ALLOWANCE FOR LOAN LOSSES

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 with potential 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 for impairment. Loans are considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the original loan agreement. Substantially all of our impaired loans have historically 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 the loan portfolio into two general business loan pools: substandard (7 risk rated) and pass-rated (0 to 6 rated) by loan type. Substandard rated loans are subject to higher credit loss rates in the allowance for loan loss calculation. The Company utilizes historical loss rates for commercial real estate and commercial and industrial loans assessed by internal risk rating. Historical loss rates on residential real estate and consumer loans are not risk graded. Residential real estate 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 12 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 three and six months ended June 30, 2018 and 2017 was as follows:



Business Activities Loans	At or for the Three Months Ended June 30, 2018
(in thousands)	Commercial real estate			Commercial and industrial			Residential real estate		Consumer			Total
Balance at beginning of period	$	5,998		$	2,612		$	3,304	$	500		$	12,414
Charged-off loans	(156		)	(27		)	—		(216		)	(399		)
Recoveries on charged-off loans	46			4			—		2			52
Provision (releases) for loan losses	479			(80		)	150		107			656
Balance at end of period	$	6,367		$	2,509		$	3,454	$	393		$	12,723
Individually evaluated for impairment	682			34			80		—			796
Collectively evaluated	5,685			2,475			3,374		393			11,927
Total	$	6,367		$	2,509		$	3,454	$	393		$	12,723



Business Activities Loans	At or for the Six Months Ended June 30, 2018
(in thousands)	Commercial real estate			Commercial and industrial			Residential real estate		Consumer			Total
Balance at beginning of period	$	6,037		$	2,373		$	3,357	$	386		$	12,153
Charged-off loans	(156		)	(111		)	—		(386		)	(653		)
Recoveries on charged-off loans	61			6			1		4			72
Provision (releases) for loan losses	425			241			96		389			1,151
Balance at end of period	$	6,367		$	2,509		$	3,454	$	393		$	12,723
Individually evaluated for impairment	682			34			80		—			796
Collectively evaluated	5,685			2,475			3,374		393			11,927
Total	$	6,367		$	2,509		$	3,454	$	393		$	12,723



Business Activities Loans	At or for the Three Months Ended June 30, 2017
(in thousands)	Commercial real estate			Commercial and industrial			Residential real estate			Consumer			Total
Balance at beginning of period	$	5,307		$	2,143		$	2,806		$	628		$	10,884
Charged-off loans	(7		)	(170		)	(13		)	(23		)	(213		)
Recoveries on charged-off loans	1			32			—			2			35
Provision (releases) for loan losses	202			105			326			(6		)	627
Balance at end of period	$	5,503		$	2,110		$	3,119		$	601		$	11,333
Individually evaluated for impairment	380			4			10			—			394
Collectively evaluated	5,123			2,106			3,109			601			10,939
Total	$	5,503		$	2,110		$	3,119		$	601		$	11,333



Business Activities Loans	At or for the Six Months Ended June 30, 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	(112		)	(187		)	(212		)	(46		)	(557		)
Recoveries on charged-off loans	3			32			1			13			49
Provision (releases) for loan losses	467			313			609			33			1,422
Balance at end of period	$	5,503		$	2,110		$	3,119		$	601		$	11,333
Individually evaluated for impairment	380			4			10			—			394
Collectively evaluated	5,123			2,106			3,109			601			10,939
Total	$	5,503		$	2,110		$	3,119		$	601		$	11,333



Acquired Loans	At or for the Three Months Ended June 30, 2018
(in thousands)	Commercial real estate		Commercial and industrial			Residential real estate			Consumer			Total
Balance at beginning of period	$	83	$	124		$	58		$	—		$	265
Charged-off loans	—		(37		)	(64		)	(17		)	(118		)
Recoveries on charged-off loans	18		6			—			82			106
Provision (releases) for loan losses	99		(11		)	91			(65		)	114
Balance at end of period	$	200	$	82		$	85		$	—		$	367
Individually evaluated for impairment	—		77			—			—			77
Collectively evaluated	200		5			85			—			290
Total	$	200	$	82		$	85		$	—		$	367



Acquired Loans	At or for the Six Months Ended June 30, 2018
(in thousands)	Commercial real estate			Commercial and industrial			Residential real estate			Consumer			Total
Balance at beginning of period	$	97		$	16		$	59		$	—		$	172
Charged-off loans	(106		)	(95		)	(64		)	(60		)	(325		)
Recoveries on charged-off loans	18			6			—			82			106
Provision (releases) for loan losses	191			155			90			(22		)	414
Balance at end of period	$	200		$	82		$	85		$	—		$	367
Individually evaluated for impairment	—			77			—			—			77
Collectively evaluated	200			5			85			—			290
Total	$	200		$	82		$	85		$	—		$	367



Acquired Loans	At or for the Three Months Ended June 30, 2017
(in thousands)	Commercial real estate		Commercial and industrial		Residential real estate		Consumer		Total
Balance at beginning of period	$	—	$	—	$	—	$	—	$	—
Charged-off loans	—		—		—		—		—
Recoveries on charged-off loans	—		—		—		—		—
Provision (releases) for loan losses	51		24		34		—		109
Balance at end of period	$	51	$	24	$	34	$	—	$	109
Individually evaluated for impairment	51		24		34		—		109
Collectively evaluated	—		—		—		—		—
Total	$	51	$	24	$	34	$	—	$	109



Acquired Loans	At or for the Six Months Ended June 30, 2017
(in thousands)	Commercial real estate		Commercial and industrial		Residential real estate		Consumer		Total
Balance at beginning of period	$	—	$	—	$	—	$	—	$	—
Charged-off loans	—		—		—		—		—
Recoveries on charged-off loans	—		—		—		—		—
Provision (releases) for loan losses	51		24		34		—		109
Balance at end of period	$	51	$	24	$	34	$	—	$	109
Individually evaluated for impairment	51		24		34		—		109
Collectively evaluated	—		—		—		—		—
Total	$	51	$	24	$	34	$	—	$	109

Loan Origination/Risk Management: The Bank has certain lending policies and procedures in place 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 portfolio, management applies a credit quality indicator and uses an internal risk rating system to categorize commercial loans. 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 special mention, substandard, doubtful, or loss (i.e. risk rated 6, 7, 8 and 9, respectively).

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 contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. Management believes there is a low risk of loss related to these loans considered pass rated.

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, 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 liquidation 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 the Bank classifies as doubtful have all of the weaknesses inherent in those loans that are classified as substandard.These loans have the added characteristic of 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. Loans are generally not classified doubtful for an extended period of time (i.e., over a year).

Loss: Loans 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 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 partial recovery may be affected in the future. Losses are taken in the period in which they are determined to be uncollectible.

The following tables present the Company’s loans by risk rating at June 30, 2018 and December 31, 2017:

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)	Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017
Grade:
Pass	$	27,647	$	28,180	$	517,753	$	483,711	$	545,400	$	511,891
Special mention	73		73		7,139		5,706		7,212		5,779
Substandard	2		639		15,688		15,702		15,690		16,341
Total	$	27,722	$	28,892	$	540,580	$	505,119	$	568,302	$	534,011

Commercial and Industrial

Credit Risk Profile by Creditworthiness Category



	Other Commercial				Agricultural				Tax exempt loans				Total commercial and industrial
(in thousands)	Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017
Grade:
Pass	$	222,898	$	194,147	$	24,684	$	27,046	$	45,243	$	42,208	$	292,825	$	263,401
Special mention	1,355		1,933		68		63		157		157		1,580		2,153
Substandard	1,890		1,971		532		479		—		—		2,422		2,450
Total	$	226,143	$	198,051	$	25,284	$	27,588	$	45,400	$	42,365	$	296,827	$	268,004

Residential Real Estate and Consumer Loans

Credit Risk Profile Based on Payment Activity



	Residential real estate				Home equity				Other consumer				Total Residential real estate and consumer
(in thousands)	Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017
Performing	$	598,904	$	588,003	$	53,413	$	51,246	$	8,127	$	7,733	$	660,444	$	646,982
Nonperforming	7,224		3,408		440		130		88		95		7,752		3,633
Total	$	606,128	$	591,411	$	53,853	$	51,376	$	8,215	$	7,828	$	668,196	$	650,615

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)	Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017
Grade:
Pass	$	9,289	$	16,523	$	251,388	$	266,477	$	260,677	$	283,000
Special mention	—		235		1,596		2,440		1,596		2,675
Substandard	253		23		7,718		7,037		7,971		7,060
Total	$	9,542	$	16,781	$	260,702	$	275,954	$	270,244	$	292,735

Commercial and Industrial

Credit Risk Profile by Creditworthiness Category



	Other Commercial				Agricultural				Tax exempt loans				Total commercial and industrial
(in thousands)	Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017
Grade:
Pass	$	54,605	$	60,300	$	—	$	—	$	41,213	$	43,350	$	95,818	$	103,650
Special mention	5,934		5,753		—		—		—		—		5,934		5,753
Substandard	1,714		2,016		—		—		—		—		1,714		2,016
Total	$	62,253	$	68,069	$	—	$	—	$	41,213	$	43,350	$	103,466	$	111,419

Residential Real Estate and Consumer Loans

Credit Risk Profile Based on Payment Activity



	Residential real estate				Home equity				Other consumer				Total Residential real estate and consumer
(in thousands)	Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017		Jun 30, 2018		Dec 31, 2017
Performing	$	518,067	$	562,516	$	54,291	$	62,000	$	1,794	$	2,283	$	574,152	$	626,799
Nonperforming	3,700		1,755		166		217		13		58		3,879		2,030
Total	$	521,767	$	564,271	$	54,457	$	62,217	$	1,807	$	2,341	$	578,031	$	628,829

The following table summarizes information about total classified and criticized loans loans as of June 30, 2018 and December 31, 2017:



	June 30, 2018						December 31, 2017
(in thousands)	Business Activities Loans		Acquired Loans		Total		Business Activities Loans		Acquired Loans		Total
Non-accrual	$	17,965	$	3,981	$	21,946	$	12,140	$	2,156	$	14,296
Substandard accruing	7,901		9,583		17,484		10,284		7,833		18,117
Total classified	25,866		13,564		39,430		22,424		9,989		32,413
Special mention	8,792		7,530		16,322		7,932		8,428		16,360
Total Criticized	$	34,658	$	21,094	$	55,752	$	30,356	$	18,417	$	48,773