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ALLOWANCE FOR LOAN LOSSES

12 Months Ended

Dec. 31, 2020

NOTE 4. ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is maintained at a level considered adequate to provide for an estimate of probable credit losses inherent in the loan portfolio. The allowance is increased by the provision charged to operating expense and reduced by net charge-offs. Loans are charged against the allowance for loan losses when the Company believes collectability has declined to a point where there is a distinct possibility of some loss of principal and interest. While the Company uses the best information available to make the 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 employed on a quarterly basis with respect to each of these components in order to evaluate the overall adequacy of the Company’s allowance for loan losses is as follows:

Specific Reserve for Loans Individually Evaluated

First, the Company identifies loan relationships having aggregate balances in excess of $150 thousand with potential credit weaknesses. Such loan relationships are identified primarily through the Company’s analysis of internal loan evaluations, past due loan reports, TDRs and loans adversely classified. 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 Company will be unable to collect all amounts due according to the contractual terms of the original loan agreement. Substantially all 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, the Company measures 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. The Company’s 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, the Company stratifies 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, the Company considers the necessity to adjust the 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 Company’s loan review system, (7) concentrations in the loan 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 is generated utilizing a charge-off look-back analysis, which evaluates 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 establishes 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, 2020, 2019 and 2018 was as follows:


Business Activities Loans	At or for the Year Ended December 31, 2020
	Commercial		Commercial		Residential
(in thousands)	real estate		and industrial		real estate		Consumer		Total
Balance at beginning of period	$	7,668	$	3,608	$	3,402	$	379	$	15,057
Charged-off loans		(1,036)		(540)		(43)		(306)		(1,925)
Recoveries on charged-off loans		154		21		—		45		220
Provision for loan losses		4,167		288		718		261		5,434
Balance at end of period	$	10,953	$	3,377	$	4,077	$	379	$	18,786
Individually evaluated for impairment		366		—		67		1		434
Collectively evaluated		10,587		3,377		4,010		378		18,352
Total	$	10,953	$	3,377	$	4,077	$	379	$	18,786


Acquired Loans	At or for the Year Ended December 31, 2020
	Commercial		Commercial		Residential
(in thousands)	real estate		and industrial		real estate		Consumer		Total
Balance at beginning of period	$	147	$	6	$	143	$	—	$	296
Charged-off loans		(101)		(53)		(11)		(78)		(243)
Recoveries on charged-off loans		19		9		13		11		52
Provision (release) for loan losses		225		43		(144)		67		191
Balance at end of period	$	290	$	5	$	1	$	—	$	296
Individually evaluated for impairment		290		5		1		—		296
Collectively evaluated		—		—		—		—		—
Total	$	290	$	5	$	1	$	—	$	296


Business Activities Loans	At or for the Year Ended December 31, 2019
	Commercial		Commercial		Residential
(in thousands)	real estate		and industrial		real estate		Consumer		Total
Balance at beginning of period	$	6,811	$	2,380	$	3,982	$	408	$	13,581
Charged-off loans		(212)		(336)		(109)		(228)		(885)
Recoveries on charged-off loans		194		65		55		6		320
Provision (release) for loan losses		875		1,499		(526)		193		2,041
Balance at end of period	$	7,668	$	3,608	$	3,402	$	379	$	15,057
Individually evaluated for impairment		1,231		164		57		—		1,452
Collectively evaluated		6,437		3,444		3,345		379		13,605
Total	$	7,668	$	3,608	$	3,402	$	379	$	15,057


Acquired Loans	At or for the Year Ended December 31, 2019
	Commercial		Commercial		Residential
(in thousands)	real estate		and industrial		real estate		Consumer		Total
Balance at beginning of period	$	173	$	35	$	77	$	—	$	285
Charged-off loans		—		(23)		(240)		(5)		(268)
Recoveries on charged-off loans		—		—		—		3		3
Provision (releases) for loan losses		(26)		(6)		306		2		276
Balance at end of period	$	147	$	6	$	143	$	—	$	296
Individually evaluated for impairment		12		—		49		—		61
Collectively evaluated		135		6		94		—		235
Total	$	147	$	6	$	143	$	—	$	296


Business Activities Loans	At or for the Twelve Months Ended December 31, 2018
	Commercial		Commercial		Residential
(in thousands)	real estate		and industrial		real estate		Consumer		Total
Balance at beginning of period	$	6,037	$	2,373	$	3,357	$	386	$	12,153
Charged-off loans		(417)		(111)		(225)		(629)		(1,382)
Recoveries on charged-off loans		275		76		166		18		535
Provision for loan losses		916		42		684		633		2,275
Balance at end of period	$	6,811	$	2,380	$	3,982	$	408	$	13,581
Individually evaluated for impairment		422		78		111		—		611
Collectively evaluated		6,389		2,302		3,871		408		12,970
Total	$	6,811	$	2,380	$	3,982	$	408	$	13,581


Acquired Loans	At or for the Twelve Months Ended December 31, 2018
	Commercial		Commercial		Residential
(in thousands)	real estate		and industrial		real estate		Consumer		Total
Balance at beginning of period	$	97	$	16	$	59	$	—	$	172
Charged-off loans		(136)		(166)		(158)		(65)		(525)
Recoveries on charged-off loans		43		7		—		83		133
Provision (releases) for loan losses		169		178		176		(18)		505
Balance at end of period	$	173	$	35	$	77	$	—	$	285
Individually evaluated for impairment		—		—		41		—		41
Collectively evaluated		173		35		36		—		244
Total	$	173	$	35	$	77	$	—	$	285

Credit Quality Information

Loan Origination/Risk Management: The Company has certain lending policies and procedures in place designed to maximize loan income within an acceptable level of risk. The Company’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 Company’s Board of Directors with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies, non-performing loans and potential problem loans. The Company 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 Company 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 Company’s credit quality indicators:

Pass: Loans the Company considers in the 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 the Company considers having some potential weaknesses, but are deemed to not carry levels of risk inherent in one of the subsequent categories, 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 may require a higher level of supervision or internal reporting because of: (i) declining industry trends; (ii) increasing reliance on secondary sources of repayment; (iii) the poor condition of or lack of control over collateral; or (iv) 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 Company to sufficient risks to warrant classification.

Substandard: Loans the Company considers as substandard are 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 Company considers as doubtful have all of the weaknesses inherent in those loans that are classified as substandard. These loans have the added characteristic of a well-defined weakness which is inadequately protected by the current sound worth and paying capacity of borrower or of the collateral pledged, if any, and calls into question the collectability of the full balance of the loan. 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 Company considers 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 commercial loans by risk rating at December 31, 2020 and December 31, 2019:

Business Activities 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)	Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019
Grade:
Pass	$	129,065	$	31,057	$	745,600	$	646,886	$	874,665	$	677,943
Special mention		—		—		4,626		5,483		4,626		5,483
Substandard		—		330		15,076		11,974		15,076		12,304
Doubtful		189		—		560		1,708		749		1,708
Loss		1		—		—		—		1		—
Total	$	129,255	$	31,387	$	765,862	$	666,051	$	895,117	$	697,438

Commercial and Industrial

Credit Risk Profile by Creditworthiness Category


	Commercial				Agricultural				Tax exempt loans				Total commercial and industrial
(in thousands)	Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019
Grade:
Pass	$	298,568	$	221,329	$	16,025	$	18,940	$	39,429	$	66,860	$	354,022	$	307,129
Special mention		1,644		2,744		334		298		—		—		1,978		3,042
Substandard		14,158		14,866		438		780		—		—		14,596		15,646
Doubtful		633		753		—		—		—		—		633		753
Loss		2		—		—		—		—		—		2		—
Total	$	315,005	$	239,692	$	16,797	$	20,018	$	39,429	$	66,860	$	371,231	$	326,570

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)	Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019
Performing	$	630,089	$	737,325	$	54,654	$	58,753	$	9,911	$	11,146	$	694,654	$	807,224
Nonperforming		3,301		3,362		438		615		13		21		3,752		3,998
Total	$	633,390	$	740,687	$	55,092	$	59,368	$	9,924	$	11,167	$	698,406	$	811,222

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)	Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019
Grade:
Pass	$	1,703	$	2,412	$	177,405	$	218,491	$	179,108	$	220,903
Special mention		—		12		1,449		2,261		1,449		2,273
Substandard		165		479		7,026		9,400		7,191		9,879
Doubtful		—		—		1,516		168		1,516		168
Total	$	1,868	$	2,903	$	187,396	$	230,320	$	189,264	$	233,223

Commercial and Industrial

Credit Risk Profile by Creditworthiness Category


	Commercial				Agricultural				Tax exempt loans				Total commercial and industrial
(in thousands)	Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019
Grade:
Pass	$	43,972	$	51,184	$	20	$	58	$	24,002	$	37,407	$	67,994	$	88,649
Special mention		793		5,432		—		—		—		—		793		5,432
Substandard		451		2,115		133		148		—		36		584		2,299
Doubtful		467		341		—		—		—		—		467		341
Total	$	45,683	$	59,072	$	153	$	206	$	24,002	$	37,443	$	69,838	$	96,721

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)	Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019		Dec 31, 2020		Dec 31, 2019
Performing	$	288,073	$	407,811	$	47,081	$	62,504	$	1,156	$	1,707	$	336,310	$	472,022
Nonperforming		2,428		3,359		291		529		—		8		2,719		3,896
Total	$	290,501	$	411,170	$	47,372	$	63,033	$	1,156	$	1,715	$	339,029	$	475,918

The following table summarizes information about total classified and criticized loans as of December 31, 2020 and December 31, 2019.


	December 31, 2020						December 31, 2019
	Business						Business
(in thousands)	Activities Loans		Acquired Loans		Total		Activities Loans		Acquired Loans		Total
Non-accrual	$	6,437	$	5,751	$	12,188	$	8,354	$	3,196	$	11,550
Substandard accruing		28,371		6,726		35,097		26,055		13,387		39,442
Loss accruing		1		—		1		—		—		—
Total classified		34,809		12,477		47,286		34,409		16,583		50,992
Special mention		6,604		2,242		8,846		8,525		7,705		16,230
Total Criticized	$	41,413	$	14,719	$	56,132	$	42,934	$	24,288	$	67,222