the LEP considered in the allowance calculation. This reserving methodology established the approximate number of months of LEP that represents incurred losses for each loan portfolio within each portfolio segment in addition to the qualitative reserves.

Activity in the allowance for loan losses for the twelve months ended December 31, 2017, 2016 and 2015 was as follows:



Business Activities Loans	At or for the Twelve Months Ended December 31, 2017
(in thousands)	Commercial real estate			Commercial and industrial			Residential real estate			Consumer			Total
Balance at beginning of period	$	5,145		$	1,952		$	2,721		$	601		$	10,419
Charged-off loans	(124		)	(189		)	(226		)	(162		)	(701		)
Recoveries on charged-off loans	49			11			65			18			143
Provision/(releases) for loan losses	967			599			797			(71		)	2,292
Balance at end of period	$	6,037		$	2,373		$	3,357		$	386		$	12,153
Individually evaluated for impairment	447			3			9			—			459
Collectively evaluated	5,590			2,370			3,348			386			11,694
Total	$	6,037		$	2,373		$	3,357		$	386		$	12,153



Business Activities Loans	At or for the Twelve Months Ended December 31, 2016
(in thousands)	Commercial real estate			Commercial and industrial			Residential real estate			Consumer			Total
Balance at beginning of period	$	4,430		$	1,590		$	2,747		$	672		$	9,439
Charged-off loans	(133		)	(90		)	(141		)	(47		)	(411		)
Recoveries on charged-off loans	40			289			44			39			412
Provision/(releases) for loan losses	808			163			71			(63		)	979
Balance at end of period	$	5,145		$	1,952		$	2,721		$	601		$	10,419
Individually evaluated for impairment	193			173			49			9			424
Collectively evaluated	4,952			1,779			2,672			592			9,995
Total	$	5,145		$	1,952		$	2,721		$	601		$	10,419



Business Activities Loans	At or for the Twelve Months Ended December 31, 2015
(in thousands)	Commercial real estate			Commercial and industrial			Residential real estate			Consumer			Total
Balance at beginning of period	$	4,613		$	1,277		$	2,714		$	365		$	8,969
Charged-off loans	(667		)	(395		)	(70		)	(487		)	(1,619		)
Recoveries on charged-off loans	98			54			129			23			304
Provision/(releases) for loan losses	386			654			(26		)	771			1,785
Balance at end of period	$	4,430		$	1,590		$	2,747		$	672		$	9,439
Individually evaluated for impairment	101			175			97			—			373
Collectively evaluated	4,329			1,415			2,650			672			9,066
Total	$	4,430		$	1,590		$	2,747		$	672		$	9,439



Acquired Loans	At or for the Twelve Months Ended December 31, 2017
(in thousands)	Commercial real estate			Commercial and industrial			Residential real estate			Consumer			Total
Balance at beginning of period	$	—		$	—		$	—		$	—		$	—
Charged-off loans	(151		)	(18		)	(29		)	(127		)	(325		)
Recoveries on charged-off loans	1			—			—			—			1
Provision/(releases) for loan losses	247			34			88			127			496
Balance at end of period	$	97		$	16		$	59		$	—		$	172
Individually evaluated for impairment	—			—			—			—			—
Collectively evaluated	97			16			59			—			172
Total	$	97		$	16		$	59		$	—		$	172

There were no loans meeting the definition of acquired for the twelve month period ending December 31, 2016 and 2015.

Credit Quality Information

Loan Origination/Risk Management: The Bank has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. The Bank’s Board of Directors reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management and the Bank's Board of Directors with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing loans and potential problem loans. The Bank seeks to diversify the loan portfolio as a means of managing risk associated with fluctuations in economic conditions.

Credit Quality Indicators/Classified Loans: In monitoring the credit quality of the commercial portfolio, management applies a credit quality indicator and uses an internal risk rating system to categorize each loan. These credit quality indicators range from one through nine, with a higher number correlating to increasing risk of loss. These ratings are used as inputs to the calculation of the allowance for loan losses. Consistent with regulatory guidelines, the Bank provides for the classification of loans which are considered to be of lesser quality as substandard, doubtful, or loss.

The following are the definitions of the Bank’s credit quality indicators:

Pass: Loans within all classes of commercial portfolio segments that are not adversely rated, are generally contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. Management believes that there is a lower risk of loss related to these loans that are considered pass.

Special mention: Loans that do not expose the Bank to risk sufficient to warrant classification in one of the subsequent categories, but which possess some weaknesses, are designated as special mention. A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. This might include loans which the lending officer may be unable to supervise properly because of: (i) lack of expertise or inadequate loan agreement; (ii) the poor condition of or lack of control over collateral; or (iii) failure to obtain proper documentation or any other deviations from prudent lending practices. Economic or market conditions which may, in the future, affect the obligor may warrant special mention of the asset. Loans for which an adverse trend in the borrower's operations or an imbalanced position in the balance sheet which has not reached a point where the liquidity, or liquidation of collateral is jeopardized may be included in this classification. Special mention loans are not adversely classified and do not expose the Bank to sufficient risks to warrant classification.

Substandard: The Bank considers a loan substandard if it is inadequately protected by the current net worth and paying capacity of the borrower or of the collateral pledged, if any. Substandard loans have a well-defined weakness that jeopardizes liquidation of the debt. Substandard loans include those loans where there is the distinct possibility of some loss of principal, if the deficiencies are not corrected.

Doubtful: Loans that the Bank classifies as doubtful have all of the weaknesses inherent in those loans that are classified as substandard but also have the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is high but because of certain important and reasonably specific pending factors which may work to the advantage and strengthening of the loan, its classification as loss is deferred until its more exact status is determined. Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans. The entire amount of the loan might not be classified as doubtful when collection of a specific portion appears highly probable.

Loss: Loans that the Bank classifies as losses are those considered uncollectible and of such little value that their continuance as an asset is not warranted and the uncollectible amounts are charged-off. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this worthless asset even though a partial recovery may be effected in the future. Losses are taken in the period in which they are determined to be uncollectible.

The following tables present the Company’s commercial loans by risk rating at December 31, 2017 and December 31, 2016:

Business Activities Loans

Commercial Real Estate

Credit Risk Profile by Creditworthiness Category



	Construction and land development				Commercial real estate other				Total commercial real estate
(in thousands)	December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016
Grade:
Pass	$	28,180	$	14,695	$	483,711	$	376,968	$	511,891	$	391,663
Special mention	73		—		5,706		5,868		5,779		5,868
Substandard	639		—		15,702		20,588		16,341		20,588
Total	$	28,892	$	14,695	$	505,119	$	403,424	$	534,011	$	418,119

Commercial and Industrial

Credit Risk Profile by Creditworthiness Category



	Commercial other				Agricultural and other loans to farmers				Tax exempt loans				Total commercial and industrial
(in thousands)	December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016
Grade:
Pass	$	194,147	$	98,968	$	27,046	$	31,279	$	42,208	$	15,679	$	263,401	$	145,926
Special mention	1,933		2,384		63		251		157		167		2,153		2,802
Substandard	1,971		2,234		479		278		—		—		2,450		2,512
Total	$	198,051	$	103,586	$	27,588	$	31,808	$	42,365	$	15,846	$	268,004	$	151,240

Acquired Loans

Commercial Real Estate

Credit Risk Profile by Creditworthiness Category



	Commercial construction and land development				Commercial real estate other				Total commercial real estate
(in thousands)	December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016
Grade:
Pass	$	16,523	$	—	$	266,477	$	—	$	283,000	$	—
Special mention	235		—		2,440		—		2,675		—
Substandard	23		—		7,037		—		7,060		—
Total	$	16,781	$	—	$	275,954	$	—	$	292,735	$	—

Commercial and Industrial

Credit Risk Profile by Creditworthiness Category



	Commercial other				Agricultural and other loans to farmers				Tax exempt loans				Total commercial and industrial
(in thousands)	December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016		December 31, 2017		December 31, 2016
Grade:
Pass	$	60,300	$	—	$	—	$	—	$	43,350	$	—	$	103,650	$	—
Special mention	5,753		—		—		—		—		—		5,753		—
Substandard	2,016		—		—		—		—		—		2,016		—
Total	$	68,069	$	—	$	—	$	—	$	43,350	$	—	$	111,419	$	—

The following table summarizes information about total loans rated Special Mention or higher as of December 31, 2017 and December 31, 2016. The table below includes consumer loans that are special mention and substandard accruing that are classified in the above table as performing based on payment activity.



	December 31, 2017						December 31, 2016
(in thousands)	Business Activities Loans		Acquired Loans		Total		Business Activities Loans		Acquired Loans		Total
Non-accrual	$	12,162	$	2,156	$	14,318	$	6,496	$	—	$	6,496
Substandard accruing	10,284		7,833		18,117		20,368		—		20,368
Total classified	22,446		9,989		32,435		26,864		—		26,864
Special mention	7,913		8,429		16,342		8,669		—		8,669
Total Criticized	$	30,359	$	18,418	$	48,777	$	35,533	$	—	$	35,533