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EX-21 - LIST OF SUBSIDIARIES - CITIZENS FINANCIAL SERVICES INCsubsidiaries.htm
EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - CITIZENS FINANCIAL SERVICES INCceocert.htm
EX-32.1 - SECTION 1350 CERTIFICATION OF CHIEF EXECUTIVE OFFICER - CITIZENS FINANCIAL SERVICES INCcertceo.htm
EX-31.2 - CERTFIICATION OF CHIEF FINANCIAL OFFICER - CITIZENS FINANCIAL SERVICES INCcfocert.htm
EX-32.2 - SECTION 1350 CERTIFICATION OF CHIEF FINANCIAL OFFICER - CITIZENS FINANCIAL SERVICES INCcertcfo.htm
EXCEL - IDEA: XBRL DOCUMENT - CITIZENS FINANCIAL SERVICES INCFinancial_Report.xls
EX-23 - CONSENT OF SR SNODGRASS CERTIFIED PUBLIC ACCOUNTANTS - CITIZENS FINANCIAL SERVICES INCsnodgrassconsent.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
(Mark One)

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

For the fiscal year ended
 
     December 31, 2014

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

For the transition period from
 
to
 

Commission file number
     000-13222

CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)
Pennsylvania
 
23-2265045
State or other jurisdiction of
incorporation or organization
 
(I.R.S. Employer
Identification No.)
15 South Main Street, Mansfield, Pennsylvania
 
16933
(Address of principal executive offices)
 
(Zip Code)
Registrant’s telephone number, including area code
(570) 662-2121
         
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 period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
  Yes       No
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted 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 and post such files).
  Yes       No
 
 
 

 
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
                
 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer  o                                                                                     Accelerated filer  
 
 
Non-accelerated filer  o                                                                           Smaller reporting company  o
 
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
      Yes       No

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $146,929,872 as of June 30, 2014.
 
As of February 23, 2015, there were 3,029,726 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE
 
Certain information required by Part III is incorporated by reference to the Registrant’s Definitive Proxy Statement for the 2015 Annual Meeting of Shareholders.



 
 

 
 
Citizens Financial Services, Inc.
Form 10-K
INDEX
 
Page
PART I
 
ITEM 1 – BUSINESS
1 – 8
 
ITEM 1A – RISK FACTORS
8 – 13
 
ITEM 1B – UNRESOLVED STAFF COMMENTS
13
 
ITEM 2 – PROPERTIES
13
 
ITEM 3 – LEGAL PROCEEDINGS
13
 
ITEM 4 – MINE SAFETY DISCLOSURES
13
 
PART II
 
ITEM 5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
14 – 15
 
ITEM 6 – SELECTED FINANCIAL DATA
16
 
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS  OF OPERATIONS
17 – 46
 
ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
46
 
ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
47 – 93
 
ITEM 9 – CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
94
 
ITEM 9A – CONTROLS AND PROCEDURES
94
 
ITEM 9B– OTHER INFORMATION
94
 
PART III
 
ITEM 10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
95
 
ITEM 11 – EXECUTIVE COMPENSATION
95
 
ITEM 12 – SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
95 – 96
 
ITEM 13 – CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
96
 
ITEM 14 – PRINCIPAL ACCOUNTANT FEES AND SERVICES
96
 
PART IV
 
ITEM 15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
97 – 98
 
SIGNATURES
99
 

 
 

 
 
PART I
 
ITEM 1 – BUSINESS.
 
CITIZENS FINANCIAL SERVICES, INC.
 
Citizens Financial Services, Inc. (the “Company”), a Pennsylvania corporation, was incorporated on April 30, 1984 to be the holding company for First Citizens Community Bank (the “Bank”), which until 2012, and in connection with its conversion from a national bank to a Pennsylvania-chartered bank and trust company, operated under the name First Citizens National Bank. The Company is primarily engaged in the ownership and management of the Bank and the Bank’s wholly-owned insurance agency subsidiary, First Citizens Insurance Agency, Inc.
 
AVAILABLE INFORMATION
 
A copy of the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current events reports on Form 8-K, and amendments to these reports, filed or furnished pursuant to Section 13(a) or 15(d)  of the Securities Exchange Act of 1934, as amended, are made available free of charge through the Company’s web site at www.firstcitizensbank.com as soon as reasonably practicable after such reports are filed with or furnished to  the Securities and Exchange Commission. Information on our website shall not be considered as incorporated by reference into this Form 10-K.
 
FIRST CITIZENS COMMUNITY BANK
 
The Bank is a full-service bank engaged in a broad range of banking activities and services for individual, business, governmental and institutional customers.  These activities and services principally include checking, savings, and time deposit accounts; residential, commercial and agricultural real estate, commercial and industrial, state and political subdivision and consumer loans; and a variety of other specialized financial services.  The Trust and Investment division of the Bank offers a full range of client investment, estate, mineral management and retirement services.
 
The Bank’s main office is located at 15 South Main Street, Mansfield, (Tioga County) Pennsylvania.  The Bank’s primary market area consists of the Pennsylvania Counties of Bradford, Potter and Tioga in north central Pennsylvania.  It also includes Allegany, Steuben, Chemung and Tioga Counties in Southern New York.  The economy of the Bank’s market area is diversified and includes manufacturing industries, wholesale and retail trade, service industries, family farms and the production of natural resources of gas and timber.  We are dependent geographically upon the economic conditions in north central Pennsylvania and the southern tier of New York.  In addition to the main office, the Bank has 16 other full service branch offices in its market area and two loan production offices located in Clinton and Luzerne Counties in Pennsylvania. In February 2015, the Bank opened a full service branch that replaced the loan production office in Clinton County.
 
As of December 31, 2014, the Bank had 172 full time employees and 34 part-time employees, resulting in 189 full time equivalent employees at our corporate offices and other banking locations.
 
COMPETITION
 
The banking industry in the Bank’s service area is competitive, both among commercial banks and with financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions and internet entities.  The increased competition has resulted from changes in the legal and regulatory guidelines as well as from economic conditions, specifically, the additional wealth resulting from the exploration for natural gas in in our primary market.  Mortgage banking firms, financial companies, financial affiliates of industrial companies, brokerage firms, retirement fund management firms and government sponsored agencies, such as Freddie Mac and Fannie Mae, provide additional competition for loans and other financial services.  The Bank is generally competitive with all competing financial institutions in its service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.
 
 
1

 
 
Additional information related to our business and competition is included in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations”.
 
SUPERVISION AND REGULATION

GENERAL
 
The Bank is subject to extensive regulation, examination and supervision by the Pennsylvania Department of Banking (“PDB”) and, as a member of the Federal Reserve System, by the Board of Governors of the Federal Reserve System (the “FRB”).  Federal and state banking laws and regulations govern, among other things, the scope of a bank’s business, the investments a bank may make, the reserves against deposits a bank must maintain, terms of deposit accounts, loans a bank makes, the interest rates a bank charges and collateral a bank takes, the activities of a bank with respect to mergers and consolidations and the establishment of branches.  The Company is registered as a bank holding company and is subject to supervision and regulation by FRB under the Bank Holding Company Act of 1956, as amended (the “BHCA”).

PENNSYLVANIA BANKING LAWS
 
The Pennsylvania Banking Code (“Banking Code”) contains detailed provisions governing the organization, location of offices, rights and responsibilities of directors, officers, and employees, as well as corporate powers, savings and investment operations and other aspects of the Bank and its affairs. The Banking Code delegates extensive rule-making power and administrative discretion to the PDB so that the supervision and regulation of state chartered banks may be flexible and readily responsive to changes in economic conditions and in savings and lending practices.
 
Pennsylvania law also provides Pennsylvania state chartered institutions elective parity with the power of national banks, federal thrifts, and state-chartered institutions in other states as authorized by the FDIC, subject to a required notice to the PDB. The Federal Deposit Insurance Corporation Act (“FDIA”), however, prohibits state chartered banks from making new investments, loans, or becoming involved in activities as principal and equity investments which are not permitted for national banks unless (1) the FDIC determines the activity or investment does not pose a significant risk of loss to the Deposit Insurance Fund and (2) the bank meets all applicable capital requirements. Accordingly, the additional operating authority provided to the Bank by the Banking Code is restricted by the FDIA.
 
In April 2008, banking regulators in the States of New Jersey, New York, and Pennsylvania entered into a Memorandum of Understanding (the “Interstate MOU”) to clarify their respective roles, as home and host state regulators, regarding interstate branching activity on a regional basis pursuant to the Riegle-Neal Amendments Act of 1997. The Interstate MOU establishes the regulatory responsibilities of the respective state banking regulators regarding bank regulatory examinations and is intended to reduce the regulatory burden on state chartered banks branching within the region by eliminating duplicative host state compliance exams.  Under the Interstate MOU, the activities of branches we established in New York would be governed by Pennsylvania state law to the same extent that federal law governs the activities of the branch of an out-of-state national bank in such host states. Issues regarding whether a particular host state law is preempted are to be determined in the first instance by the PDB. In the event that the PDB and the applicable host state regulator disagree regarding whether a particular host state law is pre-empted, the PDB and the applicable host state regulator would use their reasonable best efforts to consider all points of view and to resolve the disagreement.
 
COMMUNITY REINVESTMENT ACT
 
The Community Reinvestment Act, (“CRA”), as implemented by FRB regulations, provides that the Bank has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods.  The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA.  The CRA requires the FRB, in connection with its examination of the Bank, to assess the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain corporate applications by such institution, such as mergers and branching.  The Bank’s most recent rating was “Satisfactory.”  Various consumer laws and regulations also affect the operations of the Bank.  In addition to the impact of regulation, commercial banks are affected significantly by the actions of the FRB as it attempts to control the money supply and credit availability in order to influence the economy.
 
 
2

 
 
THE DODD-FRANK ACT
 
The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) has significantly changed the current bank regulatory structure and will affect into the immediate future the lending and investment activities and general operations of depository institutions and their holding companies.
 
The Dodd-Frank Act requires the FRB to establish minimum consolidated capital requirements for bank holding companies that are as stringent as those required for insured depository institutions; the components of Tier 1 capital would be restricted to capital instruments that are currently considered to be Tier 1 capital for insured depository institutions. In addition, the proceeds of trust preferred securities are excluded from Tier 1 capital unless (i) such securities are issued by bank holding companies with assets of less than $500 million or (ii) such securities were issued prior to May 19, 2010 by bank or savings and loan holding companies with less than $15 billion of assets. The exclusion of such proceeds will be phased in over a three year period beginning in 2013.
 
The Dodd-Frank Act also created a new Consumer Financial Protection Bureau with extensive powers to implement and enforce consumer protection laws. The Consumer Financial Protection Bureau has broad rulemaking authority for a wide range of consumer protection laws that apply to all banks, among other things, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. However, institutions of less than $10 billion in assets, such as the Bank, will continue to be examined for compliance with consumer protection and fair lending laws and regulations by, and be subject to the enforcement authority of, their prudential regulators.
 
The Dodd-Frank Act created a new supervisory structure for oversight of the U.S. financial system, including the establishment of a new council of regulators, the Financial Stability Oversight Council, to monitor and address systemic risks to the financial system. Non-bank financial companies that are deemed to be significant to the stability of the U.S. financial system and all bank holding companies with $50 billion or more in total consolidated assets will be subject to heightened supervision and regulation. The FRB will implement prudential requirements and prompt corrective action procedures for such companies.
 
The Dodd-Frank Act made many other changes in banking regulation. Those include allowing depository institutions, for the first time, to pay interest on business checking accounts, requiring originators of securitized loans to retain a percentage of the risk for transferred loans, establishing regulatory rate-setting for certain debit card interchange fees and establishing a number of reforms for mortgage originations. Effective October 1, 2011, the debit-card interchange fee was capped at $0.21 per transaction, plus an additional 5 basis point charge to cover fraud losses. These fees are much lower than the current market rates. Although the regulation only impacts banks with assets above $10 billion, we believe that the provisions could result in a reduction in interchange revenue in the future.
 
The Dodd-Frank Act also broadened the base for FDIC insurance assessments. The FDIC was required to promulgate rules revising its assessment system so that it is based on the average consolidated total assets less tangible equity capital of an insured institution instead of deposits. That rule took effect April 1, 2011. The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2008.
 
Under provisions of the Dodd-Frank Act referred to as the “Volcker Rule” certain limitations are placed on the ability of bank holding companies and their affiliates to engage in sponsoring, investing in and transacting with certain investment funds, including hedge funds and private equity funds (collectively “covered funds”). The Volcker Rule also places restrictions on proprietary trading, which could impact certain hedging activities. The Volcker Rule becomes fully effective in July 2015. We do not expect this rule to have a material impact on the Company.
 
Many of the provisions of the Dodd-Frank Act are not yet effective, and the Dodd-Frank Act requires various federal agencies to promulgate numerous and extensive implementing regulations over the next several years. It is therefore difficult to predict at this time what impact the Dodd-Frank Act and implementing regulations will have on the Company and the Bank. Although the substance and scope of many of these regulations cannot be determined at this time, particularly those provisions relating to the new Consumer Financial Protection Bureau, the Dodd-Frank Act and implementing regulations may have a material impact on operations through, among other things, increased compliance costs, heightened regulatory supervision, and higher interest expense.
 
 
3

 
 
CURRENT CAPITAL REQUIREMENTS
 
Federal banking agencies have issued certain “risk-based capital” guidelines, which supplemented existing capital requirements.  In addition, the FRB imposes certain “leverage” requirements on member banks such as us.  Banking regulators have authority to require higher minimum capital ratios for an individual bank or bank holding company in view of its circumstances.
 
The risk-based guidelines require all banks and bank holding companies to maintain two “risk-weighted assets” ratios.  The first is a minimum ratio of total capital (Tier 1 and Tier 2 capital) to risk-weighted assets equal to 8.0%; the second is a minimum ratio of Tier 1 capital to risk-weighted assets equal to 4.0%.  Assets are assigned to five risk categories, with higher levels of capital being required for the categories perceived as representing greater risk.  In making the calculation, certain intangible assets must be deducted from the capital base.  The risk-based capital rules are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and to minimize disincentives for holding liquid assets.
 
The risk-based capital rules also account for interest rate risk.  Institutions with interest rate risk exposure above a normal level would be required to hold extra capital in proportion to that risk.  A bank’s exposure to declines in the economic value of its capital due to changes in interest rates is a factor that banking agencies will consider in evaluating a bank’s capital adequacy.  The rule does not codify an explicit minimum capital charge for interest rate risk.  We currently monitor and manage our assets and liabilities for interest rate risk, and management believes that the interest rate risk rules which have been implemented and proposed will not materially adversely affect our operations.
 
The FRB’s “leverage” ratio rules require member banks which are rated the highest in the composite areas of capital, asset quality, management, earnings and liquidity to maintain a ratio of Tier 1 capital to “adjusted total assets” of not less than 3.0%.  For banks which are not the most highly rated, the minimum “leverage” ratio will range from 4.0% to 5.0%, or higher at the discretion of the FRB, and is required to be at a level commensurate with the nature of the level of risk of a bank’s condition and activities.
 
For purposes of the capital requirements, “Tier 1” or “core” capital is defined to include common shareholders’ equity and certain noncumulative perpetual preferred stock and related surplus.  “Tier 2” or “qualifying supplementary” capital is defined to include a bank’s allowance for loan and lease losses up to 1.25% of risk-weighted assets, plus certain types of preferred stock and related surplus, certain “hybrid capital instruments” and certain term subordinated debt instruments.
 
NEW CAPITAL RULE – BASEL III
 
On July 9, 2013, the federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision (“Basel III”) and certain provisions of the Dodd-Frank Act. The final rule applies to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more and top-tier savings and loan holding companies.
 
The rule establishes a new common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets), increases the minimum Tier 1 capital to risk-based assets requirement (from 4.0% to 6.0% of risk-weighted assets) and assigns a higher risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and to certain commercial real estate facilities that finance the acquisition, development or construction of real property.
 
 
4

 
 
The rule also includes changes in what constitutes regulatory capital, some of which are subject to a transition period. These changes include the phasing-out of certain instruments as qualifying capital. In addition, Tier 2 capital is no longer limited to the amount of Tier 1 capital included in total capital. Mortgage servicing rights, certain deferred tax assets and investments in unconsolidated subsidiaries over designated percentages of common stock will be required to be deducted from capital, subject to a transition period. Finally, Tier 1 capital will include accumulated other comprehensive income (which includes all unrealized gains and losses on available for sale debt and equity securities), subject to a transition period and a one-time opt-out election.
 
The new capital requirements also include changes in the risk weights of assets to better reflect credit risk and other risk exposures. These include a 150% risk weight (up from 100%) for certain high volatility commercial real estate acquisition, development and construction loans and nonresidential mortgage loans that are 90 days past due or otherwise on nonaccrual status; a 20% (up from 0%) credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable; a 250% risk weight (up from 100%) for mortgage servicing rights and deferred tax assets that are not deducted from capital; and increased risk-weights (from 0% to up to 600%) for equity exposures.
 
Finally, the rule limits capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements.
 
The final rule becomes effective on January 1, 2015. The capital conservation buffer requirement will be phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, increasing each year until fully implemented at 2.5% on January 1, 2019.
 
It is management’s belief that, as of December 31, 2014, we would have met all capital adequacy requirements under the new capital rules on a fully phased-in basis if such requirements were then in effect.
 
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.”  Institutions that are classified as undercapitalized, significantly undercapitalized or critically undercapitalized are subject to various supervision measures based on the degree of undercapitalization.  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).  The Bank satisfies the criteria to be classified as “well capitalized” within the meaning of applicable regulations.
 
REGULATORY RESTRICTIONS ON BANK DIVIDENDS
 
The Bank may not declare a dividend without approval of the FRB, unless the dividend to be declared by the Bank's Board of Directors does not exceed the total of:  (i) the Bank's net profits for the current year to date, plus (ii) its retained net profits for the preceding two years, less any required transfers to surplus.
 
Under Pennsylvania law, the Bank may only declare and pay dividends from its accumulated net earnings.  In addition, the Bank may not declare and pay dividends from the surplus funds that Pennsylvania law requires that it maintain.  Under these policies and subject to the restrictions applicable to the Bank, the Bank could have declared, during 2014, without prior regulatory approval, aggregate dividends of approximately $19.3 million, plus net profits earned to the date of such dividend declaration.
 
BANK SECRECY ACT
 
Under the Bank Secrecy Act (BSA), banks and other financial institutions are required to retain records to assure that the details of financial transactions can be traced if investigators need to do so.  Banks are also required to report most cash transactions in amounts exceeding $10,000 made by or on behalf of their customers.  Failure to meet BSA requirements may expose the Bank to statutory penalties, and a negative compliance record may affect the willingness of regulating authorities to approve certain actions by the Bank requiring regulatory approval, including new branches.
 
 
5

 
 
INSURANCE OF DEPOSIT ACCOUNTS
 
The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund (DIF) of the FDIC.  Under the FDIC’s risk-based assessment system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors, with less risky institutions paying lower assessments.  An institution’s assessment rate depends upon the category to which it is assigned, and certain adjustments specified by FDIC regulations.  Until recently, assessment rates ranged from seven to 77.5 basis points of assessable deposits.
 
On February 7, 2011, as required by the Dodd-Frank Act, the FDIC issued final rules implementing changes to the assessment rules. The rule, which took effect April 1, 2011, changes the assessment base used for calculating deposit insurance assessments from deposits to total assets less tangible (Tier 1) capital. Since the new base is larger than the previous base, the FDIC also lowered assessment rates so that the rule would not significantly alter the total amount of revenue collected from the industry. The range of adjusted assessment rates is now 2.5 to 45 basis points of the new assessment base. The rule is expected to benefit smaller financial institutions, which typically rely more on deposits for funding, and shift more of the burden for supporting the insurance fund to larger institutions, which are thought to have greater access to nondeposit funding. No institution may pay a dividend if it is in default of its assessments.
 
Due to the recent difficult economic conditions, deposit insurance per account owner has been raised to $250,000 for all types of accounts.  That coverage was made permanent by the Dodd-Frank Act.
 
The Dodd-Frank Act increased the minimum target DIF ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits.  The FDIC must seek to achieve the 1.35% ratio by September 30, 2020.  Insured institutions with assets of $10 billion or more are supposed to fund the increase.  The Dodd-Frank Act eliminated the 1.5% maximum fund ratio, instead leaving it to the discretion of the FDIC. The FDIC has recently exercised that discretion by establishing a long range fund ratio of 2%.
 
The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank.  Management cannot predict what insurance assessment rates will be in the future.
 
Insurance of deposits may be terminated by the FDIC upon a finding that the 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 regulatory condition imposed in writing.  The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
 
FEDERAL RESERVE SYSTEM
 
Under FRB regulations, the Bank is required to maintain reserves against its transaction accounts (primarily NOW and regular checking accounts). For 2015, the Bank is required to maintain average daily reserves equal to 3% on aggregate transaction accounts of up to $103.6 million, plus 10% on the remainder, and the first $14.5 million of otherwise reservable balances will be exempt. These reserve requirements are subject to adjustment by the FRB.  The Bank is in compliance with the foregoing requirements.
 
ACQUISITION OF THE HOLDING COMPANY
 
Under the Federal Change in Bank Control Act (the “CIBCA”), a notice must be submitted to the FRB if any person (including a company), or group acting in concert, seeks to acquire 10% or more of the Company’s shares of outstanding common stock, unless the FRB has found that the acquisition will not result in a change in control of the Company. Under the CIBCA, the FRB generally has 60 days within which to act on such notices, taking into consideration certain factors, including the financial and managerial resources of the acquirer, the convenience and needs of the communities served by the Company and the Bank, and the anti-trust effects of the acquisition. Under the BHCA, any company would be required to obtain prior approval from the FRB before it may obtain “control” of the Company within the meaning of the BHCA. Control generally is defined to mean the ownership or power to vote 25% or more of any class of voting securities of the Company or the ability to control in any manner the election of a majority of the Company’s directors. An existing bank holding company would be required to obtain the FRB’s prior approval under the BHCA before acquiring more than 5% of the Company’s voting stock.
 
 
6

 
 
HOLDING COMPANY REGULATION
 
The Company, as a bank holding company, is subject to examination, supervision, regulation, and periodic reporting under the Bank Holding Company Act of 1956, as amended, as administered by the FRB.  The Company is required to obtain the prior approval of the FRB to acquire all, or substantially all, of the assets of any bank or bank holding company.  Prior FRB approval would be required for the Company to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if it would, directly or indirectly, own or control more than 5% of any class of voting shares of the bank or bank holding company.
 
A bank holding company is generally prohibited from engaging in, or acquiring, direct or indirect control of more than 5% of the voting securities of any company engaged in nonbanking activities.  One of the principal exceptions to this prohibition is for activities found by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.  Some of the principal activities that the FRB has determined by regulation to be closely related to banking are: (i) making or servicing loans; (ii) performing certain data processing services; (iii) providing securities brokerage services; (iv) acting as fiduciary, investment or financial advisor; (v) leasing personal or real property under certain conditions; (vi) making investments in corporations or projects designed primarily to promote community welfare; and (vii) acquiring a savings association.
 
A bank holding company that meets specified conditions, including that its depository institutions subsidiaries are “well capitalized” and “well managed,” can opt to become a “financial holding company.” A “financial holding company” may engage in a broader array of financial activities than permitted a typical bank holding company.  Such activities can include insurance underwriting and investment banking.  The Company does not anticipate opting for “financial holding company” status at this time.
 
The Company is subject to the FRB’s consolidated capital adequacy guidelines for bank holding companies.  Traditionally, those guidelines have been structured similarly to the regulatory capital requirements for the subsidiary depository institutions, but were somewhat more lenient.  For example, the holding company capital requirements allowed inclusion of certain instruments in Tier 1 capital that are not includable at the institution level.  As previously noted, the Dodd-Frank Act requires that the guidelines be amended so that they are at least as stringent as those required for the subsidiary depository institutions.  See  “—The Dodd-Frank Act.”
 
A bank holding company is generally required to give the FRB prior written notice of any purchase or redemption of then outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the Company’s consolidated net worth.  The FRB may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, FRB order or directive, or any condition imposed by, or written agreement with, the FRB.  The FRB has adopted an exception to that approval requirement for well-capitalized bank holding companies that meet certain other conditions.
 
The FRB has issued a policy statement regarding the payment of dividends by bank holding companies.  In general, the FRB’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition.  The FRB’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by using available resources to provide capital funds during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary.  The Dodd-Frank Act codified the source of strength policy and requires the promulgation of implementing regulations.  Under the prompt corrective action laws, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized.  These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.
 
 
7

 
 
The Federal Deposit Insurance Act makes depository institutions liable to the Federal Deposit Insurance Corporation for losses suffered or anticipated by the insurance fund in connection with the default of a commonly controlled depository institution or any assistance provided by the Federal Deposit Insurance Corporation to such an institution in danger of default.  That law would have potential applicability if the Company ever held as a separate subsidiary a depository institution in addition to the Bank.
 
The status of the Company as a registered bank holding company under the Bank Holding Company Act will not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws.
 
EFFECT OF GOVERNMENT MONETARY POLICIES
 
The earnings and growth of the banking industry are affected by the credit policies of monetary authorities, including the Federal Reserve System.  An important function of the Federal Reserve System is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures.  Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market activities in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits.  These operations are used in varying combinations to influence overall economic growth and indirectly, bank loans, securities, and deposits.  These variables may also affect interest rates charged on loans or paid on deposits.  The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.
 
In view of the changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities including the Federal Reserve System, no prediction can be made as to possible changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and the Bank.   Additional information is included under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in this Annual Report on Form 10-K.
 
ITEM 1A – RISK FACTORS.
 
Changing interest rates may decrease our earnings and asset values.
 
Our net interest income is the interest we earn on loans and investments less the interest we pay on our deposits and borrowings.  Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding.  Changes in interest rates—up or down—could adversely affect our net interest margin and, as a result, our net interest income.  Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract.  Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates.  As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the asset yields catch up.   Changes in the slope of the “yield curve”—or the spread between short-term and long-term interest rates—could also reduce our net interest margin.  Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates.  Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets.
 
Changes in interest rates also affect the value of the Bank’s interest-earning assets, and in particular the Bank’s securities portfolio.  Generally, the value of fixed-rate securities fluctuates inversely with changes in interest rates.  Unrealized gains and losses on securities available for sale are reported as a separate component of shareholder equity, net of tax.  Decreases in the fair value of securities available for sale resulting from increases in interest rates could have an adverse effect on shareholders’ equity.
 
Local economic conditions are being increasingly impacted by the exploration and drilling activities for natural gas in the in the Marcellus and Utica Shale formations.
 
 
8

 
 
The economy in a large portion of our market areas has become increasingly influenced by the natural gas industry. Our market area is predominately centered in the Marcellus and Utica Shale natural gas exploration and drilling area.  These natural gas exploration and drilling activities have significantly impacted the overall interest in real estate in our market area due to the related lease and royalty revenues associated with it.  The natural gas activities have had a positive impact on the value of local real estate. Additionally, many of our customers provide transportation and other services and products that support natural gas exploration and production activities.  Moreover, we have experienced an increase in deposits as a result of this natural resource exploration and have developed products specifically targeting those that have benefited from this activity. Exploration and drilling of the natural gas reserves in our market area may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection. In addition, these activities can be affected by the market price for natural gas. These factors could negatively impact our customers and, as a result, negatively impact our loan and deposit volume.  If there is a significant downturn in this industry, as a result of regulatory action or otherwise, the ability of our borrowers to repay their loans in accordance with their terms could be negatively impacted and/or reduce demand for loans. Finally, the borrowing needs of some of the residents in our market area have been limited due to the economic benefits afforded them as a result of the exploration activities.  These factors could have a material adverse effect on our business, prospects, financial condition and results of operations.
 
Higher loan losses could require us to increase our allowance for loan losses through a charge to earnings.
 
When we loan money we incur the risk that our borrowers do not repay their loans. We reserve for loan losses by establishing an allowance through a charge to earnings. The amount of this allowance is based on our assessment of loan losses inherent in our loan portfolio. The process for determining the amount of the allowance is critical to our financial results and condition. It requires subjective and complex judgments about the future, including forecasts of economic or market conditions that might impair the ability of our borrowers to repay their loans. We might underestimate the loan losses inherent in our loan portfolio and have loan losses in excess of the amount reserved. We might increase the allowance because of changing economic conditions. For example, in a rising interest rate environment, borrowers with adjustable-rate loans could see their payments increase. There may be a significant increase in the number of borrowers who are unable or unwilling to repay their loans, resulting in our charging off more loans and increasing our allowance. In addition, when real estate values decline, the potential severity of loss on a real estate-secured loan can increase significantly, especially in the case of loans with high combined loan-to-value ratios. A decline in the national economy and the local economies of the areas in which the loans are concentrated could result in an increase in loan delinquencies, foreclosures or repossessions resulting in increased charge-off amounts and the need for additional loan loss allowances in future periods. In addition, bank regulators may require us to make a provision for loan losses or otherwise recognize further loan charge-offs following their periodic review of our loan portfolio, our underwriting procedures, and our loan loss allowance. Any increase in our allowance for loan losses or loan charge-offs as required by such regulatory authorities could have a material adverse effect on our financial condition and results of operations. Our allowance for loan losses amounted to $6.8 million, or 1.23% of total loans outstanding and 91.7% of nonperforming loans, at December 31, 2014. Our allowance for loan losses at December 31, 2014 may not be sufficient to cover future loan losses. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would decrease our earnings. In addition, at December 31, 2014, we had a total of 24 loan relationships with outstanding balances that exceeded $3.0 million, 23 of which were performing according to their original terms. However, the deterioration of one or more of these loans could result in a significant increase in our nonperforming loans and our provision for loan losses, which would negatively impact our results of operations.
 
Our emphasis on commercial real estate, agricultural, construction and municipal lending may expose us to increased lending risks.
 
At December 31, 2014, we had $190.9 million in loans secured by commercial real estate, $24.6 million in agricultural loans, $6.4 million in construction loans and $79.7 million in municipal loans. Commercial real estate loans, agricultural, construction and municipal loans represented 34.5%, 4.4%, 1.1% and 14.4%, respectively, of our loan portfolio.  At December 31, 2014, we had $4.4 million of reserves specifically allocated to these loan types.  While commercial real estate, agricultural, construction and municipal loans are generally more interest rate sensitive and carry higher yields than do residential mortgage loans, these types of loans generally expose a lender to greater risk of non-payment and loss than single-family residential mortgage loans because repayment of the loans often depends on the successful operation of the property, the income stream of the borrowers and, for construction loans, the accuracy of the estimate of the property’s value at completion of construction and the estimated cost of construction.  Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to single-family residential mortgage loans.
 
 
9

 
 
Loan participations have been a significant source of loan originations in recent periods and a decline in loan participation volume could hurt profits and slow loan growth.

We have actively engaged in loan participations in recent periods whereby we are invited to participate in loans, primarily commercial real estate and municipal loans, originated by another financial institution known as the lead lender.  We have participated with other financial institutions in both our primary markets and out of market areas. Loan participations accounted for approximately $4.2 million, $14.3 million and $14.4 million, or 28.4%, 37.6% and 100% of the Company’s loan growth during 2012, 2013 and 2014, respectively.  Our profits and loan growth could be significantly and adversely affected if the volume of loan participations would materially decrease, whether because loan demand declines, loan payoffs, lead lenders may come to perceive us as a potential competitor in their respective market areas, or otherwise.
 
If we conclude that the decline in value of any of our investment securities is other than temporary, we are required to write down the value of that security through a charge to earnings.
 
We review our investment securities portfolio monthly and at each quarter-end reporting period to determine whether the fair value is below the current carrying value. When the fair value of any of our investment securities has declined below its carrying value, we are required to assess whether the decline is other than temporary. If we conclude that the decline is other than temporary, we are required to write down the value of that security through a charge to earnings. As of December 31, 2014, our investment portfolio included available for sale investment securities with an amortized cost of $301.5 million and a fair value of $306.1 million, which included unrealized losses on 58 securities totaling $916,000.  Changes in the expected cash flows of these securities and/or prolonged price declines may result in our concluding in future periods that the impairment of these securities is other than temporary, which would require a charge to earnings to write down theses securities to their fair value. Any charges for other-than-temporary impairment would not impact cash flow, tangible capital or liquidity.
 
Income from secondary mortgage market operations is volatile, and we may incur losses or charges with respect to our secondary mortgage market operations which would negatively affect our earnings.
 
We generally sell in the secondary market the longer term fixed-rate residential mortgage loans that we originate, earning non-interest income in the form of gains on sale. When interest rates rise, the demand for mortgage loans tends to fall and may reduce the number of loans available for sale. Furthermore, the prolonged low interest rate environment has reduced the demand for loans available for sale.  In addition to interest rate levels, weak or deteriorating economic conditions also tend to reduce loan demand. Although we sell loans in the secondary market without recourse, we are required to give customary representations and warranties to the buyers. If we breach those representations and warranties, the buyers can require us to repurchase the loans and we may incur a loss on the repurchase. Because we generally retain the servicing rights on the loans we sell in the secondary market, we are required to record a mortgage servicing right asset, which we test annually for impairment. The value of mortgage servicing rights tends to increase with rising interest rates and to decrease with falling interest rates. If we are required to take an impairment charge on our mortgage servicing rights our earnings would be adversely affected.
 
The Company’s financial condition and results of operations are dependent on the economy in the Bank’s market area.
 
The Bank’s primary market area consists of the Pennsylvania Counties of Bradford, Clinton, Potter, and Tioga in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga Counties in Southern New York.  As of December 31, 2014, management estimates that approximately 92.6% of deposits and 76.7% of loans came from households whose primary address is located in the Bank’s primary market area.  Because of the Bank’s concentration of business activities in its market area, the Company’s financial condition and results of operations depend upon economic conditions in its market area.  Adverse economic conditions in our market area could reduce our growth rate, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations.  Conditions such as inflation, recession, unemployment, high interest rates and short money supply and other factors beyond our control may adversely affect our profitability.  We are less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies.  Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the States of Pennsylvania and New York could adversely affect the value of our assets, revenues, results of operations and financial condition.  Moreover, we cannot give any assurance we will benefit from any market growth or favorable economic conditions in our primary market areas if they do occur.
 
 
10

 
 
A return of recessionary conditions could result in increases in our level of nonperforming loans and/or reduce demand for our products and services, which could have an adverse effect on our results of operations.
 
Although the U.S. economy is not currently in a recession, economic growth has been slow and uneven, and the percentage of people out of the workforce is at historical levels. A return to prolonged deteriorating economic conditions and/or continued negative developments in the domestic and international credit markets could significantly affect the markets in which we do business, the value of our loans and investments, and our ongoing operations, costs and profitability. These events may cause us to incur losses and may adversely affect our financial condition and results of operations.
 
Regulation of the financial services industry is undergoing major changes, and future legislation could increaseour cost of doing business or harm our competitive position.
 
We are subject to extensive regulation, supervision and examination by the FRB and the PDB, our primary regulators, and by the FDIC, as insurer of our deposits. Such regulation and supervision governs the activities in which an institution and its holding company may engage and are intended primarily for the protection of the insurance fund and the depositors and borrowers of the Bank rather than for holders of our common stock. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on our profitability and operations. Future legislative changes could require changes to business practices or force us to discontinue businesses and potentially expose us to additional costs, liabilities, enforcement action and reputational risk.
 
We are periodically subject to examination and scrutiny by a number of banking agencies and, depending upon the findings and determinations of these agencies, we may be required to make adjustments to our business that could adversely affect us.
 
Federal and state banking agencies periodically conduct examinations of our business, including compliance with applicable laws and regulations. If, as a result of an examination, a banking agency was to determine that the financial condition, capital resources, asset quality, asset concentration, earnings prospects, management, liquidity, sensitivity to market risk or other aspects of any of our operations has become unsatisfactory, or that we or our management is in violation of any law or regulation, it could take a number of different remedial actions as it deems appropriate. These actions include the power to enjoin “unsafe or unsound” practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to restrict our growth, to change the asset composition of our portfolio or balance sheet, to assess civil monetary penalties against our officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate our deposit insurance.  If we become subject to such regulatory actions, our business, results of operations and reputation may be negatively impacted.
 
Strong competition within the Bank’s market area could hurt profits and slow growth.
 
The Bank faces intense competition both in making loans and attracting deposits.  This competition has made it more difficult for the Bank to make new loans and at times has forced the Bank to offer higher deposit rates.  Price competition for loans and deposits might result in the Bank earning less on loans and paying more on deposits, which would reduce net interest income.  Competition also makes it more difficult to increase the volume of our loan and deposit portfolios.  As of June 30, 2014, which is the most recent date for which information is available, for those counties in which the Bank has branches, we held 35.0% of the deposits in Bradford, Potter and Tioga Counties, Pennsylvania, which was the largest share of deposits out of eight financial institutions with offices in the area, and 5.5% of the deposits in Allegany County, New York, which was the fourth largest share of deposits out of five financial institutions with offices in this area.  Competition also makes it more difficult to hire and retain experienced employees.  Some of the institutions with which the Bank competes have substantially greater resources and lending limits than the Bank has and may offer services that the Bank does not provide.  Management expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry.  The Bank’s profitability depends upon its continued ability to compete successfully in its market area.
 
 
11

 
 
We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.
 
We are and will continue to be dependent upon the services of our executive management team. In addition, we will continue to depend on our ability to retain and recruit key commercial loan officers. The unexpected loss of services of any key management personnel or commercial loan officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
 
Environmental liability associated with lending activities could result in losses.
 
In the course of our business, we may foreclose on and take title to properties securing our loans.  If hazardous substances were discovered on any of these properties, we could be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage.  Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination.  In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site even if we neither own nor operate the disposal site.  Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure.  In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.
 
Our ability to pay dividends is limited by law.
 
Our ability to pay dividends to our shareholders largely depends on our receipt of dividends from the Bank. The amount of dividends that the Bank may pay to us is limited by federal and state laws and regulations. We also may decide to limit the payment of dividends even when we have the legal ability to pay them in order to retain earnings for use in our business.
 
Federal and state banking laws, our articles of incorporation and our by-laws may have an anti-takeover effect.
 
Federal law imposes restrictions, including regulatory approval requirements, on persons seeking to acquire control over us.  Pennsylvania law also has provisions that may have an anti-takeover effect.  These provisions may serve to entrench management or discourage a takeover attempt that shareholders consider to be in their best interest or in which they would receive a substantial premium over the current market price.
 
We are subject to certain risks in connection with our use of technology
 
Communications and information systems are essential to the conduct of our business, as we use such systems to manage our customer relationships, our general ledger, our deposits, our loans, and to deliver on-line and electronic banking services. Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, the security of our computer systems, software, and networks may be vulnerable to breaches, unauthorized access, misuse, computer viruses, or other malicious code and cyber attacks that could have a security impact.
 
In addition, breaches of security may occur through intentional or unintentional acts by those having authorized or unauthorized access to our confidential or other information or the confidential or other information of our customers, clients, or counterparties. If one or more of such events were to occur, the confidential and other information processed and stored in, and transmitted through, our computer systems and networks could potentially be jeopardized, or could otherwise cause interruptions or malfunctions in our operations or the operations of our customers, clients, or counterparties. This could cause us significant reputational damage or result in our experiencing significant losses from fraud or otherwise.
 
 
12

 
 
Furthermore, we may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures arising from operational and security risks. Also, we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance we maintain.
 
In addition, we routinely transmit and receive personal, confidential, and proprietary information by e-mail and other electronic means. We have discussed and worked with our customers, clients, and counterparties to develop secure transmission capabilities, but we do not have, and may be unable to put in place, secure capabilities with all of these constituents, and we may not be able to ensure that these third parties have appropriate controls in place to protect the confidentiality of such information. Any interception, misuse, or mishandling of personal, confidential, or proprietary information being sent to or received from a customer, client, or counterparty could result in legal liability, regulatory action, and reputational harm, and could have a significant adverse effect on our competitive position, financial condition, and results of operations.
 
Our risk management framework may not be effective in mitigating risks and/or losses to us.
 
We have implemented a risk management framework to manage our risk exposure. This framework is comprised of various processes, systems and strategies, and is designed to manage the types of risk to which we are subject, including, among others, credit, market, liquidity, interest rate and compliance. Our framework also includes financial or other modeling methodologies which involve management assumptions and judgment. There is no assurance that our risk management framework will be effective under all circumstances or that it will adequately mitigate any risk or loss to us. If our framework is not effective, we could suffer unexpected losses and our business, financial condition, results of operations or prospects could be materially and adversely affected. We may also be subject to potentially adverse regulatory consequences.
 
ITEM 1B – UNRESOLVED STAFF COMMENTS.
 
Not applicable.
 
ITEM 2 – PROPERTIES.
 
The headquarters of the Company and Bank are located at 15 South Main Street, Mansfield, Pennsylvania. The building contains the central offices of the Company and Bank. Our bank owns fourteen banking facilities, leases five other facilities and is in the process of constructing an additional banking facility, which was opened in February 2015. All buildings owned by the Bank are free of any liens or encumbrances.
 
The net book value of owned banking facilities and leasehold improvements totaled $10,027,000 as of December 31, 2014.  The properties are adequate to meet the needs of the employees and customers. We have equipped all of our facilities with current technological improvements for data processing.
 
ITEM 3 - LEGAL PROCEEDINGS.
 
The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition or results of operations.

ITEM 4 – MINE SAFETY DISCLOSURES
 
Not applicable.
 
 
13

 
 
PART II
 
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
 
The Company's stock is not listed on any stock exchange, but it is quoted on the OTC Bulletin Board under the trading symbol CZFS.  Prices presented in the table below are bid prices between broker-dealers published by the OTC Bulletin Board and the Pink Sheets Electronic Quotation Service.  The prices do not include retail markups or markdowns or any commission to the broker-dealer.  The bid prices do not necessarily reflect prices in actual transactions.  Cash dividends are declared on a quarterly basis and are summarized in the table below (also see dividend restrictions in Note 14 of the consolidated financial statements).
 
 
Dividends
   
Dividends
 
2014
declared
2013
declared
 
High
Low
per share
High
Low
per share
First quarter
 $      52.56
 $      47.00
 $      0.385
 $    47.62
 $     40.05
 $        0.285
Second quarter
         53.56
         50.02
         0.385
       49.53
        45.91
           0.285
Third quarter
         52.59
         50.86
         1.000
       49.24
        46.05
           0.285
Fourth quarter
         53.34
         51.51
         0.400
       54.00
        47.00
           0.385
 
The Company has paid dividends since April 30, 1984, the effective date of our formation as a bank holding company. The Company's Board of Directors expects that comparable cash dividends will continue to be paid by the Company in the future; however, future dividends necessarily depend upon earnings, financial condition, appropriate legal restrictions and other factors in existence at the time the Board of Directors considers a dividend policy. Cash available for dividend distributions to stockholders of the Company comes primarily from dividends paid to the Company by the Bank. Therefore, restrictions on the ability of the Bank to make dividend payments are directly applicable to the Company.  Under the Pennsylvania Business Corporation Law of 1988, the Company may pay dividends only if, after payment, the Company would be able to pay debts as they become due in the usual course of our business and total assets will be greater than the sum of total liabilities.  These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions. Also see “Supervision and Regulation – Regulatory Restrictions on Bank Dividends,” “Supervision and Regulation – Holding Company Regulation,” and “Note 14 – Regulatory Matter” to the consolidated financial statements.
 
The Company distributed a 1% stock dividend on June 27, 2014 to all shareholders of record as of June 20, 2014. All per share calculations were adjusted to reflect the stock dividend.
 
As of February 23, 2014, the Company had approximately 1,559 stockholders of record.  The computation of stockholders of record excludes investors whose shares were held for them by a bank or broker at that date. The following table presents information regarding the Company’s stock repurchases during the three months ended December 31, 2014:
 
Period
Total Number of
Shares (or units
Purchased)
Average
Price Paid
per Share
 (or Unit)
Total Number of Shares (or
Units) Purchased as Part of
Publicly Announced Plans of
Programs
Maximum Number (or Approximate
Dollar Value) of Shares (or Units)
that May Yet Be Purchased Under
the Plans or Programs (1)
         
10/1/14 to 10/31/14
                             102
$50.00
                                      102
                                 77,614
11/1/14 to 11/31/14
                               98
$51.00
                                        98
                                 77,516
12/1/14 to 12/31/14
                          4,515
$53.25
                                   4,515
                                 73,001
Total
                          4,715
$53.13
                                   4,715
                                 73,001
 
(1)  
On January 17, 2012, the Company announced that the Board of Directors authorized the Company to repurchase up to 140,000 shares.  The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors.  No time limit was placed on the duration of the share repurchase program.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.
 
Set forth below is a line graph comparing the yearly dollar changes in the cumulative shareholder return on the Company’s common stock against the cumulative total return of the S&P 500 Stock index, SNL Mid-Atlantic Bank Index and SNL Bank $500 Million to $1 Billion index for the period of seven fiscal years assuming the investment of $100.00 on December 31, 2007 and assuming the reinvestment of dividends. The shareholder return shown on the graph below is not necessarily indicative of future performance and was obtained from SNL Financial LC, Charlottesville, VA.
 
 
14

 

Peer Performance Graph 
 
 
 
 
15

 

ITEM 6 - SELECTED FINANCIAL DATA.
 
 
The following table sets forth certain financial data as of and for each of the years in the five year period ended December 31, 2014:
 
(in thousands, except share data)
2014
2013
2012
2011
2010
Interest income
 $       35,291
 $     36,234
 $     38,085
 $    38,293
 $     39,000
Interest expense
4,953
          6,315
          7,659
          9,683
        11,340
Net interest income
30,338
        29,919
        30,426
        28,610
        27,660
Provision for loan losses
585
              405
              420
             675
          1,255
Net interest income after provision
         
  for loan losses
29,753
        29,514
        30,006
        27,935
        26,405
Non-interest income
6,740
          6,982
          7,364
          6,625
          6,207
Investment securities gains, net
616
              441
              604
             334
                99
Non-interest expenses
20,165
        19,810
        19,428
        18,452
        18,053
Income before provision for income taxes
16,944
        17,127
        18,546
        16,442
        14,658
Provision for income taxes
3,559
          3,752
          4,331
          3,610
          3,156
Net income
 $       13,385
 $     13,375
 $     14,215
 $    12,832
 $     11,502
           
Per share data:
         
Net income - Basic (1)
 $           4.41
 $         4.38
 $         4.61
 $         4.12
 $         3.68
Net income - Diluted (1)
4.40
             4.38
             4.60
            4.12
             3.68
Cash dividends declared (1)
2.17
             1.21
             1.49
            1.08
             1.01
Stock dividend
1%
5%
1%
1%
1%
Book value (1) (2)
32.83
          30.64
          27.62
          24.64
          21.66
           
End of Period Balances:
         
Total assets
 $     925,048
 $  914,934
 $  882,427
 $  878,567
 $  812,526
Total investments
306,146
      317,301
      310,252
     318,823
      251,303
Loans
554,105
      540,612
      502,463
     487,509
      473,517
Allowance for loan losses
6,815
          7,098
          6,784
          6,487
          5,915
Total deposits
773,933
      748,316
      737,096
     733,993
      680,711
Total borrowings
41,799
        66,932
        46,126
        53,882
        55,996
Stockholders' equity
100,528
        92,056
        89,475
        81,468
        68,690
           
Key Ratios
         
Return on assets (net income to average total assets)
1.48%
1.51%
1.62%
1.52%
1.50%
Return on equity (net income to average total equity)
13.73%
14.89%
17.48%
17.86%
18.13%
Equity to asset ratio (average equity to average total assets,
         
  excluding other comprehensive income)
10.74%
10.13%
9.26%
8.49%
8.25%
Net interest margin
3.84%
3.87%
3.99%
3.94%
4.19%
Efficiency
48.61%
48.12%
46.10%
46.23%
47.96%
Dividend payout ratio (dividends declared divided by net income)
49.32%
27.63%
32.37%
26.30%
27.50%
Tier 1 leverage
10.99%
10.42%
9.70%
8.83%
8.32%
Tier 1 risk-based capital
17.30%
16.44%
16.21%
14.94%
13.72%
Total risk-based capital
18.55%
17.75%
17.50%
16.23%
14.97%
Nonperforming assets/total loans
1.67%
1.88%
1.83%
2.11%
2.80%
Nonperforming loans/total loans
1.34%
1.63%
1.71%
1.94%
2.65%
Allowance for loan losses/total loans
1.23%
1.31%
1.35%
1.33%
1.25%
Net charge-offs/average loans
0.16%
0.02%
0.02%
0.02%
0.05%
           
(1) Amounts were adjusted to reflect stock dividends.
         
(2) Calculation excludes accumulated other comprehensive income.
       
 
 
16

 

ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
 
CAUTIONARY STATEMENT
 
We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Company, the Bank, First Citizens Insurance Agency, Inc. or the Company on a consolidated basis. When we use words such as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements.  Forward-looking statements may prove inaccurate. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements:
 
 
·
Interest rates could change more rapidly or more significantly than we expect.
 
·
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
 
·
The financial markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
 
·
It could take us longer than we anticipate implementing strategic initiatives designed to increase revenues or manage expenses, or we may be unable to implement those initiatives at all.
 
·
Acquisitions and dispositions of assets could affect us in ways that management has not anticipated.
 
·
We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition or operating results.
 
·
We may become subject to new and unanticipated accounting, tax, or regulatory practices or requirements.
 
·
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.  We could also experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
 
·
We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge.
 
·
The agricultural economy is subject to extreme swings in both the costs of resources and the prices received from the sale of products, which could negatively impact our customers.
 
·
Exploration and drilling of the natural gas reserves in our market area may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection, which could negatively impact our customers and, as a result, negatively impact our loan and deposit volume and loan quality.
 
·
Similarly, customers dependent on the exploration and drilling of the natural gas reserves may be dependent on the market price of natural gas.  As a result, decreases in the market price of natural gas could also negatively impact our customers.
 
Additional factors are discussed in this Annual Report on Form 10-K under “Item 1A. Risk Factors.”  These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.  Forward-looking statements speak only as of the date they are made and the Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date of the forward-looking statements or to reflect the occurrence of unanticipated events. Accordingly, past results and trends should not be used by investors to anticipate future results or trends.
 
INTRODUCTION
 
The following is management’s discussion and analysis of the significant changes in financial condition, the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for the Company. Our Company’s consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes. Except as noted, tabular information is presented in thousands of dollars.
 
Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga, Clinton and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung, and Tioga counties in Southern New York. We maintain our central office in Mansfield, Pennsylvania. Presently we operate 20 banking facilities, 17 of which operate as bank branches.  In Pennsylvania, these offices are located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, Rome, the Wellsboro Weis Market store and the Mansfield Wal-Mart Super Center.  In New York, our office is in Wellsville.  We also have two loan production offices in Lock Haven and Dallas, Pennsylvania. We are constructing a full service branch that will replace the Lock Haven loan production office, which was opened in February 2015.
 
 
17

 
 
Risk identification and management are essential elements for the successful management of the Company.  In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity, reputational and regulatory risk.
 
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates.  Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company.  The Company uses its asset/liability and funds management policies to control and manage interest rate risk.
 
Credit risk represents the possibility that a customer may not perform in accordance with contractual terms.  Credit risk results from loans with customers and the purchasing of securities.  The Company’s primary credit risk is in the loan portfolio.  The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses.  Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.
 
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors.  The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk.  These guidelines include, among other things, contingent funding alternatives.
 
Reputational risk, or the risk to our business, earnings, liquidity, and capital from negative public opinion, could result from our actual or alleged conduct in a variety of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, ethical issues, or inadequate protection of customer information, which could include identify theft, or theft of customer information through third parties. We expend significant resources to comply with regulatory requirements. Failure to comply could result in reputational harm or significant legal or remedial costs. Damage to our reputation could adversely affect our ability to retain and attract new customers, and adversely impact our earnings and liquidity.
 
Regulatory risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company and its subsidiary.  We cannot predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations.  We cannot anticipate additional requirements or additional compliance efforts regarding the Bank Secrecy Act, Dodd-Frank Act or USA Patriot Act, or regulatory burdens regarding the ever increasing information theft and fraudulent activities impacting our customers and the banking industry in general.
 
Readers should carefully review the risk factors described in other documents our Company files with the SEC, including the annual reports on Form 10-K, the quarterly reports on Form 10-Q and any current reports on Form 8-K filed by us.
 
TRUST AND INVESTMENT SERVICES; OIL AND GAS SERVICES
Our Investment and Trust Division is committed to helping our customers meet their financial goals.  The Trust Division offers professional trust administration, investment management services, estate planning and administration, custody of securities and individual retirement accounts.  Assets held by the Bank in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Bank. As of December 31, 2014 and 2013, assets owned and invested by customers of the Bank through the Bank’s investment representatives totaled $111.7 million and $102.5 million, respectively.  Additionally, as summarized in the table below, the Trust Department had assets under management as of December 31, 2014 and 2013 of $100.7 million and $99.4 million, respectively. The increase in assets under management is due to market value increases of $3.3 million offset by net account withdrawals of $2.0 million.

 
18

 

(market values - in thousands)
2014
2013
INVESTMENTS:
   
Bonds
 $         15,558
 $         15,729
Stock
            17,925
            16,893
Savings and Money Market Funds
            12,395
            13,959
Mutual Funds
            53,456
            51,591
Mortgages
                 701
                 562
Real Estate
                 637
                 645
Miscellaneous
                   49
                   56
TOTAL
 $       100,721
 $         99,435
ACCOUNTS:
   
Trusts
            21,268
            20,866
Guardianships
              1,684
                 226
Employee Benefits
            41,289
            39,819
Investment Management
            36,478
            38,510
Custodial
                     2
                   14
TOTAL
 $       100,721
 $         99,435
 
Our financial consultants offer full service brokerage services throughout the Bank’s market area.  Appointments can be made at any Bank branch.  The financial consultants provide financial planning which includes mutual funds, annuities, health and life insurance.  These products are made available through our insurance subsidiary, First Citizens Insurance Agency, Inc.
 
In addition to the trust and investment services offered we have an oil and gas division, which serves as a network of experts to assist our customers through various oil and gas specific leasing matters from lease negotiations to establishing a successful approach to personal wealth management. As of December 31, 2014, customers owning 7,206 acres have signed agreements with the Bank that provide for the Bank to manage oil and gas matters related to the customers land, which may include negotiating lease payments and royalty percentages, resolving leasing issues, accounting for and ensuring the accuracy of royalty checks, distributing revenue to satisfy investment objectives and providing customized reports outlining payment and distribution information.
 
RESULTS OF OPERATIONS
 
Net income for the year ended December 31, 2014 was $13,385,000, which represents an increase of $10,000, or 0.1%, when compared to the 2013 related period.  Net income for the year ended December 31, 2013 was $13,375,000, which represents a decrease of $840,000, or 5.9%, when compared to the 2012 related period.  Basic earnings per share were $4.41, $4.38, and $4.61 for the years ended 2014, 2013 and 2012, respectively. Diluted earnings per share were $4.40, $4.38, and $4.60 for the years ended 2014, 2013 and 2012, respectively.
 
Net income is influenced by five key components: net interest income, provision for loan losses, non-interest income, non-interest expenses, and the provision for income taxes.
 
Net Interest Income
 
The most significant source of revenue is net interest income; the amount of interest earned on interest-earning assets exceeding interest incurred on interest-bearing liabilities.  Factors that influence net interest income are changes in volume of interest-earning assets and interest-bearing liabilities as well as changes in the associated interest rates.
 
The following table sets forth our Company’s average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created:
 
 
19

 
 
 
Analysis of Average Balances and Interest Rates
     
 
2014
2013
2012
 
Average
 
Average
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
$
$
%
ASSETS
                 
Interest-bearing deposits at banks
          8,479
             9
0.11
      15,024
25
0.17
      14,439
21
0.15
Interest bearing time deposits at banks
          3,651
           73
2.00
           743
15
2.02
                -
-
-
Investment securities:
                 
  Taxable
     212,338
     3,531
1.66
    215,746
3,807
1.76
    226,424
4,592
2.03
  Tax-exempt (3)
       96,954
     5,082
5.24
      92,911
5,159
5.55
      94,221
5,608
5.95
  Total investment securities
     309,292
     8,613
2.78
    308,657
8,966
2.90
    320,645
10,200
3.18
Loans:
                 
  Residential mortgage loans
     187,057
   10,582
5.66
    181,887
10,941
6.02
    183,408
11,746
6.40
  Construction loans
          5,237
        247
4.71
      13,098
647
4.94
      10,746
605
5.63
  Commercial & agricultural loans
     270,164
   14,618
5.41
    252,242
14,794
5.87
    235,073
14,699
6.25
  Loans to state & political subdivisions
       69,440
     3,225
4.64
      59,759
2,647
4.43
      57,247
2,680
4.68
  Other loans
          8,643
        703
8.13
        9,762
802
8.22
      10,348
871
8.42
  Loans, net of discount (2)(3)(4)
     540,541
   29,375
5.43
    516,748
29,831
5.77
    496,822
30,601
6.16
Total interest-earning assets
     861,963
   38,070
4.42
    841,172
38,837
4.62
    831,906
40,822
4.91
Cash and due from banks
          3,781
   
        3,750
   
        3,736
   
Bank premises and equipment
       11,454
   
      11,375
   
      11,560
   
Other assets
       30,152
   
      29,905
   
      30,782
   
Total non-interest earning assets
       45,387
   
      45,030
   
      46,078
   
Total assets
     907,350
   
    886,202
   
    877,984
   
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Interest-bearing liabilities:
                 
  NOW accounts
     219,473
        764
       0.35
    209,275
791
      0.38
    200,486
791
0.39
  Savings accounts
     101,639
        119
       0.12
      92,095
146
      0.16
      84,558
165
0.20
  Money market accounts
       91,373
        424
       0.46
      85,688
405
      0.47
      73,102
316
0.43
  Certificates of deposit
     257,723
     3,040
       1.18
    271,862
3,765
      1.38
    290,710
4,841
1.67
Total interest-bearing deposits
     670,208
     4,347
       0.65
    658,920
5,107
      0.78
    648,856
6,113
0.94
Other borrowed funds
       39,209
        606
       1.55
      42,214
1,208
      2.86
      52,484
1,546
2.95
Total interest-bearing liabilities
     709,417
     4,953
       0.70
    701,134
6,315
      0.90
    701,340
7,659
1.09
Demand deposits
       92,878
   
      87,496
   
      85,890
   
Other liabilities
          7,578
   
        7,767
   
        9,430
   
Total non-interest-bearing liabilities
     100,456
   
      95,263
   
      95,320
   
Stockholders' equity
       97,477
   
      89,805
   
      81,324
   
Total liabilities & stockholders' equity
     907,350
   
    886,202
   
    877,984
   
Net interest income
 
   33,117
   
32,522
   
  33,163
 
Net interest spread (3) (5)
   
3.72%
   
3.72%
   
3.82%
Net interest income as a percentage
                 
  of average interest-earning assets (3)
   
3.84%
   
3.87%
   
3.99%
Ratio of interest-earning assets
                 
  to interest-bearing liabilities
   
       1.22
   
      1.20
   
      1.19
                   
(1) Averages are based on daily averages.
               
(2) Includes loan origination and commitment fees.
               
(3) Shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 34%.
       
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
   
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets
   
      and the average rate paid on interest-bearing liabilities.
             
 
 
20

 
 
Tax exempt interest revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 34%.  For purposes of the comparison, as well as the discussion that follows, this presentation 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 34% Federal statutory rate.  Accordingly, tax equivalent adjustments for investments and loans have been made accordingly to the previous table for the years ended December 31, 2014, 2013 and 2012, respectively (in thousands):
 
 
2014
2013
2012
Interest and dividend income from investment securities,
     
    interest bearing time deposits and short-term investments (non-tax adjusted)
 $          6,967
 $          7,252
 $        8,315
Tax equivalent adjustment
             1,728
             1,754
           1,906
Interest and dividend income from investment securities,
     
    interest bearing time deposits and short-term investments (tax equivalent basis)
 $          8,695
 $          9,006
 $      10,221
       
 
2014
2013
2012
Interest and fees on loans (non-tax adjusted)
 $        28,324
 $        28,982
 $      29,770
Tax equivalent adjustment
             1,051
                849
              831
Interest and fees on loans (tax equivalent basis)
 $        29,375
 $        29,831
 $      30,601
       
 
2014
2013
2012
Total interest income
 $        35,291
 $        36,234
 $      38,085
Total interest expense
             4,953
             6,315
           7,659
Net interest income
           30,338
           29,919
         30,426
Total tax equivalent adjustment
             2,779
             2,603
           2,737
Net interest income (tax equivalent basis)
 $        33,117
 $        32,522
 $      33,163
 
 
 
21

 

The following table shows the tax-equivalent effect of changes in volume and rates on interest income and expense (in thousands):
 
 
Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis
 
 2014 vs. 2013 (1)
 2013 vs. 2012 (1)
 
 Change in
 Change
 Total
 Change in
 Change
 Total
 
 Volume
 in Rate
 Change
 Volume
 in Rate
 Change
Interest Income:
           
Interest-bearing deposits at banks
 $             (9)
 $             (7)
 $           (16)
 $             1
 $              3
 $             4
Interest bearing time deposits at banks
               58
                 -
               58
              15
                 -
              15
Investment securities:
           
  Taxable
              (59)
            (217)
            (276)
           (209)
            (576)
           (785)
  Tax-exempt
              270
            (347)
              (77)
             (77)
            (372)
           (449)
Total investment securities
              211
            (564)
            (353)
           (286)
            (948)
        (1,234)
Total investment income
              260
            (571)
            (311)
           (270)
            (945)
        (1,215)
Loans:
           
  Residential mortgage loans
              328
            (687)
            (359)
             (96)
            (709)
           (805)
  Construction loans
             (371)
              (29)
            (400)
              96
              (54)
              42
  Commercial & agricultural loans
           1,947
         (2,123)
            (176)
            630
            (535)
              95
  Loans to state & political subdivisions
              445
             133
             578
            144
            (177)
             (33)
  Other loans
              (91)
               (8)
              (99)
             (48)
              (21)
             (69)
Total loans, net of discount
           2,258
         (2,714)
            (456)
            726
         (1,496)
           (770)
Total Interest Income
           2,518
         (3,285)
            (767)
            456
         (2,441)
        (1,985)
Interest Expense:
           
Interest-bearing deposits:
           
  NOW accounts
               43
              (70)
              (27)
              17
              (17)
                -
  Savings accounts
               18
              (45)
              (27)
              18
              (37)
             (19)
  Money Market accounts
               26
               (7)
               19
              57
               32
              89
  Certificates of deposit
             (188)
            (537)
            (725)
           (299)
            (777)
        (1,076)
Total interest-bearing deposits
             (101)
            (659)
            (760)
           (207)
            (799)
        (1,006)
Other borrowed funds
              (81)
            (521)
            (602)
           (295)
              (43)
           (338)
Total interest expense
             (182)
         (1,180)
         (1,362)
           (502)
            (842)
        (1,344)
Net interest income
 $        2,700
 $       (2,105)
 $          595
 $          958
 $       (1,599)
 $        (641)
             
(1) The portion of the total change attributable to both volume and rate changes during the year has been allocated
 
      to volume and rate components based upon the absolute dollar amount of the change in each component prior to allocation.

2014 vs. 2013
 
Tax equivalent net interest income for 2014 was $33,117,000 compared with $32,522,000 for 2013, an increase of $595,000 or 1.8%. Total interest income decreased $767,000, as total investment income decreased $311,000 and loan interest income decreased $456,000. Offsetting the decrease in interest income, interest expense decreased $1,362,000 from 2013.
 
Total tax equivalent interest income from investment securities decreased $353,000 in 2014 from 2013.  The average tax-effected yield on our investment portfolio decreased from 2.90% in 2013 to 2.78% in 2014.  This had the effect of decreasing interest income by $564,000 due to rate, the majority of which was related to non-taxable securities whose yield decreased from 5.55% in 2013 to 5.24% in 2014. The average balance of investment securities increased $635,000, which had an effect of increasing interest income by $211,000 due to volume.  During 2014, there was a flattening of the treasury yield curve as a result of a rise in rates on the short end of the yield curve with no corresponding increase in long term rates. In fact, rates related to longer term instruments decreased during 2014. The increase in short term rates was due to an expectation of a rise in the federal fund rates with the ending of the Federal Reserve’s quantitative easing. As a result, the investment strategy during 2014 was to purchase agency securities with maturities of less than four years, which was the steepest part of the yield curve during 2014, and high quality municipal bonds with high coupons. The Bank is utilizing the yield curve to provide some protection from unrealized losses, if rates rise in the future. Additionally, high coupon municipal bonds have less price volatility in rising rate scenarios than similar lower coupon bonds.
 
 
22

 
 
In total, loan interest income decreased $456,000 in 2014 from 2013.  The average balance of our loan portfolio increased by $23.8 million in 2014 compared to 2013, which resulted in an increase in interest income of $2,258,000 due to volume.  Offsetting this was a decrease in average yield on total loans from 5.77% in 2013 to 5.43% in 2014 resulting in a decrease in interest income of $2,714,000 due to rate.
 
Specifically, interest income on residential mortgage loans decreased $359,000. The change due to rate was a decrease of $687,000 as the average yield on residential mortgages decreased from 6.02% in 2013 to 5.66% in 2014. Offsetting this decrease was an increase of $328,000 due to volume as the average balance of residential mortgage loans increased $5.2 million. Loan demand for conforming mortgages in 2014 was significantly lower than in 2013 due to the significant amount of refinancing that occurred in 2013 and 2012. Additionally, demand for nonconforming loans remains limited. As a result, during 2014, the Company added to its portfolio $5.1 million of conforming mortgages with maturities of less than 15 years that would typically be sold. The Company did originate and sell $11.1 million during 2014, which compares to $20.2 million sold in 2013. Currently, all loans sold by the Bank are sold without recourse, with servicing retained.
 
The average balance of construction loans decreased $7.9 million from 2013 to 2014, due to several large projects being completed, which resulted in a decrease of $371,000 in interest income. Additionally, the average yield on construction loans decreased from 4.94% to 4.71%, which correlated to a $29,000 decrease in interest income.
 
The Company continues to focus on growing commercial and agricultural loans as a means to increase loan growth, obtain higher yields on our loan portfolio, and obtain low cost deposits from these customers.  The market for these loans has become more competitive, particularly as demand has remained soft.  As such, there has been an increase in pricing pressure for the loan demand that we are seeing in our markets, which has resulted in the Bank reducing loan rates and/or changing the terms of loans in order to maintain the relationship.  During 2014, despite competitive pressures, the average balance of commercial and agricultural loans increased $17.9 million which had a positive impact of $1,947,000 on total interest income due to volume.  Offsetting the increase due to volume, the average yield on commercial and agricultural loans decreased from 5.87% in 2013 to 5.41% in 2014, decreasing interest income by $2,123,000.
 
The average balance of loans to state and political subdivisions increased $9.7 million from 2013 to 2014 which had a positive impact of $445,000 on total interest income due to volume.  The Company’s lenders are adept at servicing these customers resulting in additional loan growth and meeting the customer’s needs.  Part of this growth during 2014 is the result of municipalities in our area that continued to borrow funds to ensure compliance with U.S. Environmental Protection Agency laws and regulations impacting the Chesapeake Bay watershed. Additionally, the Company has participated in hospital loans with other community banks, both in and out of our primary markets, to stay within regulatory guidelines while meeting the needs of these customers. The average tax equivalent yield on loans to state and political subdivisions increased from 4.43% in 2013 to 4.64% in 2014, increasing interest income by $133,000.
 
Total interest expense decreased $1,362,000 in 2014 compared to 2013.  The decrease is primarily attributable to a change in average rate from .90% in 2013 to .70% in 2014, which had the effect of decreasing interest expense by $1,180,000. The continued low interest rate environment prompted by the Federal Reserve had the effect of decreasing our short and long term borrowing costs as well as rates on all deposit products. While the Company’s rates on deposit products are below historical averages they are competitive with rates paid by other institutions in the marketplace. The average balance of interest bearing liabilities increased $8,283,000 from 2013 to 2014. Certificates of deposit and other borrowed funds decreased $14.1 million and $3.0 million, respectively, which resulted in a decrease in interest expense due to volume of $269,000. These decreases were offset by increases in NOW accounts of $10.2 million, savings accounts of $9.5 million and money market accounts of $5.7 million. The cumulative effect of these increases was an increase in interest expense of $87,000.
 
The average balance of certificates of deposit decreased $14.1 million causing a decrease in interest expense of $188,000.  In addition, as a result of the continued low rate environment, there was a decrease in the average rate on certificates of deposit from 1.38% to 1.18% resulting in a decrease in interest expense of $537,000. The continued low interest rate environment, both short-term and longer-term rates, has contributed to the decline in certificate of deposit balances.  Customers, who typically utilize certificate of deposits as a means of generating income or as a longer term investment option, are moving funds into money market and savings accounts in order to maintain flexibility for potentially rising interest rates.
 
 
23

 
 
The average balance of other borrowed funds decreased $3.0 million causing a decrease in interest expense of $81,000. In addition, there was a decrease in the average rate on other borrowed funds from 2.86% to 1.55% resulting in a decrease in interest expense of $521,000.  The decrease in rate on borrowed funds was the result of the interest rate swap for the trust preferred securities maturing in December of 2013. This resulted in the interest rate on the trust preferred securities decreasing from 5.82% to 3.09%. Additionally, as long term borrowings matured in 2013 and 2014, they were either paid off or replaced with long-term notes, which had significantly lower rates.
 
Our net interest spread for 2014 and 2013 was 3.72%.  The current economic situation has resulted in a flattening of the yield curve. It should be noted that there is currently more downward pressure on the pricing of interest earning assets than there is on interest bearing liabilities due to the rates that are currently being offered. Should short or long-term interest rates move in such a way that results in a further flattened or inverted yield curve, we would anticipate additional pressure on our margin.

2013 vs. 2012
 
Tax equivalent net interest income for 2013 was $32,522,000 compared with $33,163,000 for 2012, a decrease of $641,000 or 1.9%. Total interest income decreased $1,985,000, as total investment income decreased $1,215,000 and loan interest income decreased $770,000. Offsetting the decrease in interest income, interest expense decreased $1,344,000 from 2012.
 
Total tax equivalent interest income from investment securities decreased $1,234,000 in 2013 from 2012.  The average balance of investment securities decreased $12.0 million, which had an effect of decreasing interest income by $286,000 due to volume.  The average tax-effected yield on our investment portfolio decreased from 3.18% in 2012 to 2.90% in 2013.  This had the effect of decreasing interest income by $948,000 due to rate, the majority of which was related to taxable securities whose yield decreased from 2.03% in 2012 to 1.76% in 2013. During 2013, rates on the short end of the treasury yield curve experienced very little change, while the long end of the curve experienced a rise in excess of 100 basis points. In addition, during the fourth quarter of 2013, the Federal Reserve reduced the amount of quantitative easing it was providing to the market and indicated that a further reduction could be expected, while at the same time committing to low short term rates. This resulted in a relatively steep yield curve. As a result, the investment strategy in 2013 was to purchase agency securities with maturities of less than five years and high quality municipal bonds with high coupons. Due to the steepness of the yield curve of maturities between two to five years, the Bank provided itself some protection to rising rates. Additionally, high coupon municipal bonds have less price volatility in rising rate scenarios than similar lower coupon bonds.
 
In total, loan interest income decreased $770,000 in 2013 from 2012.  The average balance of our loan portfolio increased by $19.9 million in 2013 compared to 2012, which resulted in an increase in interest income of $726,000 due to volume.  Offsetting this was a decrease in average yield on total loans from 6.16% in 2012 to 5.77% in 2013 resulting in a decrease in interest income of $1,496,000 due to rate.
 
Interest income on residential mortgage loans decreased $805,000 in 2013, $709,000 of which was attributable to rate as the average yield on residential mortgages decreased from 6.40% in 2012 to 6.02% in 2013. There was also a decrease due to volume of $96,000, as the average balance of residential mortgage loans decreased $1.5 million.  During 2013, conforming loans totaling $20,239,000 were originated and sold on the secondary market.
 
The average balance of construction loans increased $2.4 million from 2012 to 2013, which had a positive impact of $96,000 on interest income. This was offset by a decrease due to a reduction in yield of $54,000 as the average yield on construction loans decreased from 5.63% in 2012 to 4.94% in 2013.
 
The average balance of commercial and agricultural loans increased $17.2 million from 2012 to 2013 which had a positive impact of $630,000 on total interest income due to volume.  Offsetting the increase due to volume, the average yield on commercial and agricultural loans decreased from 6.25% in 2012 to 5.87% in 2013, decreasing interest income by $535,000. The Company focus during 2013 was to grow its commercial and agricultural loan portfolio, utilizing its strong and experienced team of business development lenders.
 
 
24

 
 
The average balance of loans to state and political subdivisions increased $2.5 million from 2013 to 2012 primarily as a result of municipalities in our area that continued to borrow funds to ensure compliance with U.S. Environmental Protection Agency laws and regulations impacting the Chesapeake Bay watershed. This had a positive impact of $144,000 on total interest income due to volume. Offsetting this, the average tax equivalent yield on loans to state and political subdivisions decreased from 4.68% in 2012 to 4.43% in 2013, decreasing interest income by $177,000.
 
Total interest expense decreased $1,344,000 in 2013 compared to 2012.  The decrease is primarily attributable to a change in average rate from 1.09% in 2012 to .90% in 2013, which had the effect of decreasing interest expense by $842,000. The low interest rate environment had the effect of decreasing our short-term borrowing costs as well as rates on all deposit products. The average balance of interest bearing liabilities decreased $206,000 from 2012 to 2013. Certificates of deposit and other borrowed funds decreased $18.8 million and $10.3 million, respectively, which resulted in a decrease in interest expense due to volume of $502,000. These decreases were offset by increases in NOW accounts of $8.8 million, savings accounts of $7.5 million and money market accounts of $12.6 million. The cumulative effect of these increases was an increase in interest expense of $92,000.
 
The average balance of certificates of deposit decreased $18.8 million causing a decrease in interest expense of $299,000.  In addition, there was a decrease in the average rate on certificates of deposit from 1.67% to 1.38% resulting in a decrease in interest expense of $777,000.  The average balance of other borrowed funds decreased $10.3 million causing a decrease in interest expense of $295,000. In addition, there was a decrease in the average rate on other borrowed funds from 2.95% to 2.86% resulting in a decrease in interest expense of $43,000.
 
Our net interest spread for 2013 was 3.72% compared to 3.82% in 2012.
 
PROVISION FOR LOAN LOSSES
 
For the year ended December 31, 2014, we recorded a provision for loan losses of $585,000. The expense for 2014 was $180,000, or 44.4% higher than the same time period in 2013. The increase in the provision for loan losses was primarily the result of the increase in charge-offs the Company recorded in 2014. (see also “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).
 
For the year ended December 31, 2013, we recorded a provision for loan losses of $405,000, which represents a decrease of $15,000 or 3.6% over the same time period in 2012.  The decrease in the provision for loan losses is the result of conditions of the Company’s loan portfolio remaining consistent with 2012 and the current economic conditions in the Company’s primary market place, as of December 31, 2013.
 
NON-INTEREST INCOME
 
The following table reflects non-interest income by major category for the periods ended December 31 (dollars in thousands):
 
 
2014
2013
2012
Service charges
 $          4,297
 $          4,453
 $          4,606
Trust
                688
                694
                644
Brokerage and insurance
                567
                444
                392
Investment securities gains, net
                616
                441
                604
Gains on loans sold
                236
                443
                759
Earnings on bank owned life insurance
                507
                502
                507
Other
                445
                446
                456
Total
 $          7,356
 $          7,423
 $          7,968

 
25

 
 
 
 2014/2013
 2013/2012
 
Change
Change
 
Amount
%
Amount
%
Service charges
 $            (156)
                (3.5)
 $            (153)
                (3.3)
Trust
                   (6)
                (0.9)
                  50
                 7.8
Brokerage and insurance
                123
               27.7
                  52
               13.3
Investment securities gains, net
                175
               39.7
               (163)
              (27.0)
Gains on loans sold
               (207)
              (46.7)
               (316)
              (41.6)
Earnings on bank owned life insurance
                    5
                 1.0
                   (5)
                (1.0)
Other
                   (1)
                (0.2)
                 (10)
                (2.2)
Total
 $              (67)
                (0.9)
 $            (545)
                (6.8)
 
2014 vs. 2013
 
Non-interest income decreased $67,000 in 2014 from 2013, or 0.9%.  We recorded investment securities gains totaling $616,000 compared with net gains of $441,000 in 2013. During 2014 we elected to sell eight agency securities, seven mortgage backed securities, several lots of an equity security, and one municipal security for gains of $177,000, $197,000, $101,000 and $172,000, respectively. We also sold two US Treasury securities for a loss of $31,000. The sales during 2014 were primarily made as a result of favorable market conditions at the time, which provided for improved portfolio performance in the future regardless of changes in interest rates.
 
Gains on loans sold decreased $207,000 compared to last year, which is the result of a lower level of refinancing done in 2014 versus 2013 for conforming loans. During 2014, the Bank generated $11.1 million of loan sale proceeds, but this was $10.8 million or 49.0% less than the proceeds received in 2013.
 
Service charge income decreased by $156,000 in 2014 compared to 2013 and continues to be the Company’s primary source of non-interest income. The largest decrease was in fees charged to customers for insufficient funds, which experienced a decrease of $153,000. ATM income decreased $18,000 in 2014 compared to 2013 due to decreased usage of the Company’s ATM machines by non-customers. With the reduced exploration activities for natural gas in 2014, there were fewer temporary workers in the area working who have not established permanent residency in the Company’s primary market. Service charge fees related to customers’ usage of their debit cards increased by $22,000. Management continues to monitor regulatory changes to determine the level of impact that these regulations will have on the Company.
 
The increase in brokerage and insurance revenues was the result of hiring additional brokers in 2014 that resulted in additional business. There was also an in increase in brokerage activity as a result of increases in the stock market during 2014.
 
2013 vs. 2012
 
Non-interest income decreased $545,000 in 2013 from 2012, or 6.8%.  We recorded investment securities gains totaling $441,000 compared with net gains of $604,000 in 2012. During 2013 we elected to sell seven agency securities, nine mortgage backed securities, portions of three equity securities, four municipal securities and one corporate security for gains of $86,000, $356,000, $296,000, $87,000 and $2,000, respectively. We also sold one corporate security and two mortgage backed securities for losses of $246,000 and $140,000, respectively. During 2012, we elected to sell four agency securities, thirteen mortgage backed securities, portions of an equity security and one municipal security for total gains of $604,000 due to favorable market conditions.
 
Gains on loans sold decreased $316,000 compared to 2012 as the result of a lower level of refinancing done in 2013. During 2013, the Bank generated $21.9 million of loan sale proceeds, but this was $14.8 million or 40.4% less than the proceeds received in 2012.
 
Service charge income decreased by $153,000 in 2013 compared to 2012. Service charge fees related to customers’ usage of their debit cards decreased by $37,000 which we believe was directly attributable to certain regulations issued as part of the Durbin amendment, which resulted in lower fees being earned by the Bank. ATM income decreased $53,000 in 2013 compared to 2012 due to decreased usage of the Company’s ATM machines by non-customers. Finally, there was a decrease in fees charged to customers for insufficient funds of $34,000.
 
 
26

 
 
The increase in trust revenues of $50,000 from 2012 was is primarily attributable to the increase in average assets under management during the first nine months of 2013. In September 2013 there was a significant withdrawal of trust assets by a single customer, which will impact future revenues until additional accounts or assets are added to those under management by the Trust department. The increase in brokerage and insurance revenues in 2013 of $52,000 was primarily a result of increased customer brokerage activity as a result of increases in the stock market.
 
Non-interest Expenses
The following tables reflect the breakdown of non-interest expense by major category for the periods ended December 31 (dollars in thousands):
 
 
2014
2013
2012
Salaries and employee benefits
 $       11,505
 $       11,392
 $       11,018
Occupancy
            1,287
            1,271
            1,265
Furniture and equipment
               362
               492
               411
Professional fees
               902
               781
               891
FDIC insurance
               461
               450
               468
ORE expenses
               299
               191
               164
Pennsylvania shares tax
               686
               640
               602
Other
            4,663
            4,593
            4,609
Total
 $       20,165
 $       19,810
 $       19,428

 
 2014/2013
 2013/2012
 
Change
Change
 
Amount
%
Amount
%
Salaries and employee benefits
 $            113
                1.0
 $            374
                3.4
Occupancy
                 16
                1.3
                   6
                0.5
Furniture and equipment
             (130)
            (26.4)
                 81
              19.7
Professional fees
               121
              15.5
             (110)
            (12.3)
FDIC insurance
                 11
                2.4
               (18)
              (3.8)
ORE expenses
               108
              56.5
                 27
              16.5
Pennsylvania shares tax
                 46
                7.2
                 38
                6.3
Other
                 70
                1.5
               (16)
              (0.3)
Total
 $            355
                1.8
 $            382
                2.0
 
2014 vs. 2013
 
Non-interest expenses for 2014 totaled $20,165,000 which represents an increase of $355,000, compared with 2013 expenses of $19,810,000.  Salary and benefit costs increased $113,000.  Base salaries and related payroll taxes increased $375,000, primarily due to merit increases and additional head count as a result of continuing to implement the Company’s strategic and expansion plans.  Full time equivalent staffing was 189 and 186 employees for 2014 and 2013, respectively. Health insurance related expenses decreased $182,000 from 2013 due to significantly improved claims experience in 2014. Incentive costs increased $213,000 compared to 2013.  Retirement expenses decreased $295,000 compared to 2013 mostly due to improved earnings on pension plan assets and a decrease in the net amortization and deferral of actuarial gains and losses.
 
Professional fees increased as a result of fees and costs associated with implementing the Company’s strategic plan in 2014 and other consulting projects. The increase in ORE expenses is due to the increase in foreclosed properties owned by the Company in 2014. Furniture and equipment costs decreased as a result of purchasing equipment for the online teller system implemented during 2013 and additional assets becoming fully depreciated.

 
27

 
 
2013 vs. 2012
 
Non-interest expenses for 2013 totaled $19,810,000 which represents an increase of $382,000, compared with 2012 costs of $19,428,000.  Salary and benefit costs increased $374,000.  Base salaries and related payroll taxes increased $343,000, primarily due to merit increases and additional head count. Full time equivalent staffing was 186 and 181 employees for 2013 and 2012, respectively. Incentive costs decreased $65,000 compared to 2012 primarily due to lower net income in 2013.  Retirement expenses increased $97,000 compared to 2012 as a result of increased expense for the pension plan and increased salary levels utilized in the calculation of the supplemental executive retirement plan.
 
Professional fees decreased as a result of fees and costs incurred in connection with the Bank’s charter conversion and simultaneous name change that occurred in 2012. Furniture and equipment costs increased as a result purchasing equipment for the online teller system implemented during 2013.
 
Provision for Income Taxes
 
The provision for income taxes was $3,559,000, $3,752,000 and $4,331,000 for 2014, 2013 and 2012, respectively. The effective tax rates for 2014, 2013 and 2012 were 21.0%, 21.9% and 23.4%, respectively.
 
Income before the provision for income taxes decreased by $183,000 in 2014 compared to 2013. As the result of this decrease and an increase in non-taxable investment and loan interest income, the provision for income taxes decreased by $193,000 when compared to 2013. We have managed our effective tax rate by remaining invested in tax-exempt municipal loans and bonds and investments in certain partnerships that provide the Company with tax credits.
 
Income before the provision for income taxes decreased by $1,419,000 in 2013 compared to 2012. This resulted in the provision for income taxes decreasing by $579,000 when compared to 2012.
 
We are involved in four limited partnership agreements that established low-income housing projects in our market area. During 2014 and 2013, we recognized tax credits related to two of the four partnerships. The provision in 2013 was impacted by one partnership, which provided its first tax credits in 2013. The tax credits for the other two projects were fully utilized by December 31, 2012. We anticipate recognizing an aggregate of $1.2 million of tax credits over the next eight years.  
 
FINANCIAL CONDITION
 
The following table presents ending balances (dollars in millions), growth and the percentage change during the past two years:
 
 
 2014
 
 %
 2013
 
 %
 2012
 
 Balance
 Increase
 Change
 Balance
 Increase
 Change
 Balance
 Total assets
 $        925.0
 $           10.1
             1.1
 $      914.9
 $           32.5
             3.7
 $      882.4
 Total investments
           306.1
            (11.2)
            (3.5)
         317.3
                7.0
             2.3
         310.3
 Total loans, net
           547.3
              13.8
             2.6
         533.5
              37.8
             7.6
         495.7
 Total deposits
           773.9
              25.6
             3.4
         748.3
              11.2
             1.5
         737.1
 Total stockholders' equity
           100.5
                8.4
             9.1
           92.1
                2.6
             2.9
           89.5
 
Cash and Cash Equivalents
 
Cash and cash equivalents totaled $11.4 million at December 31, 2014 compared with $10.1 million at December 31, 2013. The increase in cash and cash equivalents is the result of the Company’s decreased investment portfolio, increased deposit levels offset by decreased borrowed funds and the increase in the loan portfolio, as discussed in more detail below. Management actively measures and evaluates its liquidity through our Asset – Liability committee and believes its liquidity needs are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, Federal Home Loan Bank financing, federal funds lines with correspondent banks, brokered certificates of deposit and the portion of the investment and loan portfolios that mature within one year.  Management expects that these sources of funds will permit us to meet cash obligations and off-balance sheet commitments as they come due.
 
 
28

 
 
Investments
 
The following table shows the year-end composition of the investment portfolio for the five years ended December 31 (dollars in thousands):
 
 
2014
% of
2013
% of
2012
% of
2011
% of
2010
% of
 
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Available-for-sale:
                   
  U. S. Agency securities
 $    150,885
      49.3
 $ 152,189
      48.0
 $ 127,234
    41.0
 $ 168,600
    52.9
 $ 118,484
      47.1
  U.S. Treasuries
           4,849
        1.6
      11,309
        3.6
        4,947
      1.6
                -
       -
                -
          -
  Obligations of state & political
                   
     subdivisions
       105,036
      34.3
      95,005
      29.9
    100,875
    32.5
    101,547
    31.9
      76,922
      30.6
  Corporate obligations
         13,958
        4.6
      16,802
        5.3
      22,109
      7.1
        8,460
      2.7
        8,681
        3.5
  Mortgage-backed securities
         29,728
        9.6
      40,671
      12.8
      53,673
    17.3
      38,974
    12.2
      46,015
      18.3
  Equity securities
           1,690
        0.6
        1,325
        0.4
        1,414
      0.5
        1,242
      0.3
        1,201
        0.5
Total
 $    306,146
    100.0
 $ 317,301
    100.0
 $ 310,252
  100.0
 $ 318,823
  100.0
 $ 251,303
    100.0

2014
 
The Company’s investment portfolio decreased by $11.2 million, or 3.5%, during the past year.  During 2014, we purchased $40.5 million of U.S. agency obligations, $15.2 million of state and local obligations and $602,000 of equity securities, which helped to offset the $6.7 million of principal repayments and $35.0 million of calls and maturities that occurred during the year. We also selectively sold $29.0 million of bonds and equities at a net gain of $616,000. The market value of our investment portfolio increased approximately $4.8 million in 2014 due to interest rate fluctuations. Excluding our short term investments consisting of monies held primarily at the Federal Reserve, the effective yield on our investment portfolio for 2014 was 2.78% compared to 2.90% for 2013 on a tax equivalent basis.
 
During 2014, rates on the short end of the treasury yield curve experienced an increase, as the result of an expected rise in the federal funds rate in the near future due to the end of the quantitative easing program by the Federal Reserve, while the long end of the curve experienced a decrease in excess of 80 basis points in the 10 year treasury. These changes resulted in the market value of the investment portfolio increasing. As a result of these items, the investment strategy during 2014 was to purchase agency securities with maturities of less than four years and high quality municipal bonds with high coupons. The Bank believes it has provided itself protection to rising rates if it occurs under this strategy. Additionally, high coupon municipal bonds have less price volatility in rising rate scenarios than similar lower coupon bonds. We believe this strategy will enable us to reinvest cash flows in the next two to five years when and if investment opportunities improve.
 
At December 31, 2014, the Company did not own any securities, other than government-sponsored and government-guaranteed mortgage-backed securities, that had an aggregate book value in excess of 10% of our stockholders’ equity at that date.
 
2013
 
The Company’s investment portfolio increased by $7.0 million, or 2.3%, when compared to 2012.  During 2013, we purchased $90.8 million of U.S. agency obligations, $9.3 million of mortgage-backed securities, $14.8 million of state and local obligations, $1.7 million of corporate obligations, $6.9 million of U.S. treasury notes and $1,000 of equity securities, which helped to offset the $13.6 million of principal repayments and $65.0 million of calls and maturities that occurred during the year. We also selectively sold $25.5 million of bonds and equities at a net gain of $441,000. The market value of our investment portfolio decreased approximately $10.4 million in 2013 due to interest rate fluctuations. Excluding our short term investments consisting of monies held primarily at the Federal Reserve, the effective yield on our investment portfolio for 2013 was 2.90% compared to 3.18% for 2012 on a tax equivalent basis.
 
During 2013, rates on the short end of the curve experienced very little change, while the long end of the curve experienced a rise in excess of 100 basis points. This resulted in the market value of the investment portfolio decreasing. In addition, during the fourth quarter of 2013, the Federal Reserve reduced the amount of quantitative easing it was providing to the market, while at the same time committing to low short term rates. This resulted in a relatively steep yield curve. As a result of these items, the investment strategy during 2013 was to purchase agency securities with maturities of less than five years and high quality municipal bonds with high coupons.
 
 
29

 
 
At December 31, 2014, the Company did not own any securities, other than government-sponsored and government-guaranteed mortgage-backed securities, that had an aggregate book value in excess of 10% of our total stockholders’ equity at that date.
 
The expected principal repayments (amortized cost) and average weighted yields for the investment portfolio (excluding equity securities) as of December 31, 2014, are shown below (dollars in thousands). Expected principal repayments, which include prepayment speed assumptions for mortgage-backed securities, are significantly different than the contractual maturities detailed in Note 3 of the consolidated financial statements. Yields on tax-exempt securities are presented on a fully taxable equivalent basis, assuming a 34% tax rate.
 
     
After One Year
After Five Years
       
 
One Year or Less
to Five years
to Ten Years
After Ten Years
Total
 
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
 
Cost
%
Cost
%
Cost
%
Cost
%
Cost
%
Available-for-sale securities:
                   
  U.S. agency securities
 $            10,762
                 1.6
 $          123,015
      1.3
 $      17,070
      1.8
 $             -
          -
 $    150,847
      1.4
  U.S. treasuries
                       -
-
4,944
      1.2
-
        -
-
          -
          4,944
      1.2
  Obligations of state & political
 
 
 
 
 
 
 
 
 
 
    Subdivisions
               11,284
3.8
47,935
     4.2
15,271
      5.1
26,791
       6.1
       101,281
      4.8
  Corporate obligations
                 1,999
3.6
11,854
     2.1
-
        -
-
          -
         13,853
      2.3
  Mortgage-backed securities
                 6,554
2.1
15,929
     2.2
5,689
      2.3
1,225
       2.4
         29,397
      2.2
Total available-for-sale
 $            30,599
2.6
 $          203,677
      2.1
 $      38,030
      3.2
 $   28,016
      5.9
 $    300,322
      2.7
 
Approximately 78.0% of the amortized cost of debt securities is expected to mature, call or pre-pay within five years or less.  The Company expects that earnings from operations, the levels of cash held at the Federal Reserve and other correspondent banks, the high liquidity level of the available-for-sale securities, growth of deposits and the availability of borrowings from the Federal Home Loan Bank and other third party banks will be sufficient to meet future liquidity needs.
 
Loans
 
The Bank’s lending efforts are focused within its market area located in North Central Pennsylvania and Southern New York. We originate loans primarily through direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants, existing customers and the Bank’s website.  The Bank offers a variety of loans although historically most of our lending has focused on real estate loans including residential, commercial, agricultural, and construction loans.  As of December 31, 2014, approximately 73.5% of our loan portfolio consisted of real estate loans.  All lending is governed by a lending policy that is developed and maintained by us and approved by the Board of Directors.
 
Primarily the Bank offers fixed rate residential mortgage loans with terms of up to 25 years and adjustable rate mortgage loans (with amortization schedules based up to 30 years) with interest rates and payments that adjust based on one, three, and five year fixed periods.  Loan to value ratios are usually 80% or less with exceptions for individuals with excellent credit and low debt to income and/or high net worth. Adjustable rate mortgages are tied to a margin above the comparable Federal Home Loan Bank of Pittsburgh borrowing rate.  Home equity loans are written with terms of up to 15 years at fixed rates.  Home equity lines of credit are variable rate loans tied to the Prime Rate generally with a ten year draw period followed by a ten year repayment period. Home equity loans are typically written with a maximum 80% loan to value.
 
Commercial real estate loan terms are generally 20 years or less with one to five year adjustable rates.  The adjustable rates are typically tied to a margin above the comparable Federal Home Loan Bank of Pittsburgh borrowing rate with a maximum loan to value ratio of 80%. Where feasible, the Bank works with the United States Department of Agriculture’s (USDA) and Small Business Administration (SBA) guaranteed loan programs to offset risk and to further promote economic growth in our market area.  During 2014, we originated $3.3 million in USDA and SBA guaranteed commercial real estate loans.
 
 
30

 
 
Agriculture, and particularly dairy farming, is an important industry in our market area. Therefore, the Bank has developed an agriculture lending team with significant experience that has a thorough understanding of this industry. Agricultural loans focus on character, cash flow and collateral, while also taking into account the particular risks of the industry.  Loan terms are generally 20 years or less with one to five year adjustable rates.  The adjustable rates are typically tied to a margin above the comparable Federal Home Loan Bank of Pittsburgh borrowing rate with a maximum loan to value of 80%. The Bank is a preferred lender under the USDA’s Farm Service Agency (FSA) and participates in the FSA guaranteed loan program.
 
The Bank, as part of its commitment to the communities it serves, is an active lender for projects by our local municipalities and school districts. These loans range from short term bridge financing to 20 year term loans for specific projects. These loans are typically written at rates that adjust at least every five years. Due to the size of certain municipal loans, we have developed participation lending relationships with other community banks that allow us to meet regulatory compliance issues, while meeting the needs of the customer. At December 31, 2014, the aggregate balance of our participation loans with other lenders totaled $56.7 million.
 
Over the past few years, we have experienced an increase in loan demand from companies and businesses associated with, and serving, the exploration for natural gas. Activities associated with this tend to be very cyclical.  As a result, while we have pursued these opportunities, we have done so in a prudent and cautious manner and have developed specific policies and procedures for lending to these entities.  The Bank has lowered the loan to value threshold for loans, shortened amortization periods, and expanded our monitoring of loan concentrations associated with this activity.
 
The following table shows the year-end composition of the loan portfolio for the five years ended December 31 (dollars in thousands):
 
 
Five Year Breakdown of Loans by Type as of December 31,
 
 
2014
2013
2012
2011
2010
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate:
                   
  Residential
 $   185,438
    33.5
 $  187,101
    34.6
 $  178,080
    35.4
$184,034
 37.7
 $185,012
39.1
  Commercial
      190,945
    34.5
     193,087
    35.7
     176,710
    35.2
165,826
34.0
152,499
32.2
  Agricultural
        24,639
      4.4
       22,001
      4.1
       18,015
      3.6
19,224
3.9
19,078
4.0
  Construction
          6,353
      1.1
         8,937
      1.7
       12,011
      2.4
8,481
1.7
9,766
2.1
Consumer
          8,497
      1.5
         9,563
      1.7
       10,559
      2.1
10,746
2.2
11,285
2.4
Other commercial and agricultural loans
        58,516
    10.6
       54,029
    10.0
       47,880
      9.5
44,299
9.1
47,156
10.0
State & political subdivision loans
        79,717
    14.4
       65,894
    12.2
       59,208
    11.8
54,899
11.4
48,721
10.2
Total loans
      554,105
  100.0
     540,612
  100.0
     502,463
  100.0
487,509
100.0
473,517
100.0
Less allowance for loan losses
          6,815
 
         7,098
 
         6,784
 
6,487
 
5,915
 
Net loans
 $   547,290
 
 $  533,514
 
 $  495,679
 
$481,022
 
 $467,602
 

 
 2014/2013
 2013/2012
 
Change
Change
 
Amount
%
Amount
%
Real estate:
       
  Residential
 $     (1,663)
    (0.9)
 $      9,021
      5.1
  Commercial
        (2,142)
    (1.1)
       16,377
      9.3
  Agricultural
          2,638
    12.0
         3,986
    22.1
  Construction
        (2,584)
  (28.9)
       (3,074)
  (25.6)
Consumer
        (1,066)
  (11.1)
          (996)
    (9.4)
Other commercial and agricultural loans
          4,487
      8.3
         6,149
    12.8
State & political subdivision loans
        13,823
    21.0
         6,686
    11.3
Total loans
 $     13,493
      2.5
 $    38,149
      7.6

 
31

 
 
2014
 
Total loans grew $13.5 million in 2014 from a balance of $540.6 million at the end of 2013 to $554.1 million at the end of 2014.  Total loans grew 2.5% in 2014 compared with a 7.6% loan growth rate in 2013.
 
During 2014, the Company experienced growth in state and political subdivision loans, which increased $13.8 million or 21.0%, other commercial and agricultural loans which increased $4.5 million or 8.3% and agricultural real estate loans which increased $2.6 million or 12.0%. The increase in state and political loans, other commercial and agricultural and agricultural real estate loans reflects on the Company’s experienced lenders and their ability to identify and meet the needs of our customers while providing growth opportunities for the Company’s loan portfolio.  We also look at commercial relationships as a way to obtain deposits from farmers, small businesses and municipalities throughout our market area. While commercial relationships are a focus of the Company, we did have several large commercial real estate loans payoff during 2014, which resulted in a decrease of $2.1 million, or 1.1%. We continue to experience growth in the two loan production offices and are currently converting the Mill Hall loan production office into a full service branch, opening in February 2015. Commercial loan demand is subject to significant competitive pressures, the yield curve, the strength of the overall regional and national economy and the local economy. The local economy has been impacted significantly by natural gas exploration activities, which are impacted by regulations and changes in the market price of natural gas. Due to the low price for natural gas throughout 2014, exploration activities remained curtailed. We work closely with local municipalities and school districts to meet their needs that otherwise would be provided by the municipal bond market.
 
Residential real estate loans decreased $1.7 million during 2014. Loan demand for conforming mortgages, which the Company typically sells on the secondary market, slowed during 2014 when compared to 2013. During 2014, $11.1 million of loans were originated and sold on the secondary market, which compares to $20.2 million for 2013. Due to the decline in demand for non-conforming mortgages and the difficult investment environment, the Company decided that certain 15 year mortgage loans that met secondary market standards would not be sold on the secondary market, but would instead be held as part of the Bank’s residential real estate portfolio. During 2014, the Company decided not to sell $5.1 million of residential mortgages that met secondary market standards. In 2013, the Company did not sell $7.5 million of loans, which met secondary market standards. For loans sold on the secondary market, the Company recognizes fee income for servicing these sold loans, which is included in non-interest income.  Management continues to build technologies which make it easier and more efficient for customers to choose the Company for their mortgage needs.
 
The decrease in construction loans of $2.6 million is attributable to transfers out of construction at completion to commercial, state and political subdivision loans and residential real estate during 2014.

2013
 
Total loans grew $38.1 million, or 7.6%, in 2013 from a balance of $502.5 million at the end of 2012 to $540.6 million at the end of 2013. In 2012, the loan growth rate was 3.1%.
 
During 2013, the Company experienced growth in commercial real estate loans which increased $16.4 million or 9.3%, residential real estate loans which increased $9.0 million or 5.1%, other commercial and agricultural loans which increased $6.1 million or 12.8% and state and political subdivision loans which increased $6.7 million or 11.3%. The growth in commercial real estate, other commercial and agricultural and state and political subdivision loans was primarily the result of growth in the Company’s two loan production offices.
 
Residential real estate loans increased $9.0 million during 2013. Loan demand for conforming mortgages, which the Company typically sells on the secondary market, remained strong during 2013, although not as strong as 2012. During 2013, $20.2 million of loans were originated and placed for sale on the secondary market, which compares to $37.4 million for 2012. In addition, due to the decline in demand for non-conforming mortgages and the difficult investment environment in the first part of 2013, the Company decided that certain 15 year mortgage loans that met secondary market standards would not be sold on the secondary market, but would instead be held as part of the Bank’s residential real estate portfolio. During 2013, the Company decided not to sell $7.5 million of residential mortgages that met secondary market standards, which accounts for the majority of the increase in residential loans.
 
 
32

 
 
The decrease in construction loans of $3.1 million is attributable to transfers out of construction at completion to commercial and residential real estate during 2013.
 
The following table shows the maturity of commercial business and agricultural, state and political subdivision loans,  commercial real estate loans, and construction loans as of December 31, 2014, classified according to the sensitivity to changes in interest rates within various time intervals (in thousands).  The table does not include any estimate of prepayments which significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below.  Demand loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.

 
Commercial,
   
 
municipal,
Real estate
 
 
agricultural
construction
Total
Maturity of loans:
     
  One year or less
 $           12,705
 $                    -
 $           12,705
  Over one year through five years
              40,407
                2,323
              42,730
  Over five years
            300,705
                4,030
            304,735
Total
 $         353,817
 $             6,353
 $         360,170
Sensitivity of loans to changes in interest
     
   rates - loans due after December 31, 2015:
     
  Predetermined interest rate
 $           73,910
 $             1,689
 $           75,599
  Floating or adjustable interest rate
            267,202
                4,664
            271,866
Total
 $         341,112
 $             6,353
 $         347,465
 
Allowance for Loan Losses and Credit Quality Risk
 
The allowance for loan losses is maintained at a level, which in management’s judgment is adequate to absorb probable future loan losses inherent in the loan portfolio.  The provision for loan losses is charged against current income.  Loans deemed not collectable are charged-off against the allowance while subsequent recoveries increase the allowance.  The following table presents an analysis of the change in the allowance for loan losses and a summary of our non-performing assets for the years ended December 31, 2014, 2013, 2012, 2011 and 2010. All non-accruing troubled debt restructurings are also included the non-accruing loans total.
 
 
33

 
 
 
December 31,
 
2014
2013
2012
2011
2010
Balance
         
  at beginning of period
 $          7,098
 $          6,784
 $          6,487
 $          5,915
 $          4,888
Charge-offs:
         
  Real estate:
         
     Residential
                  97
                  17
                  95
                101
                147
     Commercial
                516
                  62
                    2
                  29
                  53
     Agricultural
                     -
                     -
                     -
                     -
                     -
  Consumer
                  47
                  54
                  54
                  71
                  35
  Other commercial and agricultural loans
                250
                    1
                  21
                    6
                173
Total loans charged-off
                910
                134
                172
                207
                408
Recoveries:
         
  Real estate:
         
     Residential
                     -
                    5
                     -
                     -
                    4
     Commercial
                  15
                    5
                    9
                  15
                  11
     Agricultural
                     -
                     -
                     -
                     -
                     -
  Consumer
                  27
                  33
                  33
                  57
                  45
  Other commercial and agricultural loans
                     -
                     -
                    7
                  32
                120
Total loans recovered
                  42
                  43
                  49
                104
                180
           
Net loans charged-off (recovered)
                868
                  91
                123
                103
                228
Provision charged to expense
                585
                405
                420
                675
             1,255
Balance at end of year
 $          6,815
 $          7,098
 $          6,784
 $          6,487
 $          5,915
           
Loans outstanding at end of period
 $      554,105
 $      540,612
 $      502,463
 $      487,509
 $      473,517
Average loans outstanding, net
 $      540,541
 $      516,748
 $      496,822
 $      474,972
 $      468,620
Non-performing assets:
         
    Non-accruing loans
 $          6,599
 $          8,097
 $          8,067
 $          9,165
 $        11,853
    Accrual loans - 90 days or more past due
                836
                697
                506
                275
                692
      Total non-performing loans
 $          7,435
 $          8,794
 $          8,573
 $          9,440
 $        12,545
    Foreclosed assets held for sale
             1,792
             1,360
                616
                860
                693
      Total non-performing assets
 $          9,227
 $        10,154
 $          9,189
 $        10,300
 $        13,238
           
Troubled debt restructurings (TDR)
         
    Non-accruing TDRs
 $          3,654
 $          4,701
 $          4,834
 $          5,490
 $             130
    Accrual TDRs
             2,502
             2,510
                193
                123
                     -
      Total troubled debt restructurings
 $          6,156
 $          7,211
 $          5,027
 $          5,613
 $             130
Net charge-offs to average loans
0.16%
0.02%
0.02%
0.02%
0.05%
Allowance to total loans
1.23%
1.31%
1.35%
1.33%
1.25%
Allowance to total non-performing loans
91.66%
80.71%
79.13%
68.72%
47.15%
Non-performing loans as a percent of loans
         
   net of unearned income
1.34%
1.63%
1.71%
1.94%
2.65%
Non-performing assets as a percent of loans
       
  net of unearned income
1.67%
1.88%
1.83%
2.11%
2.80%
 
The Company utilizes a disciplined and thorough loan review process based upon our internal loan policy approved by the Company’s Board of Directors.  The purpose of the review is to assess loan quality, analyze delinquencies, identify problem loans, evaluate potential charge-offs and recoveries, and assess general overall economic conditions in the markets served.  An external independent loan review is performed on our commercial portfolio semi-annually for the Company.  The external consultant is engaged to 1) review a minimum of 55% (60% of loans prior to 2013) of the dollar volume of the commercial loan portfolio on an annual basis, 2) new loans originated for over $1.0 million in the last years, 3) a majority of borrowers with commitments greater than or equal to $1.0 million,  4) review selected loan relationships over $750,000 which are over 30 days past due, classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate. As part of this review, our underwriting process and loan grading system is evaluated.
 
 
34

 
 
Management believes it uses the best information available to make such determinations and that the allowance for loan losses is adequate as of December 31, 2014.  However, future adjustments could be required if circumstances differ substantially from assumptions and estimates used in making the initial determination.  A prolonged downturn in the economy, high unemployment rates, significant changes in the value of collateral and delays in receiving financial information from borrowers could result in increased levels of non-performing assets, charge-offs, loan loss provisions and reduction in income.  Additionally, bank regulatory agencies periodically examine the Bank’s allowance for loan losses.  The banking agencies could require the recognition of additions to the allowance for loan losses based upon their judgment of information available to them at the time of their examination.
 
On a monthly basis, problem loans are identified and updated primarily using internally prepared past due reports.  Based on data surrounding the collection process of each identified loan, the loan may be added or deleted from the monthly watch list.  The watch list includes loans graded special mention, substandard, doubtful, and loss, as well as additional loans that management may choose to include.  Watch list loans are continually monitored going forward until satisfactory conditions exist that allow management to upgrade and remove the loan from the watchlist.  In certain cases, loans may be placed on non-accrual status or charged-off based upon management’s evaluation of the borrower’s ability to pay.  All commercial loans, which include commercial real estate, agricultural real estate, state and political subdivision loans and commercial business loans, on non-accrual are evaluated quarterly for impairment.
 
The adequacy of the allowance for loan losses is subject to a formal, quarterly analysis by management of the Company.  In order to better analyze the risks associated with the loan portfolio, the entire portfolio is divided into several categories.  As stated above, loans on non-accrual status are specifically reviewed for impairment and given a specific reserve, if appropriate.  Loans evaluated and not found to be impaired are included with other performing loans, by category, by their respective homogenous pools.  Three year average historical loss factors were calculated for each pool and applied to the performing portion of the loan category for 2014, 2013, 2012 and 2011. For 2010 the historical loss factor was based on a five year average. This was changed as management believes the three year average is better representative of the inherent risks in the loan portfolio and is more reflective of current trends.  The historical loss factors for both reviewed and homogeneous pools are adjusted based upon the following qualitative factors:
 
·  
Level of and trends in delinquencies, impaired/classified loans
 
Change in volume and severity of past due loans
 
Volume of non-accrual loans
 
Volume and severity of classified, adversely or graded loans
·  
Level of and trends in charge-offs and recoveries
·  
Trends in volume, terms and nature of the loan portfolio
·  
Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices
·  
Changes in the quality of the Bank’s loan review system
·  
Experience, ability and depth of lending management and other relevant staff
·  
National, state, regional and local economic trends and business conditions
 
General economic conditions
 
Unemployment rates
 
Inflation / CPI
 
Changes in values of underlying collateral for collateral-dependent loans
·  
Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses.
·  
Existence and effect of any credit concentrations, and changes in the level of such concentrations
·  
Any change in the level of board oversight

 
35

 
 
See also “Note 4 – Loans and Related Allowance for Loan Losses” to the consolidated financial statements.
 
The balance in the allowance for loan losses was $6,815,000 or 1.23% of total loans as of December 31, 2014 as compared to $7,098,000 or 1.31% of loans as of December 31, 2013.  The $283,000 decrease is a result of a $585,000 provision for loan losses less net charge-offs of $868,000.  The following table shows the distribution of the allowance for loan losses and the percentage of loans compared to total loans by loan category (dollars in thousands) as of December 31:
 
 
2014
2013
2012
2011
2010
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate loans:
                   
  Residential
 $         878
 33.5
 $       946
34.6
 $       875
35.4
 $       805
37.7
 $       969
      39.1
  Commercial, agricultural
         3,870
38.9
       4,558
39.8
       4,437
38.8
       4,132
37.9
       3,380
      36.2
  Construction
              26
1.1
            50
1.7
            38
2.4
            15
1.7
            22
        2.1
Consumer
              84
1.5
          105
1.7
          119
2.1
          111
2.2
          108
        2.4
Other commercial and agricultural loans
         1,224
10.6
          942
10.0
          728
9.5
          674
9.1
          983
      10.0
State & political subdivision loans
            545
14.4
          330
12.2
          271
11.8
          235
11.4
          137
      10.2
Unallocated
            188
 N/A
          167
 N/A
          316
 N/A
          515
 N/A
          316
 N/A
Total allowance for loan losses
 $      6,815
100.0
 $    7,098
100.0
 $    6,784
100.0
 $    6,487
100.0
 $    5,915
    100.0
 
As a result of previous loss experiences and other the risk factors utilized in determining the allowance, the Bank’s allocation of the allowance does not directly correspond to the actual balances of the loan portfolio. While commercial and agricultural real estate total 38.9% of the loan portfolio, 56.8% of the allowance is assigned to this segment of the loan portfolio as these loans have more inherent risks than residential real estate or loans to state and political subdivisions. Residential real estate loans comprise 33.5% of the loan portfolio as of December 31, 2014 and 12.9% of the allowance is assigned to this segment.
 
The following table identifies amounts of loans contractually past due 30 to 90 days and non-performing loans by loan category, as well as the change from December 31, 2013 to December 31, 2014 in non-performing loans (dollars in thousands).  Non-performing loans include those loans that are contractually past due 90 days or more and non-accrual loans.  Interest does not accrue on non-accrual loans.  Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest.
 
 
December 31, 2014
 
December 31, 2013
 
Accruing
Non-Performing Loans
 
Accruing
Non-Performing Loans
 
30 - 89 Days
90 Days Past
Non-
Total Non-
 
30 - 89 Days
90 Days Past
Non-
Total Non-
 
Past Due
Due Accruing
accrual
Performing
 
Past Due
Past Due
accrual
Performing
Real estate:
                 
  Residential
 $          1,089
 $                 346
 $      828
 $         1,174
 
 $         1,006
 $             352
 $    685
 $      1,037
  Commercial
147
                   310
5,010
5,320
 
215
                344
7,247
7,591
  Agricultural
-
                       -
-
-
 
-
                    -
-
                 -
  Construction
-
                      -
-
-
 
-
                    -
-
                 -
Consumer
75
                       6
47
53
 
132
                   1
15
16
Other commercial and agricultural loans
761
                  174
714
888
 
17
                    -
150
150
Total nonperforming loans
 $          2,072
 $                 836
 $   6,599
 $         7,435
 
 $         1,370
 $             697
 $ 8,097
 $      8,794
 
 
36

 
 
 
Change in Non-Performing Loans
 
 2014 / 2013
 
Amount
%
Real estate:
   
  Residential
 $               137
                  13.2
  Commercial
 (2,271)
                 (29.9)
  Agricultural
                      -
 -
  Construction
                      -
 -
Consumer
                    37
                 231.3
Other commercial and agricultural loans
                  738
                 492.0
Total nonperforming loans
 $            (1,359)
                 (15.5)
 
The following table shows the distribution of non-performing loans by loan category (dollars in thousands) for the past five years as of December 31:
 
 
Non-Performing Loans
 
2014
2013
2012
2011
2010
Real estate:
         
  Residential
 $        1,174
 $        1,037
 $           995
 $           653
 $           711
  Commercial
           5,320
           7,591
           7,194
           8,270
           8,161
  Agricultural
                 -
                 -
                 -
                 -
           2,241
  Construction
                 -
                 -
                 -
                 -
                 -
Consumer
               53
               16
                 4
                 -
               18
Other commercial and agricultural loans
             888
             150
             380
             517
           1,414
State & political subdivision loans
                 -
                 -
                 -
                 -
                 -
Total nonperforming loans
           7,435
           8,794
           8,573
           9,440
         12,545
 
For the year ended December 31, 2014, we recorded a provision for loan losses of $585,000 which compares to $405,000 for the same period in 2013, an increase of $180,000. The increase is attributable to the increase in net charged off loans during 2014 of $777,000. While charge-offs in 2014 were historically high for the Company, they are still low relative to peer and were primarily driven by two customers, which experienced charge-offs of $463,000 and $175,000. Additionally, it should be noted that non-performing loans decreased $1.4 million or 15.5%, from December 31, 2013 to December 31, 2014 primarily due to the completion of several foreclosure actions in 2014, some of which resulted in charge-offs in 2014. Approximately 62.6% of the Bank’s non-performing loans are associated with the following three customer relationships:
 
·  
A commercial customer with a total loan relationship of $3.5 million secured by 164 residential properties was on non-accrual status as of December 31, 2014. In the first quarter of 2011, the Company and borrower entered into a forbearance agreement to restructure the debt. In July of 2013, the customer filed for bankruptcy under Chapter 11 and a Trustee was appointed in January of 2014. Through December 31, 2014 all loan payments in accordance with the forbearance agreement have been made, which has resulted in no specific reserve allocation as of December 31, 2014. We continue to monitor the bankruptcy proceedings to identify potential changes in the customer’s operations and the impact these would have on the loan payments for our loans to the customer and the underlying collateral that supports these loans.
·  
A commercial customer with a relationship of approximately $473,000 after a charge-off of $463,000 during the second quarter of 2014, secured by real estate was on non-accrual status as of December 31, 2014. The current economic conditions have significantly impacted the cash flows from the customer’s activities. Management reviewed the collateral and in the second quarter of 2014 charged-off of a portion of the balance associated with this customer, which was based on the appraised value of collateral and as a result there is no specific reserve as of December 31, 2014.
·  
A commercial customer with a relationship of approximately $633,000 secured by real estate, equipment and accounts receivable was on non-accrual status as of December 31, 2014. The slowdown in the exploration for natural gas has significantly impacted the cash flows of the customer. Management reviewed the collateral value based on an appraisal completed in 2014, which resulted in no specific reserve as of December 31, 2014.

 
37

 
 
Management believes that the allowance for loan losses at December 31, 2014 was adequate at that date, which was based on the following factors:
 
·  
47.7% of the Company’s non-performing loans are associated with one customer under bankruptcy protection that has remained current with its payments.
·  
Net and gross charge-offs continue to be low in relation to the size of the Bank’s loan portfolio and compared to our peer group. Net charge-offs for 2014 were 0.16% of the loan portfolio and in 2013 were 0.02% of the total loan portfolio.
·  
The primary market of the Bank has a relatively stable real estate market and did not experience the significant decrease in the collateral values of local residential, commercial or agricultural real estate loan portfolios as seen in other parts of the country. The local real estate market also did not realize the significant, and sometimes speculative, increases seen in other parts of the country. Finally, our market area is predominately centered in a natural gas exploration and drilling area, and while the activities associated with this exploration are cyclical, it has provided a positive impact on the value of local real estate.

Bank Owned Life Insurance