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EX-31.2 - EXHIBIT 31.2 - ARROW FINANCIAL CORPex312cfoq22015.htm
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2015

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

Commission File Number: 0-12507

ARROW FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

New York
 
22-2448962
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer
Identification No.)
250 GLEN STREET, GLENS FALLS, NEW YORK 12801
(Address of principal executive offices)   (Zip Code)
Registrant’s telephone number, including area code:   (518) 745-1000

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 Web site, 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 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.
Large accelerated filer     
Accelerated filer   x 
Non-accelerated filer     
Smaller reporting company     

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
 
Outstanding as of July 31, 2015
Common Stock, par value $1.00 per share
 
12,629,444
 







ARROW FINANCIAL CORPORATION
FORM 10-Q
TABLE OF CONTENTS







# 2



PART I - Financial Information



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Share and Per Share Amounts)
(Unaudited)
 
June 30, 2015
 
December 31, 2014
 
June 30, 2014
ASSETS
 
 
 
 
 
Cash and Due From Banks
$
31,438

 
$
35,081

 
$
35,351

Interest-Bearing Deposits at Banks
13,699

 
11,214

 
16,459

Investment Securities:
 
 
 
 
 
Available-for-Sale
391,817

 
366,139

 
366,848

Held-to-Maturity (Approximate Fair Value of $328,361 at June 30, 2015; $308,566 at December 31, 2014; and $304,259 at June 30, 2014)
324,116

 
302,024

 
297,437

Federal Home Loan Bank and Federal Reserve Bank Stock
6,470

 
4,851

 
4,583

Loans
1,479,670

 
1,413,268

 
1,344,124

Allowance for Loan Losses
(15,574
)
 
(15,570
)
 
(15,036
)
Net Loans
1,464,096

 
1,397,698

 
1,329,088

Premises and Equipment, Net
28,570

 
28,488

 
28,465

Goodwill
22,003

 
22,003

 
22,003

Other Intangible Assets, Net
3,369

 
3,625

 
3,865

Other Assets
47,793

 
46,297

 
48,952

Total Assets
$
2,333,371

 
$
2,217,420

 
$
2,153,051

LIABILITIES
 
 
 
 
 
Noninterest-Bearing Deposits
$
325,046

 
$
300,786

 
$
286,735

NOW Accounts
904,893

 
871,671

 
820,589

Savings Deposits
547,706

 
524,648

 
523,626

Time Deposits of $100,000 or More
58,284

 
61,797

 
70,600

Other Time Deposits
136,555

 
144,046

 
159,116

Total Deposits
1,972,484

 
1,902,948

 
1,860,666

Federal Funds Purchased and
  Securities Sold Under Agreements to Repurchase
24,273

 
19,421

 
16,896

Federal Home Loan Bank Overnight Advances
29,500

 
41,000

 
24,000

Federal Home Loan Bank Term Advances
55,000

 
10,000

 
10,000

Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts
20,000

 
20,000

 
20,000

Other Liabilities
25,167

 
23,125

 
23,873

Total Liabilities
2,126,424

 
2,016,494

 
1,955,435

STOCKHOLDERS’ EQUITY
 
 
 
 
 
Preferred Stock, $5 Par Value; 1,000,000 Shares Authorized


 


 


Common Stock, $1 Par Value; 20,000,000 Shares Authorized (17,079,376 Shares Issued at June 30, 2015 and December 31, 2014 and 16,744,486 Shares Issued June 30, 2014)
17,079

 
17,079

 
16,744

Additional Paid-in Capital
240,243

 
239,721

 
230,131

Retained Earnings
35,303

 
29,458

 
32,132

Unallocated ESOP Shares (58,606 Shares at June 30, 2015; 71,748 Shares at December 31, 2014; and 74,845 Shares at June 30, 2014)
(1,200
)
 
(1,450
)
 
(1,550
)
Accumulated Other Comprehensive Loss
(7,171
)
 
(7,166
)
 
(3,489
)
Treasury Stock, at Cost (4,397,740 Shares at June 30, 2015; 4,386,001 Shares at December 31, 2014; and 4,319,587 Shares at June 30, 2014)
(77,307
)
 
(76,716
)
 
(76,352
)
Total Stockholders’ Equity
206,947

 
200,926

 
197,616

Total Liabilities and Stockholders’ Equity
$
2,333,371

 
$
2,217,420

 
$
2,153,051

See Notes to Unaudited Interim Consolidated Financial Statements.

# 3



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, Except Per Share Amounts)
(Unaudited)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2015
 
2014
 
2015
 
2014
INTEREST AND DIVIDEND INCOME
 
 
 
 
 
 
 
Interest and Fees on Loans
$
13,939

 
$
13,202

 
$
27,589

 
$
25,976

Interest on Deposits at Banks
26

 
16

 
47

 
29

Interest and Dividends on Investment Securities:
 
 
 
 
 
 
 
Fully Taxable
2,013

 
2,041

 
3,957

 
4,049

Exempt from Federal Taxes
1,429

 
1,436

 
2,804

 
2,907

Total Interest and Dividend Income
17,407

 
16,695

 
34,397

 
32,961

INTEREST EXPENSE
 
 
 
 
 
 
 
NOW Accounts
338

 
495

 
668

 
959

Savings Deposits
182

 
226

 
349

 
445

Time Deposits of $100,000 or More
88

 
201

 
178

 
431

Other Time Deposits
185

 
359

 
387

 
750

Federal Funds Purchased and
  Securities Sold Under Agreements to Repurchase
5

 
5

 
10

 
9

Federal Home Loan Bank Advances
301

 
127

 
451

 
272

Junior Subordinated Obligations Issued to
  Unconsolidated Subsidiary Trusts
144

 
142

 
286

 
283

Total Interest Expense
1,243

 
1,555

 
2,329

 
3,149

NET INTEREST INCOME
16,164

 
15,140

 
32,068

 
29,812

Provision for Loan Losses
70

 
505

 
345

 
963

NET INTEREST INCOME AFTER PROVISION FOR
   LOAN LOSSES
16,094

 
14,635

 
31,723

 
28,849

NONINTEREST INCOME
 
 
 
 
 
 
 
Income From Fiduciary Activities
2,051

 
1,906

 
3,984

 
3,779

Fees for Other Services to Customers
2,334

 
2,377

 
4,573

 
4,571

Insurance Commissions
2,367

 
2,293

 
4,506

 
4,737

Net Gain (loss) on Securities Transactions
16

 
(27
)
 
106

 
(27
)
Net Gain on Sales of Loans
120

 
166

 
252

 
289

Other Operating Income
556

 
304

 
879

 
556

Total Noninterest Income
7,444

 
7,019

 
14,300

 
13,905

NONINTEREST EXPENSE
 
 
 
 
 
 
 
Salaries and Employee Benefits
8,186

 
7,880

 
15,878

 
15,522

Occupancy Expenses, Net
2,344

 
2,316

 
4,831

 
4,657

FDIC Assessments
296

 
282

 
576

 
555

Other Operating Expense
3,557

 
3,259

 
7,053

 
6,469

Total Noninterest Expense
14,383

 
13,737

 
28,338

 
27,203

INCOME BEFORE PROVISION FOR INCOME TAXES
9,155

 
7,917

 
17,685

 
15,551

Provision for Income Taxes
2,850

 
2,393

 
5,525

 
4,707

NET INCOME
$
6,305


$
5,524


$
12,160


$
10,844

Average Shares Outstanding:
 
 
 
 
 
 
 
Basic
12,633

 
12,595

 
12,633

 
12,599

Diluted
12,669

 
12,616

 
12,670

 
12,621

Per Common Share:
 
 
 
 
 
 
 
Basic Earnings
$
0.50

 
$
0.44

 
$
0.96

 
$
0.86

Diluted Earnings
0.50

 
0.44

 
0.96

 
0.86


Share and Per Share Amounts have been restated for the September 2014 2% stock dividend.
See Notes to Unaudited Interim Consolidated Financial Statements.

# 4



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In Thousands)
(Unaudited)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2015
 
2014
 
2015
 
2014
Net Income
$
6,305

 
$
5,524

 
$
12,160

 
$
10,844

Other Comprehensive Income, Net of Tax:
 
 
 
 
 
 
 
  Net Unrealized Securities Holding (Losses) Gains
     Arising During the Period
(1,014
)
 
514

 
(159
)
 
755

Reclassification Adjustments for Securities (Gains) Losses Included in Net Income
          
(10
)
 
16

 
(65
)
 
16

  Amortization of Net Retirement Plan Actuarial Loss
118

 
69

 
235

 
139

  Accretion of Net Retirement Plan Prior
     Service Credit
(9
)
 
(13
)
 
(16
)
 
(26
)
Other Comprehensive Income (Loss) Gain
(915
)
 
586

 
(5
)
 
884

  Comprehensive Income
$
5,390

 
$
6,110

 
$
12,155

 
$
11,728

 
 
 
 
 
 
 
 

See Notes to Unaudited Interim Consolidated Financial Statements.


# 5



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY
(In Thousands, Except Share and Per Share Amounts)
(Unaudited)

 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Unallo-cated ESOP
Shares
 
Accumu-lated
Other Com-
prehensive
Loss
 
Treasury
Stock
 
Total
Balance at December 31, 2014
$
17,079

 
$
239,721

 
$
29,458

 
$
(1,450
)
 
$
(7,166
)
 
$
(76,716
)
 
$
200,926

Net Income

 

 
12,160

 

 

 

 
12,160

Other Comprehensive Income

 

 

 

 
(5
)
 

 
(5
)
Cash Dividends Paid, $.50 per Share

 

 
(6,315
)
 

 

 

 
(6,315
)
Stock Options Exercised, Net  (3,027 Shares)

 
40

 

 

 

 
30

 
70

Shares Issued Under the Directors’ Stock
  Plan  (4,579 Shares)

 
73

 

 

 

 
45

 
118

Shares Issued Under the Employee Stock
  Purchase Plan  (9,775 Shares)

 
153

 

 

 

 
96

 
249

Stock-Based Compensation Expense

 
157

 

 

 

 

 
157

Purchase of Treasury Stock
  (29,120 Shares)

 

 

 

 

 
(762
)
 
(762
)
Allocation of ESOP Stock  (13,142 Shares)

 
99

 

 
250

 

 

 
349

Balance at June 30, 2015
$
17,079

 
$
240,243

 
$
35,303

 
$
(1,200
)
 
$
(7,171
)
 
$
(77,307
)
 
$
206,947

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2013
$
16,744

 
$
229,290

 
$
27,457

 
$
(1,800
)
 
$
(4,373
)
 
$
(75,164
)
 
$
192,154

Net Income

 

 
10,844

 

 

 

 
10,844

Other Comprehensive Income

 

 

 

 
884

 

 
884

Cash Dividends Paid, $.49 per Share 1

 

 
(6,169
)
 

 

 

 
(6,169
)
Stock Options Exercised, Net  (21,565 Shares)

 
308

 

 

 

 
212

 
520

Shares Issued Under the Directors’ Stock
  Plan  (3,872 Shares)

 
63

 

 

 

 
38

 
101

Shares Issued Under the Employee Stock
  Purchase Plan  (9,713 Shares)

 
146

 

 

 

 
95

 
241

Stock-Based Compensation Expense

 
180

 

 

 

 

 
180

Tax Benefit for Disposition of Stock Options

 
9

 

 

 

 

 
9

Purchase of Treasury Stock
 (61,609 Shares)

 

 

 

 

 
(1,568
)
 
(1,568
)
Acquisition of Subsidiaries  (3,595 Shares)

 
56

 

 

 

 
35

 
91

Allocation of ESOP Stock  (12,796 Shares)

 
79

 

 
250

 

 

 
329

Balance at June 30, 2014
$
16,744

 
$
230,131

 
$
32,132

 
$
(1,550
)
 
$
(3,489
)
 
$
(76,352
)
 
$
197,616


1 Cash dividends paid per share have been adjusted for the September 2014 2% stock dividend.
See Notes to Unaudited Interim Consolidated Financial Statements.

# 6



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
(Unaudited)
 
Six Months Ended June 30,
Cash Flows from Operating Activities:
2015
 
2014
Net Income
$
12,160

 
$
10,844

Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
 
 
 
Provision for Loan Losses
345

 
963

Depreciation and Amortization
3,266

 
3,854

Allocation of ESOP Stock
349

 
329

Gains on the Sale of Securities Available-for-Sale
(106
)
 

Losses on the Sale of Securities Available-for-Sale

 
27

Loans Originated and Held-for-Sale
(10,626
)
 
(9,723
)
Proceeds from the Sale of Loans Held-for-Sale
7,620

 
8,993

Net Gains on the Sale of Loans
(252
)
 
(289
)
Net Losses on the Sale of Premises and Equipment, Other Real Estate Owned and Repossessed Assets
112

 
46

Contributions to Retirement Benefit Plans
(416
)
 
(465
)
Deferred Income Tax Expense (Benefit)
297

 
(180
)
Shares Issued Under the Directors’ Stock Plan
118

 
101

Stock-Based Compensation Expense
157

 
180

Net Increase in Other Assets
(1,777
)
 
(714
)
Net Increase in Other Liabilities
2,458

 
67

Net Cash Provided By Operating Activities
13,705

 
14,033

Cash Flows from Investing Activities:
 
 
 
Proceeds from the Sale of Securities Available-for-Sale
21,426

 
40,725

Proceeds from the Maturities and Calls of Securities Available-for-Sale
55,976

 
107,292

Purchases of Securities Available-for-Sale
(104,488
)
 
(57,515
)
Proceeds from the Maturities and Calls of Securities Held-to-Maturity
30,084

 
37,435

Purchases of Securities Held-to-Maturity
(52,815
)
 
(36,380
)
Net Increase in Loans
(64,241
)
 
(77,926
)
Proceeds from the Sales of Premises and Equipment, Other Real Estate Owned and Repossessed Assets
820

 
918

Purchase of Premises and Equipment
(1,136
)
 
(618
)
Cash Paid for Subsidiaries, Net

 
(75
)
Net (Increase) Decrease in Other Investments
(1,619
)
 
1,698

Purchase of Bank Owned Life Insurance

 
(5,245
)
Net Cash (Used In) Provided By Investing Activities
(115,993
)
 
10,309

Cash Flows from Financing Activities:
 
 
 
Net Increase in Deposits
69,536

 
18,336

Net Decrease in Short-Term Borrowings
(36,148
)
 
(23,881
)
Federal Home Loan Bank Advances
74,500

 

Repayments of Federal Home Loan Bank Term Advances

 
(10,000
)
Purchase of Treasury Stock
(762
)
 
(1,568
)
Stock Options Exercised, Net
70

 
520

Shares Issued Under the Employee Stock Purchase Plan
249

 
241

Tax Benefit from Exercise of Stock Options

 
9

Cash Dividends Paid
(6,315
)
 
(6,169
)
Net Cash Provided By (Used In) Financing Activities
101,130

 
(22,512
)
Net (Decrease) Increase in Cash and Cash Equivalents
(1,158
)
 
1,830

Cash and Cash Equivalents at Beginning of Period
46,295

 
49,980

Cash and Cash Equivalents at End of Period
$
45,137

 
$
51,810

 
 
 
 
Supplemental Disclosures to Statements of Cash Flow Information:
 
 
 
Interest on Deposits and Borrowings
$
2,297

 
$
3,222

Income Taxes
4,860

 
4,485

Non-cash Investing and Financing Activity:
 
 
 
Transfer of Loans to Other Real Estate Owned and Repossessed Assets
756

 
932

Acquisition of Subsidiaries

 
91


See Notes to Unaudited Interim Consolidated Financial Statements.

# 7



NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1.     ACCOUNTING POLICIES

In the opinion of the management of Arrow Financial Corporation (Arrow), the accompanying unaudited consolidated interim financial statements contain all of the adjustments necessary to present fairly the financial position as of June 30, 2015, December 31, 2014 and June 30, 2014; the results of operations for the three-month and six-month periods ended June 30, 2015 and 2014; the consolidated statements of comprehensive income for the three-month and six-month periods ended June 30, 2015 and 2014; the changes in stockholders' equity for the six-month periods ended June 30, 2015 and 2014; and the cash flows for the six-month periods ended June 30, 2015 and 2014. All such adjustments are of a normal recurring nature. Certain prior period amounts have been reclassified to conform to the current presentation. The preparation of financial statements requires the use of management estimates. The unaudited consolidated interim financial statements should be read in conjunction with the audited annual consolidated financial statements of Arrow for the year ended December 31, 2014, included in Arrow's 2014 Form 10-K.

New Accounting Standards Updates (ASU): During 2015, through the date of this report, the FASB issued ten accounting standards updates, The standards listed below did not have had an immediate impact on Arrow, but could in the future.
ASU 2015-01 "Income Statement - Extraordinary and Unusual Items" eliminated the concept of extraordinary items. For Arrow, the standard is effective for the first quarter of 2016.
ASU 2015-02 "Consolidation" changed the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. For Arrow, the standard is effective for the first quarter of 2016.
ASU 2015-03 "Interest - Imputation of Interest" required debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability. There were no changes to the recognition and measurement of debt issuance costs. For Arrow, the standard is effective for the first quarter of 2016.
ASU 2015-04 "Compensation-Retirement Benefits" provides several practical expedients for the measurement or, in certain circumstances, the remeasurement of defined benefit plan assets and obligations. Most of the practical expedients will not apply to Arrow, however, if used, an entity must disclose the accounting policy election and the date used to measure defined benefit plan assets and obligations. For Arrow, the standard is effective for the first quarter of 2016.
ASU 2015-05 "Intangibles - Goodwill and Other - Internal use Software" provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. For Arrow, the standard is effective for the first quarter of 2016.
ASU 2015-06 "Earnings Per Share" contains guidance that addresses master limited partnerships. For Arrow, the standard is effective for the first quarter of 2016.
ASU 2015-07 "Fair Value Measurement" permits a reporting entity to measure the fair value of certain investments using the net asset value per share of the investment. For Arrow, the standard is effective for the first quarter of 2016.
ASU 2015-08 "Business Combinations" amended various SEC paragraphs pursuant to SEC Staff Accounting Bulletin No. 115.
ASU 2015-10 "Technical Corrections and Improvements"

Note 2.    INVESTMENT SECURITIES (In Thousands)

The following table is the schedule of Available-For-Sale Securities at June 30, 2015, December 31, 2014 and June 30, 2014:
Available-For-Sale Securities
 
 
U.S. Agency
Obligations
 
State and
Municipal
Obligations
 
Mortgage-
Backed
Securities -
Residential
 
Corporate
and Other
Debt
Securities
 
Mutual Funds
and Equity
Securities
 
Total
Available-
For-Sale
Securities
June 30, 2015
 
 
 
 
 
 
 
 
 
 
 
 
Available-For-Sale Securities,
  at Amortized Cost
 
$
156,248

 
$
59,230

 
$
154,501

 
$
16,910

 
$
1,120

 
$
388,009

Available-For-Sale Securities,
  at Fair Value
 
156,937

 
59,303

 
157,641

 
16,691

 
1,245

 
391,817

Gross Unrealized Gains
 
788

 
117

 
3,350

 
5

 
125

 
4,385

Gross Unrealized Losses
 
99

 
43

 
210

 
224

 

 
576

Available-For-Sale Securities,
  Pledged as Collateral
 
 
 
 
 
 
 
 
 
 
 
289,418

 
 
 
 
 
 
 
 
 
 
 
 
 
Maturities of Debt Securities,
  at Amortized Cost:
 
 
 
 
 
 
 
 
 
 
 
 
Within One Year
 

 
9,179

 
11,037

 
4,926

 
 
 
25,142

From 1 - 5 Years
 
156,248

 
48,283

 
115,431

 
10,984

 
 
 
330,946

From 5 - 10 Years
 

 
1,168

 
27,948

 

 
 
 
29,116

Over 10 Years
 

 
600

 
84

 
1,000

 
 
 
1,684

 
 
 
 
 
 
 
 
 
 
 
 
 

# 8



Available-For-Sale Securities
 
 
U.S. Agency
Obligations
 
State and
Municipal
Obligations
 
Mortgage-
Backed
Securities -
Residential
 
Corporate
and Other
Debt
Securities
 
Mutual Funds
and Equity
Securities
 
Total
Available-
For-Sale
Securities
Maturities of Debt Securities,
  at Fair Value:
 
 
 
 
 
 
 
 
 
 
 
 
Within One Year
 

 
9,194

 
11,357

 
4,930

 
 
 
25,481

From 1 - 5 Years
 
156,937

 
48,341

 
117,681

 
10,961

 
 
 
333,920

From 5 - 10 Years
 

 
1,168

 
28,513

 

 
 
 
29,681

Over 10 Years
 

 
600

 
90

 
800

 
 
 
1,490

 
 
 
 
 
 
 
 
 
 
 
 
 
Securities in a Continuous
  Loss Position, at Fair Value:
 
 
 
 
 
 
 
 
 
 
 
 
Less than 12 Months
 
$

 
$

 
$

 
$

 
$

 
$

12 Months or Longer
 
35,149

 
16,401

 
47,859

 
10,232

 

 
109,641

Total
 
$
35,149

 
$
16,401

 
$
47,859

 
$
10,232

 
$

 
$
109,641

Number of Securities in a
  Continuous Loss Position
 
10

 
71

 
1

 
14

 

 
96

 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized Losses on
  Securities in a Continuous
  Loss Position:
 
 
 
 
 
 
 
 
 
 
 
 
Less than 12 Months
 
$

 
$

 
$

 
$

 
$

 
$

12 Months or Longer
 
99

 
43

 
210

 
224

 

 
576

Total
 
$
99

 
$
43

 
$
210

 
$
224

 
$

 
$
576

 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
 
 
 
 
 
Available-For-Sale Securities,
  at Amortized Cost
 
$
137,540

 
$
81,582

 
$
124,732

 
$
16,988

 
$
1,120

 
$
361,962

Available-For-Sale Securities,
  at Fair Value
 
137,603

 
81,730

 
128,827

 
16,725

 
1,254

 
366,139

Gross Unrealized Gains
 
208

 
187

 
4,100

 
7

 
134

 
4,636

Gross Unrealized Losses
 
145

 
39

 
5

 
270

 

 
459

Available-For-Sale Securities,
  Pledged as Collateral
 
 
 
 
 
 
 
 
 
 
 
267,384

 
 
 
 
 
 
 
 
 
 
 
 
 
Securities in a Continuous
  Loss Position, at Fair Value:
 
 
 
 
 
 
 
 
 
 
 
 
Less than 12 Months
 
$
39,631

 
$
3,309

 
$
82

 
$

 
$

 
$
43,022

12 Months or Longer
 
28,020

 
14,035

 
1,546

 
10,738

 

 
54,339

Total
 
$
67,651

 
$
17,344

 
$
1,628

 
$
10,738

 
$

 
$
97,361

Number of Securities in a
  Continuous Loss Position
 
22

 
65

 
3

 
15

 

 
105

 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized Losses on
  Securities in a Continuous
  Loss Position:
 
 
 
 
 
 
 
 
 
 
 
 
Less than 12 Months
 
$
48

 
$

 
$

 
$

 
$

 
$
48

12 Months or Longer
 
97

 
39

 
5

 
270

 

 
411

Total
 
$
145

 
$
39

 
$
5

 
$
270

 
$

 
$
459

 
 
 
 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
 
 
 
Available-For-Sale Securities,
  at Amortized Cost
 
$
92,328

 
$
102,456

 
$
148,672

 
$
17,065

 
$
1,120

 
$
361,641

Available-For-Sale Securities,
  at Fair Value
 
92,186

 
102,862

 
153,770

 
16,829

 
1,201

 
366,848

Gross Unrealized Gains
 
4

 
413

 
5,143

 
15

 
81

 
5,656

Gross Unrealized Losses
 
146

 
7

 
45

 
251

 

 
449

Available-For-Sale Securities,
  Pledged as Collateral
 
 
 
 
 
 
 
 
 
 
 
228,990

 
 
 
 
 
 
 
 
 
 
 
 
 

# 9



Available-For-Sale Securities
 
 
U.S. Agency
Obligations
 
State and
Municipal
Obligations
 
Mortgage-
Backed
Securities -
Residential
 
Corporate
and Other
Debt
Securities
 
Mutual Funds
and Equity
Securities
 
Total
Available-
For-Sale
Securities
Securities in a Continuous
  Loss Position, at Fair Value:
 
 
 
 
 
 
 
 
 
 
 
 
Less than 12 Months
 
$
42,888

 
$
2,860

 
$
8,740

 
$

 
$

 
$
54,488

12 Months or Longer
 
33,031

 
4,223

 
1,935

 
8,537

 

 
47,726

Total
 
$
75,919

 
$
7,083

 
$
10,675

 
$
8,537

 
$

 
$
102,214

Number of Securities in a
  Continuous Loss Position
 
24

 
24

 
8

 
12

 

 
68

 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized Losses on
  Securities in a Continuous
  Loss Position:
 
 
 
 
 
 
 
 
 
 
 
 
Less than 12 Months
 
$
30

 
$

 
$
34

 
$

 
$

 
$
64

12 Months or Longer
 
116

 
7

 
11

 
251

 

 
385

Total
 
$
146

 
$
7

 
$
45

 
$
251

 
$

 
$
449



The following table is the schedule of Held-To-Maturity Securities at June 30, 2015, December 31, 2014 and June 30, 2014:
Held-To-Maturity Securities
 
 
State and
Municipal
Obligations
 
Mortgage-
Backed
Securities -
Residential
 
Corporate
and Other
Debt
Securities
 
Total
Held-To
Maturity
Securities
June 30, 2015
 
 
 
 
 
 
 
 
Held-To-Maturity Securities,
  at Amortized Cost
 
$
219,878

 
$
103,238

 
$
1,000

 
$
324,116

Held-To-Maturity Securities,
  at Fair Value
 
223,031

 
104,330

 
1,000

 
328,361

Gross Unrealized Gains
 
3,737

 
1,201

 

 
4,938

Gross Unrealized Losses
 
583

 
109

 

 
692

Held-To-Maturity Securities,
  Pledged as Collateral
 
 
 
 
 
 
 
300,040

 
 
 
 
 
 
 
 
 
Maturities of Debt Securities,
  at Amortized Cost:
 
 
 
 
 
 
 
 
Within One Year
 
19,962

 

 

 
19,962

From 1 - 5 Years
 
93,785

 
69,333

 

 
163,118

From 5 - 10 Years
 
91,364

 
33,905

 

 
125,269

Over 10 Years
 
14,767

 

 
1,000

 
15,767

 
 
 
 
 
 
 
 
 
Maturities of Debt Securities,
  at Fair Value:
 
 
 
 
 
 
 
 
Within One Year
 
19,972

 

 

 
19,972

From 1 - 5 Years
 
95,510

 
70,023

 

 
165,533

From 5 - 10 Years
 
92,802

 
34,308

 

 
127,110

Over 10 Years
 
14,747

 

 
1,000

 
15,747

 
 
 
 
 
 
 
 
 
Securities in a Continuous
  Loss Position, at Fair Value:
 
 
 
 
 
 
 
 
Less than 12 Months
 
$

 
$

 
$

 
$

12 Months or Longer
 
44,748

 
3,967

 

 
48,715

Total
 
$
44,748

 
$
3,967

 
$

 
$
48,715

Number of Securities in a
  Continuous Loss Position
 
157

 
1

 

 
158

 
 
 
 
 
 
 
 
 
Unrealized Losses on
  Securities in a Continuous
  Loss Position:
 
 
 
 
 
 
 
 
Less than 12 Months
 
$

 
$

 
$

 
$


# 10



Held-To-Maturity Securities
 
 
State and
Municipal
Obligations
 
Mortgage-
Backed
Securities -
Residential
 
Corporate
and Other
Debt
Securities
 
Total
Held-To
Maturity
Securities
12 Months or Longer
 
583

 
109

 

 
692

Total
 
$
583

 
$
109

 
$

 
$
692

 
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
 
Held-To-Maturity Securities,
  at Amortized Cost
 
$
188,472

 
$
112,552

 
$
1,000

 
$
302,024

Held-To-Maturity Securities,
  at Fair Value
 
193,252

 
114,314

 
1,000

 
308,566

Gross Unrealized Gains
 
4,935

 
1,770

 

 
6,705

Gross Unrealized Losses
 
155

 
8

 

 
163

Held-To-Maturity Securities,
  Pledged as Collateral
 
 
 
 
 
 
 
282,640

 
 
 
 
 
 
 
 
 
Securities in a Continuous
  Loss Position, at Fair Value:
 
 
 
 
 
 
 
 
Less than 12 Months
 
$
2,143

 
$
4,581

 
$

 
$
6,724

12 Months or Longer
 
16,033

 

 

 
16,033

Total
 
$
18,176

 
$
4,581

 
$

 
$
22,757

Number of Securities in a
  Continuous Loss Position
 
74

 
1

 

 
75

 
 
 
 
 
 
 
 
 
Unrealized Losses on
  Securities in a Continuous
  Loss Position:
 
 
 
 
 
 
 
 
Less than 12 Months
 
$
17

 
$
8

 
$

 
$
25

12 Months or Longer
 
138

 

 

 
138

Total
 
$
155

 
$
8

 
$

 
$
163

 
 
 
 
 
 
 
 

June 30, 2014
 
 
 
 
 
 
 
 
Held-To-Maturity Securities,
  at Amortized Cost
 
$
174,888

 
$
121,549

 
$
1,000

 
$
297,437

Held-To-Maturity Securities,
  at Fair Value
 
180,211

 
123,048

 
1,000

 
304,259

Gross Unrealized Gains
 
5,473

 
1,533

 

 
7,006

Gross Unrealized Losses
 
150

 
34

 

 
184

Held-To-Maturity Securities,
  Pledged as Collateral
 
 
 
 
 
 
 
296,437

 
 
 
 
 
 
 
 
 
Securities in a Continuous
  Loss Position, at Fair Value:
 
 
 
 
 
 
 
 
Less than 12 Months
 
$
2,697

 
$
9,561

 
$

 
$
12,258

12 Months or Longer
 
13,839

 
1,194

 

 
15,033

Total
 
$
16,536

 
$
10,755

 
$

 
$
27,291

Number of Securities in a
  Continuous Loss Position
 
63

 
4

 

 
67

 
 
 
 
 
 
 
 
 
Unrealized Losses on
  Securities in a Continuous
  Loss Position:
 
 
 
 
 
 
 
 
Less than 12 Months
 
$
29

 
$
27

 
$

 
$
56

12 Months or Longer
 
121

 
7

 

 
128

Total
 
$
150

 
$
34

 
$

 
$
184

 
 
 
 
 
 
 
 



# 11



In the tables above, maturities of mortgage-backed-securities - residential are included based on their expected average lives.  Actual maturities will differ from the table below because issuers may have the right to call or prepay obligations with or without prepayment penalties.
In the available-for-sale category at June 30, 2015, U.S. agency obligations consisted solely of U.S. Government Agency securities with an amortized cost of $156.2 million and a fair value of $156.9 million. Mortgage-backed securities - residential consisted of U.S. Government Agency securities with an amortized cost of $30.8 million and a fair value of $31.7 million and government sponsored entity (GSE) securities with an amortized cost of $123.7 million and a fair value of $126.0 million. In the held-to-maturity category at June 30, 2015, mortgage-backed securities-residential consisted of U.S Government Agency securities with an amortized cost of $28.8 million and a fair value of $29.0 million and GSE securities with an amortized cost of $74.5 million and a fair value of $75.4 million.
In the available-for-sale category at December 31, 2014, U.S. agency obligations consisted solely of U.S. Government Agency securities with an amortized cost of $137.5 million and a fair value of $137.6 million. Mortgage-backed securities-residential consisted of U.S. Government Agency securities with an amortized cost of $23.0 million and a fair value of $23.6 million and GSE securities with an amortized cost of $101.7 million and a fair value of $105.2 million. In the held-to-maturity category at December 31, 2014, mortgage-backed securities-residential consisted of U.S. Government Agency securities with an amortized cost of $4.4 million and a fair value of $4.5 million and GSE securities with an amortized cost of $108.1 million and a fair value of $109.8 million.
In the available-for-sale category at June 30, 2014, U.S. agency obligations consisted solely of U.S. Government Agency securities with an amortized cost of $92.3 million and a fair value of $92.2 million. Mortgage-backed securities-residential consisted of US Government Agency securities with an amortized cost of $29.4 million and a fair value of $30.1 million and GSE securities with an amortized cost of $119.3 million and a fair value of $123.7 million. In the held-to-maturity category at June 30, 2014, mortgage-backed securities-residential consisted of U.S. Government Agency securities with an amortized cost of $4.6 million and a fair value of $4.7 million and GSE securities with an amortized cost of $116.9 million and a fair value of $118.3 million.
Securities in a continuous loss position, in the tables above for June 30, 2015, December 31, 2014 and June 30, 2014, do not reflect any deterioration of the credit worthiness of the issuing entities.  U.S. Agency issues, including agency-backed collateralized mortgage obligations and mortgage-backed securities, are all rated at least Aaa by Moody's or AA+ by Standard and Poor's.  The state and municipal obligations are general obligations supported by the general taxing authority of the issuer, and in some cases are insured. Obligations issued by school districts are supported by state aid.  For any non-rated municipal securities, credit analysis is performed in-house based upon data that has been submitted by the issuers to the NY State Comptroller. That analysis reflects satisfactory credit worthiness of the municipalities.  Corporate and other debt securities continue to be rated above investment grade according to Moody's and Standard and Poor's. Subsequent to June 30, 2015, and through the date of filing this report, there were no securities downgraded below investment grade.  
The unrealized losses on these temporarily impaired securities are primarily the result of changes in interest rates for fixed rate securities where the interest rate received is less than the current rate available for new offerings of similar securities, changes in market spreads as a result of shifts in supply and demand, and/or changes in the level of prepayments for mortgage related securities.   Because we do not currently intend to sell any of our temporarily impaired securities, and because it is not more likely-than-not that we would be required to sell the securities prior to recovery, the impairment is considered temporary.



# 12



Note 3.    LOANS (In Thousands)

Loan Categories and Past Due Loans

The following table presents loan balances outstanding as of June 30, 2015, December 31, 2014 and June 30, 2014 and an analysis of the recorded investment in loans that are past due at these dates.  Generally, Arrow considers a loan past due 30 or more days if the borrower is two or more payments past due.   Loans held-for-sale of $3,656, $398 and $1,084 a as of June 30, 2015, December 31, 2014 and June 30, 2014, respectively, are included in the residential real estate balances for current loans.
 
 
 
 
Commercial
 
 
 
 
 
 
 
Commercial
 
Real Estate
 
Consumer
 
Residential
 
Total
June 30, 2015
 
 
 
 
 
 
 
 
 
Loans Past Due 30-59 Days
$
109

 
$

 
$
3,355

 
$
265

 
$
3,729

Loans Past Due 60-89 Days
86

 

 
1,116

 
1,062

 
2,264

Loans Past Due 90 or more Days
382

 
2,600

 
195

 
2,846

 
6,023

Total Loans Past Due
577

 
2,600

 
4,666

 
4,173

 
12,016

Current Loans
94,756

 
351,195

 
450,213

 
571,490

 
1,467,654

Total Loans
$
95,333

 
$
353,795

 
$
454,879

 
$
575,663

 
$
1,479,670

 
 
 
 
 
 
 
 
 
 
Loans 90 or More Days Past Due
  and Still Accruing Interest
$

 
$
883

 
$
21

 
$
666

 
$
1,570

Nonaccrual Loans
$
513

 
$
1,777

 
$
417

 
$
4,224

 
$
6,931

 
 
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
 
 
Loans Past Due 30-59 Days
$
124

 
$
432

 
$
4,167

 
$
482

 
$
5,205

Loans Past Due 60-89 Days
154

 
7

 
1,225

 
1,495

 
2,881

Loans Past Due 90 or more Days
345

 
1,832

 
206

 
2,999

 
5,382

Total Loans Past Due
623

 
2,271

 
5,598

 
4,976

 
13,468

Current Loans
98,888

 
337,841

 
431,443

 
531,628

 
1,399,800

Total Loans
$
99,511

 
$
340,112

 
$
437,041

 
$
536,604

 
$
1,413,268

 
 
 
 
 
 
 
 
 
 
Loans 90 or More Days Past Due
  and Still Accruing Interest
$

 
$

 
$

 
$
537

 
$
537

Nonaccrual Loans
$
473

 
$
2,071

 
$
415

 
$
3,940

 
$
6,899

 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
Loans Past Due 30-59 Days
$
212

 
$

 
$
2,726

 
$
439

 
$
3,377

Loans Past Due 60-89 Days
575

 
443

 
817

 
1,441

 
3,276

Loans Past Due 90 or more Days
108

 
1,887

 
272

 
2,955

 
5,222

Total Loans Past Due
895

 
2,330

 
3,815

 
4,835

 
11,875

Current Loans
92,995

 
337,018

 
413,349

 
488,887

 
1,332,249

Total Loans
$
93,890

 
$
339,348

 
$
417,164

 
$
493,722

 
$
1,344,124

 
 
 
 
 
 
 
 
 
 
Loans 90 or More Days Past Due
  and Still Accruing Interest
$

 
$
51

 
$
5

 
$
1,269

 
$
1,325

Nonaccrual Loans
$
164

 
$
2,079

 
$
473

 
$
3,469

 
$
6,185

    

The Company disaggregates its loan portfolio into the following four categories:

Commercial - The Company offers a variety of loan options to meet the specific needs of our commercial customers including term loans, time notes and lines of credit. Such loans are made available to businesses for working capital needs such as inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment or other assets owned by the borrower. These loans carry a higher risk than commercial real estate loans due to the nature of the underlying collateral, which can be business assets such as equipment and accounts receivable and generally have a lower liquidation value than real estate. In the event of default by the borrower, the Company may be required to liquidate collateral at deeply discounted values. To reduce the risk, management usually obtains personal guarantees of the borrowers.


# 13



Commercial Real Estate - The Company offers commercial real estate loans to finance real estate purchases, refinancings, expansions and improvements to commercial properties. Commercial real estate loans are made to finance the purchases of real property which generally consists of real estate with completed structures. These commercial real estate loans are secured by first liens on the real estate, which may include apartments, commercial structures, housing businesses, healthcare facilities, and both owner and non owner-occupied facilities. These loans are typically less risky than commercial loans, since they are secured by real estate and buildings, and are generally originated in amounts of no more than 80% of the appraised value of the property. However, the Company also offers commercial construction and land development loans to finance projects, primarily within the communities that we serve. Many projects will ultimately be used by the borrowers' businesses, while others are developed for resale. These real estate loans are also secured by first liens on the real estate, which may include apartments, commercial structures, housing business, healthcare facilities and both owner-occupied and non-owner-occupied facilities. There is enhanced risk during the construction period, since the loan is secured by an incomplete project.

Consumer Loans - The Company offers a variety of consumer installment loans to finance personal expenditures. Most of these loans carry a fixed rate of interest with principal repayment terms typically ranging from one to five years, based upon the nature of the collateral and the size of the loan. In addition to installment loans, the Company also offers personal lines of credit and overdraft protection. Several loans are unsecured, which carry a higher risk of loss. Also included in this category are automobile loans. The Company primarily finances the purchases of automobiles indirectly through dealer relationships located throughout upstate New York and Vermont. Most of these loans carry a fixed rate of interest with principal repayment terms typically ranging from three to seven years. Indirect consumer loans are underwritten on a secured basis using the underlying collateral being financed.

Residential Real Estate Mortgages - Residential real estate loans consist primarily of loans secured by first or second mortgages on primary residences. We originate adjustable-rate and fixed-rate one-to-four-family residential real estate loans for the construction, purchase or refinancing of an existing mortgage. These loans are collateralized primarily by owner-occupied properties generally located in the Company’s market area. Loans on one-to-four-family residential real estate are generally originated in amounts of no more than 85% of the purchase price or appraised value (whichever is lower), or have private mortgage insurance. The Company’s underwriting analysis for residential mortgage loans typically includes credit verification, independent appraisals, and a review of the borrower’s financial condition. Mortgage title insurance and hazard insurance are normally required. It is our general practice to underwrite our residential real estate loans to secondary market standards. Construction loans have a unique risk, because they are secured by an incomplete dwelling. This risk is reduced through periodic site inspections, including one at each loan draw period. In addition, the Company offers fixed home equity loans as well as home equity lines of credit to consumers to finance home improvements, debt consolidation, education and other uses.  Our policy allows for a maximum loan to value ratio of 80%, although periodically higher advances are allowed.  The Company originates home equity lines of credit and second mortgage loans (loans secured by a second junior lien position on one-to-four-family residential real estate).  Risk is generally reduced through underwriting criteria, which include credit verification, appraisals, a review of the borrower's financial condition, and personal cash flows.  A security interest, with title insurance when necessary, is taken in the underlying real estate.

Allowance for Loan Losses

The following table presents a roll-forward of the allowance for loan losses and other information pertaining to the allowance for loan losses:
Allowance for Loan Losses
 
 
 
Commercial
 
 
 
 
 
 
 
 
 
Commercial
 
Real Estate
 
Consumer
 
Residential
 
Unallocated
 
Total
Roll-forward of the Allowance for Loan Losses for the Quarterly Periods:
 
 
 
 
 
 
 
 
 
 
 
March 31, 2015
$
2,163

 
$
3,833

 
$
5,267

 
$
3,629

 
$
733

 
$
15,625

Charge-offs
(16
)
 

 
(147
)
 
(2
)
 

 
(165
)
Recoveries
12

 

 
32

 

 

 
44

Provision
(344
)
 
99

 
264

 
72

 
(21
)
 
70

June 30, 2015
$
1,815

 
$
3,932

 
$
5,416

 
$
3,699

 
$
712

 
$
15,574

 
 
 
 
 
 
 
 
 
 
 
 
March 31, 2014
$
1,797

 
$
4,198

 
$
4,586

 
$
3,077

 
$
978

 
$
14,636

Charge-offs
(43
)
 

 
(95
)
 
(30
)
 

 
(168
)
Recoveries
6

 

 
57

 

 

 
63

Provision
295

 
17

 
132

 
86

 
(25
)
 
505

June 30, 2014
$
2,055

 
$
4,215

 
$
4,680

 
$
3,133

 
$
953

 
$
15,036

 
 
 
 
 
 
 
 
 
 
 
 

# 14



Allowance for Loan Losses
 
 
 
Commercial
 
 
 
 
 
 
 
 
 
Commercial
 
Real Estate
 
Consumer
 
Residential
 
Unallocated
 
Total
Roll-forward of the Allowance for Loan Losses for the Year-to-Date Periods:
 
 
 
 
 
 
 
 
 
 
 
December 31, 2014
$
2,100

 
$
4,128

 
$
5,210

 
$
3,369

 
$
763

 
$
15,570

Charge-offs
(32
)
 

 
(332
)
 
(92
)
 

 
(456
)
Recoveries
19

 

 
95

 

 

 
114

Provision
(272
)
 
(196
)
 
443

 
422

 
(51
)
 
346

June 30, 2015
$
1,815

 
$
3,932

 
$
5,416

 
$
3,699

 
$
712

 
$
15,574

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013
$
1,886

 
$
3,962

 
$
4,478

 
$
3,026

 
$
1,082

 
$
14,434

Charge-offs
(166
)
 

 
(293
)
 
(45
)
 

 
(504
)
Recoveries
25

 

 
118

 

 

 
143

Provision
310

 
253

 
377

 
152

 
(129
)
 
963

June 30, 2014
$
2,055

 
$
4,215

 
$
4,680

 
$
3,133

 
$
953

 
$
15,036

 
 
 
 
 
 
 
 
 
 
 
 
June 30, 2015
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses - Loans Individually Evaluated for Impairment
$

 
$

 
$

 
$
144

 
$

 
$
144

Allowance for loan losses - Loans Collectively Evaluated for Impairment
$
1,815

 
$
3,932

 
$
5,416

 
$
3,555

 
$
712

 
$
15,430

Ending Loan Balance - Individually Evaluated for Impairment
$
432

 
$
1,491

 
$
93

 
$
2,291

 
$

 
$
4,307

Ending Loan Balance - Collectively Evaluated for Impairment
$
94,901

 
$
352,304

 
$
454,786

 
$
573,372

 
$

 
$
1,475,363

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses - Loans Individually Evaluated for Impairment
$

 
$

 
$

 
$
109

 
$

 
$
109

Allowance for loan losses - Loans Collectively Evaluated for Impairment
$
2,100

 
$
4,128

 
$
5,210

 
$
3,260

 
$
763

 
$
15,461

Ending Loan Balance - Individually Evaluated for Impairment
$
494

 
$
1,492

 
$
118

 
$
2,237

 
$

 
$
4,341

Ending Loan Balance - Collectively Evaluated for Impairment
$
99,017

 
$
338,620

 
$
436,923

 
$
534,367

 
$

 
$
1,408,927

 
 
 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses - Loans Individually Evaluated for Impairment
$

 
$

 
$

 
$
82

 
$

 
$
82

Allowance for loan losses - Loans Collectively Evaluated for Impairment
$
2,055

 
$
4,215

 
$
4,680

 
$
3,051

 
$
953

 
$
14,954

Ending Loan Balance - Individually Evaluated for Impairment
$
208

 
$
1,493

 
$
125

 
$
1,695

 
$

 
$
3,521

Ending Loan Balance - Collectively Evaluated for Impairment
$
93,682

 
$
337,855

 
$
417,039

 
$
492,027

 
$

 
$
1,340,603


# 15



    
Through the provision for loan losses, an allowance for loan losses is maintained that reflects our best estimate of the inherent risk of loss in the Company’s loan portfolio as of the balance sheet date. Additions are made to the allowance for loan losses through a periodic provision for loan losses. Actual loan losses are charged against the allowance for loan losses when loans are deemed uncollectible and recoveries of amounts previously charged off are recorded as credits to the allowance for loan losses.
Our loan officers and risk managers meet at least quarterly to discuss and review the conditions and risks associated with certain criticized and classified commercial-related relationships. In addition, our independent internal loan review department performs periodic reviews of the risk ratings on individual loans in our commercial loan portfolio.
We use a two-step process to determine the provision for loan losses and the amount of the allowance for loan losses. We measure impairment on our impaired loans on a quarterly basis. Our impaired loans are generally nonaccrual loans over $250 thousand and all troubled debt restructured loans. Our impaired loans are generally considered to be collateral dependent with the specific reserve, if any, determined based on the value of the collateral less estimated costs to sell.
The remainder of the portfolio is evaluated on a pooled basis. For each homogeneous loan pool, we estimate a total loss factor based on the historical net loss rates adjusted for applicable qualitative factors. We update the total loss factors assigned to each loan category on a quarterly basis. For the commercial and commercial real estate categories, we further segregate the loan categories by credit risk profile (pools of loans graded satisfactory, special mention and substandard). Additional description of the credit risk classifications is detailed in the Credit Quality Indicators section of this note.
We determine the annualized historical net loss rate for each loan category using a trailing three-year net charge-off average. While historical net loss experience provides a reasonable starting point for our analysis, historical net losses, or even recent trends in net losses, do not by themselves form a sufficient basis to determine the appropriate level of the allowance for loan losses. Therefore, we also consider and adjust historical net loss factors for qualitative factors that impact the inherent risk of loss associated with our loan categories within our total loan portfolio. These include:
Changes in the volume and severity of past due, nonaccrual and adversely classified loans
Changes in the nature and volume of the portfolio and in the terms of loans
Changes in the value of the underlying collateral for collateral dependent loans
Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses
Changes in the quality of the loan review system
Changes in the experience, ability, and depth of lending management and other relevant staff
Changes in international, national, regional, and local economic and business conditions and developments that affect the collectibility of the portfolio
The existence and effect of any concentrations of credit, and changes in the level of such concentrations
The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the  existing portfolio or pool
Further, due to the imprecise nature of the loan loss estimation process, the risk attributes of our loan portfolio may not be fully captured in data related to the determination of loss factors used to determine our analysis of the adequacy of the allowance for loan losses. Management, therefore, has established an unallocated portion within the allowance for loan losses reflecting the imprecision that naturally exists in the allowance for loan loss estimation process. The unallocated allowance for loan losses is not considered a significant component of the overall allowance for loan loss estimation process.

























# 16




Credit Quality Indicators

The following table presents the credit quality indicators by loan category at June 30, 2015, December 31, 2014 and June 30, 2014:
Loan Credit Quality Indicators
 
 
 
Commercial
 
 
 
 
 
 
 
Commercial
 
Real Estate
 
Consumer
 
Residential
 
Total
June 30, 2015
 
 
 
 
 
 
 
 
 
Credit Risk Profile by Creditworthiness Category:
 
 
 
 
 
 
 
 
 
Satisfactory
$
85,451

 
$
331,320

 
 
 
 
 
$
416,771

Special Mention
1,224

 
4,583

 
 
 
 
 
5,807

Substandard
8,658

 
17,892

 
 
 
 
 
26,550

Doubtful

 

 
 
 
 
 

Credit Risk Profile Based on Payment Activity:
 
 
 
 
 
 
 
 
 
Performing
 
 
 
 
$
454,440

 
$
570,772

 
1,025,212

Nonperforming
 
 
 
 
439

 
4,891

 
5,330

 
 
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
 
 
Credit Risk Profile by Creditworthiness Category:
 
 
 
 
 
 
 
 
 
Satisfactory
85,949

 
317,747

 
 
 
 
 
403,696

Special Mention
2,442

 
3,718

 
 
 
 
 
6,160

Substandard
11,120

 
18,647

 
 
 
 
 
29,767

Doubtful

 

 
 
 
 
 

Credit Risk Profile Based on Payment Activity:
 
 
 
 
 
 
 
 
 
Performing
 
 
 
 
436,626

 
532,127

 
968,753

Nonperforming
 
 
 
 
415

 
4,477

 
4,892

 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
Credit Risk Profile by Creditworthiness Category:
 
 
 
 
 
 
 
 
 
Satisfactory
81,183

 
316,565

 
 
 
 
 
397,748

Special Mention
2,642

 
3,515

 
 
 
 
 
6,157

Substandard
10,065

 
19,268

 
 
 
 
 
29,333

Doubtful

 

 
 
 
 
 

Credit Risk Profile Based on Payment Activity:
 
 
 
 
 
 
 
 
 
Performing
 
 
 
 
416,683

 
488,984

 
905,667

Nonperforming
 
 
 
 
481

 
4,738

 
5,219


We use an internally developed system of five credit quality indicators to rate the credit worthiness of each commercial loan defined as follows: 1) Satisfactory - "Satisfactory" borrowers have acceptable financial condition with satisfactory record of earnings and sufficient historical and projected cash flow to service the debt.  Borrowers have satisfactory repayment histories and primary and secondary sources of repayment can be clearly identified; 2) Special Mention - Loans in this category have potential weaknesses that deserve managements close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institutions credit position at some future date.  "Special mention" assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.  Loans which might be assigned this risk rating include loans to borrowers with deteriorating financial strength and/or earnings record and loans with potential for problems due to weakening economic or market conditions; 3) Substandard - Loans classified as substandard are inadequately protected by the current sound net worth or paying capacity of the borrower or the collateral pledged, if any.  Loans in this category have well defined weaknesses that jeopardize the repayment.  They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.  Substandard loans may include loans which are likely to require liquidation of collateral to effect repayment, and other loans where character or ability to repay has become suspect. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard; 4) Doubtful - Loans classified as doubtful have all of the weaknesses inherent in those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of current existing facts, conditions, and values highly questionable and improbable.  Although possibility of loss is extremely high, classification of these loans as loss has been deferred due to specific pending factors or events which may strengthen the value (i.e. possibility of additional collateral, injection of capital, collateral liquidation, debt restructure, economic recovery, etc).  Loans classified as doubtful need to be placed on

# 17



non-accrual; and 5) Loss - Loans classified as loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.  As of the date of the balance sheet, all loans in this category have been charged-off to the allowance for loan losses.  Large commercial loans are evaluated on an annual basis, unless the credit quality indicator falls to a level of "substandard" or below, when the loan is evaluated quarterly.  The credit quality indicator is one of the factors used to determine any loss, as further described in this footnote.
For the purposes of the table above, nonperforming consumer loans are those loans on nonaccrual status or are 90 days or more past due and still accruing interest.

Impaired Loans

The following table presents information on impaired loans based on whether the impaired loan has a recorded related allowance or has no recorded related allowance:
Impaired Loans
 
 
 
Commercial
 
 
 
 
 
 
 
Commercial
 
Real Estate
 
Consumer
 
Residential
 
Total
June 30, 2015
 
 

 
 
 
 
 
 
Recorded Investment:
 
 
 
 
 
 
 
 
 
With No Related Allowance
$
462

 
$
1,491

 
$
93

 
$
1,697

 
$
3,743

With a Related Allowance

 

 

 
594

 
594

Unpaid Principal Balance:
 
 
 
 
 
 
 
 
 
With No Related Allowance
462

 
1,491

 
93

 
1,697

 
3,743

With a Related Allowance

 

 

 
594

 
594

 
 
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 

 
 
Recorded Investment:
 
 
 
 
 
 
 
 
 
With No Related Allowance
$
494

 
$
1,492

 
$
118

 
$
1,678

 
$
3,782

With a Related Allowance

 

 

 
559

 
559

Unpaid Principal Balance:
 
 
 
 
 
 
 
 
 
With No Related Allowance
494

 
1,492

 
118

 
1,678

 
3,782

With a Related Allowance

 

 

 
559

 
559

 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
Recorded Investment:
 
 
 
 
 
 
 
 
 
With No Related Allowance
$
208

 
$
1,493

 
$
125

 
$
1,121

 
$
2,947

With a Related Allowance

 

 

 
574

 
574

Unpaid Principal Balance:
 
 
 
 
 
 
 
 
 
With No Related Allowance
208

 
1,493

 
125

 
1,121

 
$
2,947

With a Related Allowance

 

 

 
574

 
574

 
 
 
 
 
 
 
 
 
 
For the Quarter Ended:
 
 
 
 
 
 
 
 
 
June 30, 2015
 
 
 
 
 
 
 
 
 
Average Recorded Balance:
 
 
 
 
 
 
 
 
 
With No Related Allowance
$
461

 
$
1,492

 
$
100

 
$
1,697

 
$
3,750

With a Related Allowance

 

 

 
597

 
597

Interest Income Recognized:
 
 
 
 
 
 
 
 
 
With No Related Allowance
2

 

 
1

 

 
3

With a Related Allowance

 

 

 

 

Cash Basis Income:
 
 
 
 
 
 
 
 
 
With No Related Allowance

 

 

 

 

With a Related Allowance

 

 

 

 

 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
Average Recorded Balance:
 
 
 
 
 
 
 
 
 
With No Related Allowance
$
211

 
$
1,652

 
$
135

 
$
1,517

 
$
3,515

With a Related Allowance

 

 

 
394

 
394

Interest Income Recognized:
 
 
 
 
 
 
 
 
 
With No Related Allowance
2

 

 
2

 

 
4

With a Related Allowance

 

 

 

 

Cash Basis Income:
 
 
 
 
 
 
 
 
 
With No Related Allowance

 

 

 

 

With a Related Allowance

 

 

 

 


# 18



Impaired Loans
 
 
 
Commercial
 
 
 
 
 
 
 
Commercial
 
Real Estate
 
Consumer
 
Residential
 
Total
For the Year-To-Date Period Ended:
 
 
 
 
 
 
 
 
 
June 30, 2015
 
 
 
 
 
 
 
 
 
Average Recorded Balance:

 
 
 
 
 
 
 
 
With No Related Allowance
$
478

 
$
1,492

 
$
106

 
$
1,688

 
$
3,764

With a Related Allowance

 

 

 
577

 
577

Interest Income Recognized:
 
 
 
 
 
 
 
 
 
With No Related Allowance
4

 

 
2

 
1

 
7

With a Related Allowance

 

 

 

 

Cash Basis Income:
 
 
 
 
 
 
 
 
 
With No Related Allowance

 

 

 

 

With a Related Allowance

 

 

 

 

 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
Average Recorded Balance:
 
 
 
 
 
 
 
 
 
With No Related Allowance
$
215

 
$
1,639

 
$
149

 
$
1,715

 
$
3,718

With a Related Allowance

 

 

 
287

 
287

Interest Income Recognized:
 
 
 
 
 
 
 
 
 
With No Related Allowance
5

 
10

 
4

 
1

 
20

With a Related Allowance

 

 

 

 

Cash Basis Income:
 
 
 
 
 
 
 
 
 
With No Related Allowance

 

 

 

 

With a Related Allowance

 

 

 

 


At June 30, 2015, December 31, 2014 and June 30, 2014, all impaired loans were considered to be collateral dependent and were therefore evaluated for impairment based on the fair value of collateral less estimated cost to sell. Interest income recognized in the table above, represents income earned after the loans became impaired and includes restructured loans in compliance with their modified terms and nonaccrual loans where we have recognized interest income on a cash basis.

Loans Modified in Trouble Debt Restructurings

The following table presents information on loans modified in trouble debt restructurings during the periods indicated. All loans were modified under Arrow's own programs. The principal modification, for all the modifications in the table below, involved payment deferrals.

# 19



Loans Modified in Trouble Debt Restructurings During the Period
 
 
 
Commercial
 
 
 
 
 
 
 
Commercial
 
Real Estate
 
Consumer
 
Residential
 
Total
For the Quarter Ended:
 
 
 
 
 
 
 
 
 
June 30, 2015
 
 
 
 
 
 
 
 
 
Number of Loans

 

 

 

 

Pre-Modification Outstanding Recorded Investment
$

 
$

 
$

 
$

 
$

Post-Modification Outstanding Recorded Investment
$

 
$

 
$

 
$

 
$

 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
Number of Loans

 

 

 
1

 
1

Pre-Modification Outstanding Recorded Investment
$

 
$

 
$

 
$
574

 
$
574

Post-Modification Outstanding Recorded Investment
$

 
$

 
$

 
$
574

 
$
574

 
 
 
 
 
 
 
 
 
 
For the Year-To-Date Period Ended:
 
 
 
 
 
 
 
 
 
June 30, 2015
 
 
 
 
 
 
 
 
 
Number of Loans

 

 
1

 

 
1

Pre-Modification Outstanding Recorded Investment
$

 
$

 
$
2

 
$

 
$
2

Post-Modification Outstanding Recorded Investment
$

 
$

 
$
2

 
$

 
$
2

 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
Number of Loans

 

 
1

 
1

 
2

Pre-Modification Outstanding Recorded Investment
$

 
$

 
$
2

 
$
574

 
$
576

Post-Modification Outstanding Recorded Investment
$

 
$

 
$
2

 
$
574

 
$
576


In general, loans requiring modification are restructured to accommodate the projected cashflows of the borrower. No loans modified during the preceding twelve months subsequently defaulted as of June 30, 2015.
    
Note 4.    GUARANTEES (In Thousands)

The following table presents the balance for standby letters of credit for the periods ended June 30, 2015, December 31, 2014 and June 30, 2014:
Loan Commitments and Letters of Credit
 
June 30, 2015
 
December 31, 2014
 
June 30, 2014
Notional Amount:
 
 
 
 
 
Commitments to Extend Credit
$
290,666

 
$
249,803

 
$
252,064

Standby Letters of Credit
3,213

 
3,317

 
3,208

Fair Value:
 
 
 
 
 
Commitments to Extend Credit
$

 
$

 
$

Standby Letters of Credit
24

 
39

 
53


    
Arrow is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  Commitments to extend credit include home equity lines of credit, commitments for residential and commercial construction loans and other personal and commercial lines of credit.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.  The contract or notional amounts of those instruments reflect the extent of the involvement Arrow has in particular classes of financial instruments.

# 20



Arrow's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments.  Arrow uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Arrow evaluates each customer's creditworthiness on a case-by-case basis.  Home equity lines of credit are secured by residential real estate.  Construction commitments are secured by underlying real estate.  For other lines of credit, the amount of collateral obtained, if deemed necessary by Arrow upon extension of credit, is based on management's credit evaluation of the counterparty.  Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.  Most of the commitments are variable rate instruments.
Arrow has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party.  Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit at June 30, 2015, December 31, 2014 and June 30, 2014 represent the maximum potential future payments Arrow could be required to make.  Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements.  Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Company policies governing loan collateral apply to standby letters of credit at the time of credit extension.  Loan-to-value ratios generally range from 50% for movable assets, such as inventory, to 100% for liquid assets, such as bank CD's.  Fees for standby letters of credit typically range from 1% to 3% of the notional amount.  Fees are collected upfront and are amortized over the life of the commitment. The fair values of Arrow's standby letters of credit at June 30, 2015, December 31, 2014 and June 30, 2014, in the table above, were the same as the carrying amounts.  The fair value of standby letters of credit is based on the fees currently charged for similar agreements or the cost to terminate the arrangement with the counterparties.
The fair value of commitments to extend credit is determined by estimating the fees to enter into similar agreements, taking into account the remaining terms and present creditworthiness of the counterparties, and for fixed rate loan commitments, the difference between the current and committed interest rates.  Arrow provides several types of commercial lines of credit and standby letters of credit to its commercial customers.  The pricing of these services is not isolated, as Arrow considers the customer's complete deposit and borrowing relationship in pricing individual products and services.  The commitments to extend credit also include commitments under home equity lines of credit, for which Arrow charges no fee.  The carrying value and fair value of commitments to extend credit are not material and Arrow does not expect to incur any material loss as a result of these commitments.


# 21



Note 5.    COMPREHENSIVE INCOME (In Thousands)

The following table presents the components of other comprehensive income for the three and six months ended June 30, 2015 and 2014:
Schedule of Comprehensive Income
 
 
 
 
 
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
 
Tax
 
 
 
 
 
Tax
 
 
 
 
Before-Tax
 
(Expense)
 
Net-of-Tax
 
Before-Tax
 
(Expense)
 
 
Net-of-Tax
 
Amount
 
Benefit
 
Amount
 
Amount
 
Benefit
 
 
Amount
2015
 
 
 
 
 
 
 
 
 
 
 
 
Net Unrealized Securities Holding Losses Arising During the Period
$
(1,668
)
 
$
654

 
$
(1,014
)
 
$
(261
)
 
$
102

 
 
$
(159
)
Reclassification Adjustment for Securities Gains Included in Net Income
(16
)
 
6

 
(10
)
 
(106
)
 
41

 
 
(65
)
Amortization of Net Retirement Plan Actuarial Loss
194

 
(76
)
 
118

 
387

 
(152
)
 
 
235

Accretion of Net Retirement Plan Prior Service Credit
(15
)
 
6

 
(9
)
 
(28
)
 
12

 
 
(16
)
  Other Comprehensive Loss
$
(1,505
)
 
$
590

 
$
(915
)
 
$
(8
)
 
$
3

 
 
$
(5
)
 
 
 
 
 
 
 
 
 
 
 
 
 
2014
 
 
 
 
 
 
 
 
 
 
 
 
Net Unrealized Securities Holding Gains Arising During the Period
$
850

 
$
(336
)
 
$
514

 
$
1,249

 
$
(494
)
 
 
$
755

Reclassification Adjustment for Securities Losses Included in Net Income
27

 
(11
)
 
16

 
27

 
(11
)
 
 
16

Amortization of Net Retirement Plan Actuarial Loss
114

 
(45
)
 
69

 
230

 
(91
)
 
 
139

Accretion of Net Retirement Plan Prior Service Credit
(21
)
 
8

 
(13
)
 
(43
)
 
17

 
 
(26
)
  Other Comprehensive Income
$
970

 
$
(384
)
 
$
586

 
$
1,463

 
$
(579
)
 
 
$
884



# 22



The following table presents the changes in accumulated other comprehensive income by component:

Changes in Accumulated Other Comprehensive Income (Loss) by Component (1)
 
 
 
 
 
 
 
 
 
Unrealized
 
Defined Benefit Plan Items
 
 
 
Gains and
 
 
 
 
 
 
 
Losses on
 
 
 
Net Prior
 
 
 
Available-for-
 
Net Gain
 
Service
 
 
 
Sale Securities
 
(Loss)
 
(Cost ) Credit
 
Total
For the Quarter-To-Date periods ended:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
March 31, 2015
$
3,339

 
$
(9,138
)
 
$
(457
)
 
$
(6,256
)
Other comprehensive income or loss before reclassifications
(1,014
)
 

 

 
(1,014
)
Amounts reclassified from accumulated other comprehensive income
(10
)
 
118

 
(9
)
 
99

Net current-period other comprehensive income
(1,024
)
 
118

 
(9
)
 
(915
)
June 30, 2015
$
2,315

 
$
(9,020
)
 
$
(466
)
 
$
(7,171
)
 
 
 
 
 
 
 
 
March 31, 2014
$
2,615

 
$
(6,627
)
 
$
(63
)
 
$
(4,075
)
Other comprehensive income or loss before reclassifications
514

 

 

 
514

Amounts reclassified from accumulated other comprehensive income
16

 
69

 
(13
)
 
72

Net current-period other comprehensive income
530

 
69

 
(13
)
 
586

June 30, 2014
$
3,145

 
$
(6,558
)
 
$
(76
)
 
$
(3,489
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For the Year-To-Date periods ended:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2014
$
2,539

 
$
(9,255
)
 
$
(450
)
 
$
(7,166
)
Other comprehensive income or loss before reclassifications
(159
)
 

 

 
(159
)
Amounts reclassified from accumulated other comprehensive income
(65
)
 
235

 
(16
)
 
154

Net current-period other comprehensive income
(224
)
 
235

 
(16
)
 
(5
)
June 30, 2015
$
2,315

 
$
(9,020
)
 
$
(466
)
 
$
(7,171
)
 
 
 
 
 
 
 
 
December 31, 2013
$
2,374

 
$
(6,697
)
 
$
(50
)
 
$
(4,373
)
Other comprehensive income or loss before reclassifications
755

 

 

 
755

Amounts reclassified from accumulated other comprehensive income
16

 
139

 
(26
)
 
129

Net current-period other comprehensive income
771

 
139

 
(26
)
 
884

June 30, 2014
$
3,145

 
$
(6,558
)
 
$
(76
)
 
$
(3,489
)
 
 
 
 
 
 
 
 
 

(1) All amounts are net of tax. Amounts in parentheses indicate debits.

# 23



The following table presents the reclassifications out of accumulated other comprehensive income:


Reclassifications Out of Accumulated Other Comprehensive Income (1)
 
 
 
Amounts Reclassified
 
 
Details about Accumulated Other
 
from Accumulated Other
 
Affected Line Item in the Statement
Comprehensive Income (Loss) Components
 
Comprehensive Income
 
Where Net Income Is Presented
 
 
 
 
 
For the Quarter-to-date periods ended:
 
 
 
 
 
 
 
 
 
June 30, 2015
 
 
 
 
Unrealized gains and losses on available-for-sale securities
 
$
16

 
Gain on Securities Transactions
 
 
16

 
Total before Tax
 
 
(6
)
 
Provision for Income Taxes
 
 
$
10

 
Net of Tax
 
 
 
 
 
Amortization of defined benefit pension items:
 
 
 
 
Prior-service costs
 
$
15

(2) 
Salaries and Employee Benefits
Actuarial gains/(losses)
 
(194
)
(2) 
Salaries and Employee Benefits
 
 
(179
)
 
Total before Tax
 
 
70

 
Provision for Income Taxes
 
 
$
(109
)
 
Net of Tax
 
 
 
 
 
Total reclassifications for the period
 
$
(99
)
 
Net of Tax
 
 
 
 
 
June 30, 2014
 
 
 
 
Unrealized gains and losses on available-for-sale securities
 
$
(27
)
 
Gain on Securities Transactions
 
 
(27
)
 
Total before Tax
 
 
11

 
Provision for Income Taxes
 
 
$
(16
)
 
Net of Tax
 
 
 
 
 
Amortization of defined benefit pension items:
 
 
 
 
Prior-service costs
 
$
21

(2) 
Salaries and Employee Benefits
Actuarial gains/(losses)
 
(114
)
(2) 
Salaries and Employee Benefits
 
 
(93
)
 
Total before Tax
 
 
37

 
Provision for Income Taxes
 
 
$
(56
)
 
Net of Tax
 
 
 
 
 
Total reclassifications for the period
 
$
(72
)
 
Net of Tax
 
 
 
 
 
 
 
 
 
 

# 24



Reclassifications Out of Accumulated Other Comprehensive Income (1)
 
 
 
Amounts Reclassified
 
 
Details about Accumulated Other
 
from Accumulated Other
 
Affected Line Item in the Statement
Comprehensive Income (Loss) Components
 
Comprehensive Income
 
Where Net Income Is Presented
 
 
 
 
 
 
 
 
 
 
For the Year-to-date periods ended:
 
 
 
 
 
 
 
 
 
June 30, 2015
 
 
 
 
Unrealized gains and losses on available-for-sale securities
 
$
106

 
Gain on Securities Transactions
 
 
106

 
Total before Tax
 
 
(41
)
 
Provision for Income Taxes
 
 
$
65

 
Net of Tax
 
 
 
 
 
Amortization of defined benefit pension items:
 
 
 
 
Prior-service costs
 
$
28

(2) 
Salaries and Employee Benefits
Actuarial gains/(losses)
 
(387
)
(2) 
Salaries and Employee Benefits
 
 
(359
)
 
Total before Tax
 
 
141

 
Provision for Income Taxes
 
 
$
(218
)
 
Net of Tax
 
 
 
 
 
Total reclassifications for the period
 
$
(153
)
 
Net of Tax
 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
Unrealized gains and losses on available-for-sale securities
 
$
(27
)
 
Gain on Securities Transactions
 
 
(27
)
 
Total before Tax
 
 
11

 
Provision for Income Taxes
 
 
$
(16
)
 
Net of Tax
 
 
 
 
 
Amortization of defined benefit pension items:
 
 
 
 
Prior-service costs
 
43

(2) 
Salaries and Employee Benefits
Actuarial gains/(losses)
 
$
(230
)
(2) 
Salaries and Employee Benefits
 
 
(187
)
 
Total before Tax
 
 
74

 
Provision for Income Taxes
 
 
$
(113
)
 
Net of Tax
 
 
 
 
 
Total reclassifications for the period
 
$
(129
)
 
Net of Tax
 
 
 
 
 
 
 
 
 
 
(1) Amounts in parentheses indicate debits to profit/loss.
(2) These accumulated other comprehensive income components are included in the computation of net periodic pension cost.

# 25



Note 6.    STOCK BASED COMPENSATION PLANS

Under our 2013 Long-Term Incentive Plan, we granted options in the first quarter of 2015 to purchase shares of our common stock. The fair values of the options were estimated on the date of grant using the Black-Scholes option-pricing model. The fair value of our grants is expensed over the four year vesting period.
The following table presents a roll-forward of our stock option plans and grants issued during 2015:
Schedule of Share-based Compensation Arrangements
 
Stock Option Plans
Roll-Forward of Shares Outstanding:
 
Outstanding at January 1, 2015
401,442

Granted
54,500

Exercised
(3,027
)
Forfeited

Outstanding at June 30, 2015
452,915

Exercisable at Period-End
319,815

Vested and Expected to Vest
133,100

 
 
Roll-Forward of Shares Outstanding - Weighted Average Exercise Price:
 
Outstanding at January 1, 2015
$
22.66

Granted
25.86

Exercised
22.78

Forfeited

Outstanding at June 30, 2015
23.04

Exercisable at Period-End
22.11

Vested and Expected to Vest
25.28

 
 
Grants Issued During 2015 - Weighted Average Information:
 
Fair Value
5.78

Fair Value Assumptions:
 
Dividend Yield
3.90
%
Expected Volatility
33.55
%
Risk Free Interest Rate
1.57
%
Expected Lives (in years)
7.66



The following table presents information on the amounts expensed for the periods ended June 30, 2015 and 2014:
Share-Based Compensation Expense
 
 
 
 
 
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
 
2015
 
2014
 
2015
 
2014
Share-Based Compensation Expense
 
$
75

 
$
90

 
$
157

 
$
180


Arrow also sponsors an Employee Stock Purchase Plan under which employees purchase Arrow's common stock at a 5% discount below market price. Under current accounting guidance, a stock purchase plan with a discount of 5% or less is not considered a compensatory plan.

# 26



Note 7.    RETIREMENT PLANS (Dollars in Thousands)

The following tables provide the components of net periodic benefit costs for the three-month period ended June 30:
 
 
 
 
Select
 
 
 
 
Employees'
 
Executive
 
Postretirement
 
 
Pension
 
Retirement
 
Benefit
 
 
Plan
 
Plan
 
Plans
Net Periodic Benefit Cost
 
 
 
 
 
 
For the Three Months Ended June 30, 2015:
 
 
 
 
 
 
Service Cost
 
$
353

 
$
3

 
$
43

Interest Cost
 
407

 
71

 
159

Expected Return on Plan Assets
 
(808
)
 

 

Amortization of Prior Service (Credit) Cost
 
(21
)
 
15

 
(8
)
Amortization of Net Loss
 
139

 
30

 
24

Net Periodic Benefit Cost
 
$
70

 
$
119

 
$
218

 
 
 
 
 
 
 
Plan Contributions During the Period
 
$

 
$
159

 
$
78

 
 
 
 
 
 
 
For the Three Months Ended June 30, 2014:
 
 
 
 
 
 
Service Cost
 
$
376

 
$

 
$
53

Interest Cost
 
268

 
48

 
62

Expected Return on Plan Assets
 
(723
)
 

 

Amortization of Prior Service (Credit) Cost
 
(11
)
 
18

 
(28
)
Amortization of Net Loss
 
86

 
22

 
6

Net Periodic Benefit Cost
 
$
(4
)
 
$
88

 
$
93

 
 
 
 
 
 
 
Plan Contributions During the Period
 
$

 
$
118

 
$
86

 
 
 
 
 
 
 
Net Periodic Benefit Cost
 
 
 
 
 
 
For the Six Months Ended June 30, 2015:
 
 
 
 
 
 
Service Cost
 
$
705

 
$
5

 
$
87

Interest Cost
 
802

 
121

 
217

Expected Return on Plan Assets
 
(1,615
)
 

 

Amortization of Prior Service Cost (Credit)
 
(42
)
 
29

 
(16
)
Amortization of Net Loss
 
278

 
61

 
48

Net Periodic Benefit Cost
 
$
128

 
$
216

 
$
336

 
 
 
 
 
 
 
Plan Contributions During the Period
 
$

 
$
274

 
$
125

 
 
 
 
 
 
 
Estimated Future Contributions in the Current Fiscal Year
 
$

 
$
548

 
$
250

 
 
 
 
 
 
 
For the Six Months Ended June 30, 2014:
 
 
 
 
 
 
Service Cost
 
$
753

 
$

 
$
106

Interest Cost
 
598

 
109

 
172

Expected Return on Plan Assets
 
(1,445
)
 

 

Amortization of Prior Service (Credit) Cost
 
(22
)
 
36

 
(57
)
Amortization of Net Loss
 
172

 
45

 
13

Net Periodic Benefit Cost
 
$
56

 
$
190

 
$
234

 
 
 
 
 
 
 
Plan Contributions During the Period
 
$

 
$
237

 
$
228


We are not required to make a contribution to our qualified pension plan in 2015, and currently, we do not expect to make a contribution in 2015. Arrow makes contributions to its other post-retirement benefit plans in an amount equal to benefit payments for the year.


# 27



Note 8.    EARNINGS PER COMMON SHARE (In Thousands, Except Per Share Amounts)

The following table presents a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per common share (EPS) for periods ended June 30, 2015 and 2014.  All share and per share amounts have been adjusted for the September 2014 2% stock dividend.
Earnings Per Share
 
Quarterly Period Ended:
 
Year-to-Date Period Ended:
 
June 30, 2015
 
June 30, 2014
 
June 30, 2015
 
June 30, 2014
Earnings Per Share - Basic:
 
 
 
 
 
 
 
Net Income
$
6,305

 
$
5,524

 
$
12,160

 
$
10,844

Weighted Average Shares - Basic
12,633

 
12,595

 
12,633

 
12,599

Earnings Per Share - Basic
$
0.50

 
$
0.44

 
$
0.96

 
$
0.86

 
 
 
 
 
 
 
 
Earnings Per Share - Diluted:
 
 
 
 
 
 
 
Net Income
$
6,305

 
$
5,524

 
$
12,160

 
$
10,844

Weighted Average Shares - Basic
12,633

 
12,595

 
12,633

 
12,599

Dilutive Average Shares Attributable to Stock Options
36

 
21

 
37

 
22

Weighted Average Shares - Diluted
12,669

 
12,616

 
12,670

 
12,621

Earnings Per Share - Diluted
$
0.50

 
$
0.44

 
$
0.96

 
$
0.86

Antidilutive Shares Excluded from the Calculation
of Earnings Per Share

 
33

 

 
33


# 28



Note 9.    FAIR VALUE OF FINANCIAL INSTRUMENTS (In Thousands)

FASB ASC Subtopic 820-10 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP) and requires certain disclosures about fair value measurements. We do not have any nonfinancial assets or liabilities measured at fair value on a recurring basis. The only assets or liabilities that Arrow measured at fair value on a recurring basis at June 30, 2015, December 31, 2014 and June 30, 2014 were securities available-for-sale. Arrow held no securities or liabilities for trading on such dates.
The table below presents the financial instrument's fair value and the amounts within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement:
Fair Value of Assets and Liabilities Measured on a Recurring and Nonrecurring Basis
 
 
 
 
 
Fair Value Measurements at Reporting Date Using:
 
 
 
Fair Value
 
Quoted Prices
In Active Markets for Identical Assets
(Level 1)
 
Significant Other
Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
 
Total Gains (Losses)
Fair Value of Assets and Liabilities Measured on a Recurring Basis:
 
 
 
 
 
 
 
 
 
June 30, 2015
 
 
 
 
 
 
 
 
 
Securities Available-for Sale:
 
 
 
 
 
 
 
 
 
U.S. Agency Obligations
$
156,937

 
$

 
$
156,937

 
$

 
 
State and Municipal Obligations
59,303

 

 
59,303

 

 
 
Mortgage-Backed Securities - Residential
157,641

 

 
157,641

 

 
 
Corporate and Other Debt Securities
16,691

 

 
16,691

 

 
 
Mutual Funds and Equity Securities
1,245

 

 
1,245

 

 
 
  Total Securities Available-for-Sale
$
391,817

 
$

 
$
391,817

 
$

 
 
December 31, 2014
 
 
 
 
 
 
 
 
 
Securities Available-for Sale:
 
 
 
 
 
 
 
 
 
U.S. Agency Obligations
$
137,603

 
$

 
$
137,603

 
$

 
 
State and Municipal Obligations
81,730

 

 
81,730

 

 
 
Mortgage-Backed Securities - Residential
128,827

 

 
128,827

 

 
 
Corporate and Other Debt Securities
16,725

 

 
16,725

 

 
 
Mutual Funds and Equity Securities
1,254

 

 
1,254

 

 
 
Total Securities Available-for Sale
$
366,139

 
$

 
$
366,139

 
$

 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
Securities Available-for Sale:
 
 
 
 
 
 
 
 
 
U.S. Agency Obligations
$
92,186

 
$

 
$
92,186

 
$

 
 
State and Municipal Obligations
102,862

 

 
102,862

 

 
 
Mortgage-Backed Securities - Residential
153,770

 

 
153,770

 

 
 
Corporate and Other Debt Securities
16,829

 

 
16,829

 

 
 
Mutual Funds and Equity Securities
1,201

 

 
1,201

 

 
 
Total Securities Available-for Sale
$
366,848

 
$

 
$
366,848

 
$

 
 
 
 
 
 
 
 
 
 
 
 
Fair Value of Assets and Liabilities Measured on a Nonrecurring Basis:
 
 
 
 
 
 
 
 
 
June 30, 2015
 
 
 
 
 
 
 
 
 
Other Real Estate Owned and Repossessed Assets, Net
$
308

 
$

 
$

 
$
308

 
$
(78
)
Collateral Dependent Impaired Loans
594

 

 

 
$
594

 
(144
)
December 31, 2014

 
 
 
 
 
 
 
 
Other Real Estate Owned and Repossessed Assets, Net
$
393

 
$

 
$

 
$
393

 
$
(15
)
Collateral Dependent Impaired Loans
574

 

 

 
$
574

 
(109
)
June 30, 2014

 
 
 
 
 
 
 
 
Other Real Estate Owned and Repossessed Assets, Net
$
326

 
$

 
$

 
$
326

 
$
(139
)
Collateral Dependent Impaired Loans

 

 

 
$

 


# 29




We determine the fair value of financial instruments under the following hierarchy:
Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; and
Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).

Fair Value Methodology for Assets and Liabilities Measured on a Recurring Basis

The fair value of Level 1 securities available-for-sale are based on unadjusted, quoted market prices from exchanges in active markets. The fair value of Level 2 securities available-for-sale are based on an independent bond and equity pricing service for identical assets or significantly similar securities and an independent equity pricing service for equity securities not actively traded.  The pricing service uses a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models.  Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows.  

Fair Value Methodology for Assets and Liabilities Measured on a Nonrecurring Basis

The fair value of collateral dependent impaired loans was based on third-party appraisals of the collateral. The fair value of other real estate owned was based on third-party appraisals. Other assets which might have been included in this table include mortgage servicing rights, goodwill and other intangible assets. Arrow evaluates each of these assets for impairment on a quarterly basis, with no impairment recognized for these assets at June 30, 2015, December 31, 2014 and June 30, 2014.




# 30



Fair Value by Balance Sheet Grouping

The following table presents a summary of the carrying amount, the fair value or an amount approximating fair value and the fair value hierarchy of Arrows financial instruments:
Schedule of Fair Values by Balance Sheet Grouping
 
 
 
 
 
Fair Value Hierarchy
 
Carrying
Amount
 
Fair
Value
 
Level 1
 
Level 2
 
Level 3
June 30, 2015
 
 
 
 
 
 
 
 
 
Cash and Cash Equivalents
$
45,137

 
$
45,137

 
$
45,137

 
$

 
$

Securities Available-for-Sale
391,817

 
391,817

 

 
391,817

 

Securities Held-to-Maturity
324,116

 
328,361

 

 
328,361

 

Federal Home Loan Bank and Federal
  Reserve Bank Stock
6,470

 
6,470

 
6,470

 

 

Net Loans
1,464,096

 
1,469,427

 

 

 
1,469,427

Accrued Interest Receivable
6,007

 
6,007

 
6,007

 

 

Deposits
1,972,484

 
1,966,671

 
1,777,645

 
189,026

 

Federal Funds Purchased and Securities
  Sold Under Agreements to Repurchase
15,895

 
15,895

 
15,895

 

 

Federal Home Loan Bank Term Advances
50,000

 
84,900

 

 
84,900

 

Junior Subordinated Obligations Issued
  to Unconsolidated Subsidiary Trusts
20,000

 
20,000

 

 
20,000

 

Accrued Interest Payable
289

 
289

 
289

 

 

 
 
 
 
 
 
 
 
 
 
December 31, 2014
 
 
 
 
 
 
 
 
 
Cash and Cash Equivalents
$
46,295

 
$
46,295

 
$
46,295

 
$

 
$

Securities Available-for-Sale
366,139

 
366,139

 

 
366,139

 

Securities Held-to-Maturity
302,024

 
308,566

 

 
308,566

 

Federal Home Loan Bank and Federal
  Reserve Bank Stock
4,851

 
4,851

 
4,851

 

 

Net Loans
1,397,698

 
1,405,454

 

 

 
1,405,454

Accrued Interest Receivable
5,834

 
5,834

 
5,834

 

 

Deposits
1,902,948

 
1,899,682

 
1,697,105

 
202,577

 

Federal Funds Purchased and Securities
  Sold Under Agreements to Repurchase
19,421

 
19,421

 
19,421

 

 

Federal Home Loan Bank Term Advances
51,000

 
51,258

 
41,000

 
10,258

 

Junior Subordinated Obligations Issued
  to Unconsolidated Subsidiary Trusts
20,000

 
20,000

 

 
20,000

 

Accrued Interest Payable
274

 
274

 
274

 

 

 
 
 
 
 
 
 
 
 
 
June 30, 2014
 
 
 
 
 
 
 
 
 
Cash and Cash Equivalents
$
51,810

 
$
51,810

 
$
51,810

 
$

 
$

Securities Available-for-Sale
366,848

 
366,848

 

 
366,848

 

Securities Held-to-Maturity
297,437

 
304,259

 

 
304,259

 

Federal Home Loan Bank and Federal
  Reserve Bank Stock
4,583

 
4,583

 
4,583

 

 

Net Loans
1,329,088

 
1,342,104

 

 

 
1,342,104

Accrued Interest Receivable
5,849

 
5,849

 
5,849

 

 

Deposits
1,860,666

 
1,856,131

 
1,630,950

 
225,181

 

Federal Funds Purchased and Securities
  Sold Under Agreements to Repurchase
16,896

 
16,896

 
16,896

 

 

Federal Home Loan Bank Term Advances
34,000

 
34,427

 
24,000

 
10,427

 

Junior Subordinated Obligations Issued
  to Unconsolidated Subsidiary Trusts
20,000

 
20,000

 

 
20,000

 

Accrued Interest Payable
365

 
365

 
365

 

 



# 31



Fair Value Methodology for Financial Instruments Not Measured on a Recurring or Nonrecurring Basis

Securities held-to-maturity are fair valued utilizing an independent bond pricing service for identical assets or significantly similar securities.  The pricing service uses a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models. Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows.
Fair values for loans are estimated for portfolios of loans with similar financial characteristics.  Loans are segregated by type such as commercial, commercial real estate, residential mortgage, indirect and other consumer loans.  Each loan category is further segmented into fixed and adjustable interest rate terms and by performing and nonperforming categories.  The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan.  The estimate of maturity is based on historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.   Fair value for nonperforming loans is generally based on recent external appraisals.  If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows.  Assumptions regarding credit risk, cash flows and discount rates are judgmentally determined using available market information and specific borrower information.
The fair value of time deposits is based on the discounted value of contractual cash flows, except that the fair value is limited to the extent that the customer could redeem the certificate after imposition of a premature withdrawal penalty.  The discount rates are estimated using the FHLBNY yield curve, which is considered representative of Arrows time deposit rates. The fair value of all other deposits is equal to the carrying value.
The fair value of FHLBNY advances is estimated based on the discounted value of contractual cash flows.  The discount rate is estimated using current rates on FHLBNY advances with similar maturities and call features.
Based on Arrows capital adequacy, the book value of the outstanding trust preferred securities (Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts) are considered to approximate fair value since the interest rates are variable (indexed to LIBOR) and Arrow is well-capitalized.

# 32




Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Arrow Financial Corporation:

We have reviewed the consolidated balance sheets of Arrow Financial Corporation and subsidiaries (the Company) as of June 30, 2015 and 2014, and related consolidated statements of income, comprehensive income for the three-month and six-month periods ended June 30, 2015 and 2014, and related consolidated statements of changes in stockholders' equity and cash flows for the six-month periods ended June 30, 2015 and 2014. These consolidated financial statements are the responsibility of the Company's management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Arrow Financial Corporation and subsidiaries as of December 31, 2014, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for the year then ended (not presented herein); and in our report dated March 13, 2015, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2014, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.


/s/ KPMG LLP
Albany, New York
August 6, 2015


# 33



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
June 30, 2015
Note on Terminology - In this Quarterly Report on Form 10-Q, the terms “Arrow,” “the registrant,” “the company,” “we,” “us,” and “our” generally refer to Arrow Financial Corporation and its subsidiaries as a group, except where the context indicates otherwise.

The Company and Its Subsidiaries - Arrow is a two-bank holding company headquartered in Glens Falls, New York. Our banking subsidiaries are Glens Falls National Bank and Trust Company (Glens Falls National) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (Saratoga National) whose main office is located in Saratoga Springs, New York. Our non-bank subsidiaries include Capital Financial Group, Inc. (an insurance agency specializing in selling and servicing group health care policies); three property and casualty insurance agencies: Loomis & LaPann, Inc., Upstate Agency LLC, and McPhillips Agency which is a division of Glens Falls National Insurance Agencies LLC; North Country Investment Advisers, Inc. (a registered investment adviser that provides investment advice to our proprietary mutual funds); Glens Falls National Community Development Corporation (which invests in qualifying community development projects); and Arrow Properties, Inc. (a real estate investment trust, or REIT). All of these are wholly- owned or majority owned subsidiaries of Glens Falls National.    
    
Our Peer Group - At certain points in this Report, our performance is compared with that of our “peer group” of financial institutions. Unless otherwise specifically stated, this peer group is comprised of the group of 342 domestic bank holding companies with $1 to $3 billion in total consolidated assets as identified in the Federal Reserve Board’s “Bank Holding Company Performance Report” for March 31, 2015 (the most recent such Report currently available), and peer group data contained herein has been derived from such Report.
Forward Looking Statements - This Quarterly Report on Form 10-Q contains statements that are not historical in nature but rather are based on our beliefs, assumptions, expectations, estimates and projections about the future. These statements are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk. Words such as “expects,” “believes,” “anticipates,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements. Some of these statements, such as those included in the interest rate sensitivity analysis in Part I, Item 3, entitled “Quantitative and Qualitative Disclosures About Market Risk,” are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulation models. Other forward-looking statements are based on our general perceptions of market conditions and trends in business activity, both our own and in the banking industry generally, as well as current management strategies for future operations and development.
Examples of Forward-Looking Statements:
 
 
Topic
Page
Location
Future compliance with regulatory capital standards
39
1st paragraph under "Regulatory Capital and Increase in Stockholders' Equity"
VISA
40
"VISA Class B Common Stock"
Impact of market rate structure on net interest margin, loan yields and deposit rates
44
1st and last paragraphs under "Quarterly Taxable Equivalent Yield on Loans"
 
57
Last paragraph under "Quantitative and Qualitative Disclosures about Market Risk
Future level of residential real estate loans
43
2nd paragraph under "Residential Real Estate Loans"
Future level of indirect consumer loans
44
Last paragraph under "Automobile Loans"
Future level of commercial loans
44
3rd paragraph under "Commercial, Commercial Real Estate and Construction and Land Development Loans"
Impact of changes in mortgage rates
46
Paragraph under "Investment Sales, Purchases and Maturities"
Provision for loan losses
47
1st paragraph in section
Future level of nonperforming assets
48
Last 3 paragraphs under "Risk Elements"
Liquidity
51
2nd full paragraph
Fees for other services to customers
53,55
3rd paragraph under "Noninterest Income"
Forward-looking statements contained herein are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify.  In the case of all such forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast.  Factors that could cause or contribute to such differences include, but are not limited to:  
a.
rapid and dramatic changes in economic and market conditions, such as the U.S. economy experienced in the early stages of the 2008-2009 "financial crisis;"
b.sharp fluctuations in interest rates, economic activity, and consumer spending patterns;
c.network attacks or unauthorized access to computer systems and network infrastructure, interruptions of service and other
security risks;
d.sudden changes in the market for products we provide, such as real estate loans;

# 34



e.
significant new banking laws and regulations, including an assortment of banking regulations recently issued or still to be issued under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act or Dodd-Frank);
f.
unexpected or enhanced competition from new or unforeseen sources; and
g.
similar uncertainties inherent in banking operations, the financial world, or governmental finance generally, such as periodic heightened concerns about U.S. or state governmental budgets, deficits, spending and taxes.
Readers are cautioned not to place undue reliance on forward-looking statements in this Report, which speak only as of the date hereof. We undertake no obligation to revise or update these forward-looking statements to reflect the occurrence of unanticipated events. This Quarterly Report should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2014.
USE OF NON-GAAP FINANCIAL MEASURES
Regulation G, a rule adopted by the Securities and Exchange Commission (SEC), applies to certain SEC filings, including earnings releases, made by registered companies that contain non-GAAP financial measures.  GAAP is generally accepted accounting principles in the United States of America.  Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure (if a comparable GAAP measure exists) and a statement of the Companys reasons for utilizing the non-GAAP financial measure as part of its financial disclosures.  The SEC has exempted from the definition of non-GAAP financial measures certain commonly used financial measures that are not based on GAAP.  When these exempted measures are included in public disclosures, supplemental information is not required. Financial institutions like the Company and its subsidiary banks are subject to an array of bank regulatory capital measures that are financial in nature but are not based on GAAP and are not easily reconcilable to the closest comparable GAAP financial measures, even in those cases where a comparable measure exists. The Company follows industry practice in disclosing its financial condition under these various regulatory capital measures, including period-end regulatory capital ratios for itself and its subsidiary banks, in its periodic reports filed with the SEC, including this Report, and does so without compliance with Regulation G, on the widely-shared assumption that the SEC regards such non-GAAP measures to be exempt from Regulation G.  
In addition, the Company uses in this Report several additional non-GAAP financial measures that are commonly utilized by financial institutions and have not been specifically exempted by the SEC from Regulation G. Some of the more significant such non-GAAP measures included in this Report are identified and described below, with a brief explanation for the Company's usage of such measures. Some of these non-GAAP measures are also included in the following tables, "Selected Quarterly Information--Unaudited," and "Average Consolidated Balance Sheets and Net Interest Income Analysis." Where any such non-GAAP measure is used in this Report, and a comparable GAAP measure exists, a reconciliation of the non-GAAP measure to the GAAP measure is set forth in proximity to, or cross-referenced from, the non-GAAP measure.
Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, as well as disclosures based on that tabular presentation, is commonly presented on a tax-equivalent basis.  That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual before-tax net interest income total.  This adjustment is considered helpful in comparing one financial institution's net interest income to that of another institution or in analyzing any institutions net interest income trend line over time, to correct any analytical distortion that might otherwise arise from the fact that financial institutions vary widely in the proportions of their portfolios that are invested in tax-exempt securities, and that even a single institution may significantly alter over time the proportion of its own portfolio that is invested in tax-exempt obligations.  Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets.  For purposes of this measure as well, tax-equivalent net interest income is generally used by financial institutions, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institutions performance over time. We follow these practices.
The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control.  The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and noninterest income.  Net interest income as utilized in calculating the efficiency ratio is typically the same as the net interest income presented in Selected Financial Information table discussed in the preceding paragraph, i.e., it is expressed on a tax-equivalent basis.  Moreover, most financial institutions, in calculating the efficiency ratio, also adjust both noninterest expense and noninterest income to exclude from these items (as calculated under GAAP) certain recurring component elements of income and expense, such as intangible asset amortization (deducted from noninterest expense) and securities gains or losses (excluded from noninterest income).  We follow these practices.
Tangible Book Value per Share:  Tangible equity is total stockholders equity less intangible assets.  Tangible book value per share is tangible equity divided by total shares issued and outstanding.  Tangible book value per share is often regarded as a more meaningful comparative ratio than book value per share as calculated under GAAP, that is, total stockholders equity including intangible assets divided by total shares issued and outstanding.  Intangible assets includes many items, but in our case, essentially represents goodwill.
Adjustments for Certain Items of Income or Expense:  In addition to our disclosures of net income, earnings per share (i.e. EPS), return on average assets (i.e. ROA), return on average equity (i.e. ROE) and other financial measures that are prepared in accordance with GAAP, we may also provide comparative disclosures that adjust these GAAP financial measures by removing the impact of certain transactions or other material items of income or expense.  We believe that the resulting non-GAAP financial measures may improve an understanding of our results of operations by separating out items that have a disproportional positive or negative impact on the particular period in question. Additionally, we believe that the adjustment for certain items allows a better comparison from period-to-period in our results of operations with respect to our fundamental lines of business including the commercial banking business. We believe that such non-GAAP financial measures disclosed by us from time-to-time are useful in evaluating our performance and that such information should

# 35



be considered as supplemental in nature and not as a substitute for or superior to the related financial information prepared in accordance with GAAP. 

Selected Quarterly Information - Unaudited (dollars in thousands except per share amounts)
Quarter Ended
6/30/2015

 
3/31/2015

 
12/31/2014

 
9/30/2014

 
6/30/2014

Net Income
$
6,305

 
$
5,855

 
$
6,369

 
$
6,147

 
$
5,524

Transactions Recorded in Net Income (Net of Tax):
 
 
 
 
 
 
 
 
 
Net Gain (Loss) on Securities Transactions
10

 
55

 

 
83

 
(16
)
 
 
 
 
 
 
 
 
 
 
Share and Per Share Data: 1
 
 
 
 
 
 
 
 
 
Period End Shares Outstanding
12,623

 
12,635

 
12,622

 
12,605

 
12,597

Basic Average Shares Outstanding
12,633

 
12,633

 
12,614

 
12,606

 
12,595

Diluted Average Shares Outstanding
12,669

 
12,671

 
12,655

 
12,621

 
12,616

Basic Earnings Per Share
$
0.50

 
$
0.46

 
$
0.50

 
$
0.49

 
$
0.44

Diluted Earnings Per Share
0.50

 
0.46

 
0.50

 
0.49

 
0.44

Cash Dividend Per Share
0.25

 
0.25

 
0.25

 
0.25

 
0.25

 
 
 
 
 
 
 
 
 
 
Selected Quarterly Average Balances:
 
 
 
 
 
 
 
 
 
  Interest-Bearing Deposits at Banks
37,303

 
30,562

 
58,048

 
15,041

 
22,486

  Investment Securities
701,329

 
673,753

 
664,334

 
653,702

 
712,088

  Loans
1,456,534

 
1,422,005

 
1,401,601

 
1,361,347

 
1,328,639

  Deposits
1,983,647

 
1,949,776

 
1,962,698

 
1,861,115

 
1,900,399

  Other Borrowed Funds
99,994

 
69,034

 
56,185

 
67,291

 
60,900

  Shareholders’ Equity
206,831

 
202,552

 
202,603

 
199,518

 
196,478

  Total Assets
2,316,427

 
2,248,054

 
2,247,576

 
2,154,307

 
2,183,611

Return on Average Assets, annualized
1.09
%
 
1.06
%
 
1.12
%
 
1.13
%
 
1.01
%
Return on Average Equity, annualized
12.23
%
 
11.72
%
 
12.47
%
 
12.22
%
 
11.28
%
Return on Tangible Equity, annualized 2
13.94
%
 
13.42
%
 
14.28
%
 
14.04
%
 
12.99
%
Average Earning Assets
$
2,195,166

 
$
2,126,320

 
$
2,123,983

 
$
2,030,090

 
$
2,063,213

Average Paying Liabilities
1,770,023

 
1,713,253

 
1,716,699

 
1,626,327

 
1,680,149

Interest Income, Tax-Equivalent3
18,501

 
18,073

 
18,213

 
17,834

 
17,837

Interest Expense
1,243

 
1,086

 
1,219

 
1,399

 
1,555

Net Interest Income, Tax-Equivalent3
17,258

 
16,987

 
16,994

 
16,435

 
16,282

Tax-Equivalent Adjustment3
1,094

 
1,083

 
1,073

 
1,074

 
1,142

Net Interest Margin, annualized 3
3.15
%
 
3.24
%
 
3.17
%
 
3.21
%
 
3.17
%
 
 
 
 
 
 
 
 
 
 
Efficiency Ratio Calculation: 4
 
 
 
 
 
 
 
 
 
Noninterest Expense
$
14,383

 
$
13,955

 
$
13,299

 
$
13,526

 
$
13,737

Less: Intangible Asset Amortization
(80
)
 
(91
)
 
(94
)
 
(94
)
 
(94
)
Net Noninterest Expense
$
14,303

 
$
13,864

 
$
13,205

 
$
13,432

 
$
13,643

Net Interest Income, Tax-Equivalent
$
17,258

 
$
16,987

 
$
16,994

 
$
16,435

 
$
16,282

Noninterest Income
7,444

 
6,856

 
7,060

 
7,351

 
7,019

Less: Net Securities (Gain) Loss
(16
)
 
(90
)
 

 
(137
)
 
27

Net Gross Income
$
24,686

 
$
23,753

 
$
24,054

 
$
23,649

 
$
23,328

Efficiency Ratio
57.94
%
 
58.37
%
 
54.90
%
 
56.80
%
 
58.48
%
 
 
 
 
 
 
 
 
 
 
Period-End Capital Information:
 
 
 
 
 
 
 
 
 
Total Stockholders’ Equity (i.e. Book Value)
$
206,947

 
$
204,965

 
$
200,926

 
$
200,089

 
$
197,616

Book Value per Share
16.39

 
16.22

 
15.92

 
15.87

 
15.69

Goodwill and Other Intangible Assets, net
25,372

 
25,492

 
25,628

 
25,747

 
25,868

Tangible Book Value per Share 2
14.38

 
14.20

 
13.89

 
13.83

 
13.63

 
 
 
 
 
 
 
 
 
 
Bank Regulatory Capital Ratios:5
 
 
 
 
 
 
 
 
 
Tier 1 Leverage Ratio
9.41
%
 
9.57
%
 
9.44
%
 
9.68
%
 
9.39
%
Common Equity Tier 1 Capital Ratio
12.92
%
 
13.27
%
 
N/A

 
N/A

 
N/A

Tier 1 Risk-Based Capital Ratio
14.24
%
 
14.65
%
 
14.47
%
 
14.41
%
 
14.49
%
Total Risk-Based Capital Ratio
15.28
%
 
15.73
%
 
15.54
%
 
15.48
%
 
15.57
%
 
 
 
 
 
 
 
 
 
 
Assets Under Trust Administration
  and Investment Management
$
1,246,849

 
$
1,254,823

 
$
1,227,179

 
$
1,199,930

 
$
1,214,841


See Footnote on page 37

# 36



Arrow Financial Corporation
Selected Quarterly Information - Continued
(Dollars In Thousands, Except Per Share Amounts - Unaudited)

Footnotes:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1.
Share and Per Share Data have been restated for the September 29, 2014, 2% stock dividend.
 
 
2.
Tangible Book Value and Tangible Equity exclude goodwill and other intangible assets, net from total equity.  These are non-GAAP financial measures which we believe provide investors with information that is useful in understanding our financial performance.
 
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
9/30/2014
 
6/30/2014
 
Total Stockholders' Equity (GAAP)
$
206,947

 
$
204,965

 
$
200,926

 
$
200,089

 
$
197,616

 
Less: Goodwill and Other Intangible assets, net
25,372

 
25,492

 
25,628

 
25,747

 
25,868

 
Tangible Equity (Non-GAAP)
$
181,575

 
$
179,473

 
$
175,298

 
$
174,342

 
$
171,748

 
 
 
 
 
 
 
 
 
 
 
 
Period End Shares Outstanding
12,623

 
12,635

 
12,622

 
12,605

 
12,597

 
Tangible Book Value per Share (Non-GAAP)
$
14.38

 
$
14.20

 
$
13.89

 
$
13.83

 
$
13.63

 
 
 
 
 
 
 
 
 
 
 
3.
Net Interest Margin is the ratio of our annualized tax-equivalent net interest income to average earning assets. This is also a non-GAAP financial measure which we believe provides investors with information that is useful in understanding our financial performance.
 
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
9/30/2014
 
6/30/2014
 
Net Interest Income (GAAP)
$
16,164


$
15,904


$
15,921


$
15,361


$
15,140

 
Add: Tax-Equivalent adjustment (Non-GAAP)
1,094

 
1,083

 
1,073

 
1,074

 
1,142

 
Net Interest Income - Tax Equivalent (Non-GAAP)
$
17,258

 
$
16,987

 
$
16,994

 
$
16,435

 
$
16,282

 
Average Earning Assets
2,195,166

 
2,126,320

 
2,123,983

 
2,030,090

 
2,063,213

 
Net Interest Margin (Non-GAAP)*
3.15
%
 
3.24
%
 
3.17
%
 
3.21
%
 
3.17
%
 
 
 
 
 
 
 
 
 
 
 
4.
Financial Institutions often use the "efficiency ratio", a non-GAAP ratio, as a measure of expense control. We believe the efficiency ratio provides investors with information that is useful in understanding our financial performance. We define our efficiency ratio as the ratio of our noninterest expense to our net gross income (which equals our tax-equivalent net interest income plus noninterest income, as adjusted).
 
 
 
 
 
 
 
 
 
 
 
5.
Common Equity Tier 1 Capital Ratio (CET1) is a new regulatory capital measure applicable to financial institutions, effective January 1, 2015. For the current quarter, all of the regulatory capital ratios in the table above, as well as the Total Risk-Weighted Assets and Common Equity Tier 1 Capital amounts listed in the table below, are estimates based on, and calculated in accordance with, these new bank regulatory capital rules. All prior quarters reflect actual results. The June 30, 2015 CET1 ratio listed in the tables (i.e., 13.12%) exceeds the sum of the required minimum CET1 ratio plus the fully phased-in Capital Conservation Buffer (i.e., 7.00%).
 
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
9/30/2014
 
6/30/2014
 
Total Risk Weighted Assets
$
1,515,416

 
$
1,452,975

 
N/A

 
N/A

 
N/A

 
Common Equity Tier 1 Capital
$
195,800

 
$
192,865

 
N/A

 
N/A

 
N/A

 
Common Equity Tier 1 Ratio
12.92
%
 
13.27
%
 
N/A

 
N/A

 
N/A










 

# 37




Average Consolidated Balance Sheets and Net Interest Income Analysis
(see “Use of Non-GAAP Financial Measures” on page 35)
(Fully Taxable Basis using a marginal tax rate of 35%)
(Dollars In Thousands)
Quarter Ended June 30:
2015
 
2014
 
 
 
Interest
 
Rate
 
 
 
Interest
 
Rate
 
Average
 
Income/
 
Earned/
 
Average
 
Income/
 
Earned/
 
Balance
 
Expense
 
Paid
 
Balance
 
Expense
 
Paid
Interest-Bearing Deposits at Banks
$
37,303

 
$
26

 
0.28
%
 
$
22,486

 
$
16

 
0.29
%
Investment Securities:
 
 
 
 
 
 
 
 
 
 
 
Fully Taxable
431,787

 
2,017

 
1.87

 
415,466

 
2,045

 
1.97

Exempt from Federal Taxes
269,542

 
2,422

 
3.60

 
296,622

 
2,492

 
3.37

Loans
1,456,534

 
14,036

 
3.87

 
1,328,639

 
13,284

 
4.01

Total Earning Assets
2,195,166

 
18,501

 
3.38

 
2,063,213

 
17,837

 
3.47

Allowance for Loan Losses
(15,599
)
 
 
 
 
 
(14,603
)
 
 
 
 
Cash and Due From Banks
30,457

 
 
 
 
 
28,493

 
 
 
 
Other Assets
106,403

 
 
 
 
 
106,508

 
 
 
 
Total Assets
$
2,316,427

 
 
 
 
 
$
2,183,611

 
 
 
 
Deposits:
 
 
 
 
 
 
 
 
 
 
 
NOW Accounts
$
922,532

 
338

 
0.15

 
$
865,910

 
495

 
0.23

Savings Deposits
550,150

 
182

 
0.13

 
520,028

 
226

 
0.17

Time Deposits of $100,000 or More
59,569

 
88

 
0.59

 
71,656

 
201

 
1.13

Other Time Deposits
137,778

 
185

 
0.54

 
161,655

 
359

 
0.89

Total Interest-Bearing Deposits
1,670,029

 
793

 
0.19

 
1,619,249

 
1,281

 
0.32

Short-Term Borrowings
25,873

 
10

 
0.16

 
24,746

 
12

 
0.19

FHLBNY Term Advances and Other Long-Term Debt
74,121

 
440

 
2.38

 
36,154

 
262

 
2.91

Total Interest-Bearing Liabilities
1,770,023

 
1,243

 
0.28

 
1,680,149

 
1,555

 
0.37

Demand Deposits
313,618

 
 
 
 
 
281,150

 
 
 
 
Other Liabilities
25,955

 
 
 
 
 
25,834

 
 
 
 
Total Liabilities
2,109,596

 
 
 
 
 
1,987,133

 
 
 
 
Stockholders’ Equity
206,831

 
 
 
 
 
196,478

 
 
 
 
Total Liabilities and Stockholders’ Equity
$
2,316,427

 
 
 
 
 
$
2,183,611

 
 
 
 
Net Interest Income (Tax-equivalent Basis)
 
 
17,258

 
 
 
 
 
16,282

 
 
Reversal of Tax Equivalent Adjustment
 
 
(1,094
)
 
0.20
%
 
 
 
(1,142
)
 
0.22
%
Net Interest Income
 
 
$
16,164

 
 
 
 
 
$
15,140

 
 
Net Interest Spread (Non-GAAP)
 
 
 
 
3.10
%
 
 
 
 
 
3.10
%
Net Interest Margin (Non-GAAP)
 
 
 
 
3.15
%
 
 
 
 
 
3.17
%
 
 
 
 
 
 
 
 
 
 
 
 

# 38




Average Consolidated Balance Sheets and Net Interest Income Analysis
(see “Use of Non-GAAP Financial Measures” on page 35)
(Fully Taxable Basis using a marginal tax rate of 35%)
(Dollars In Thousands)
Six-Month Period Ended June 30:
2015
 
2014
 
 
 
Interest
 
Rate
 
 
 
Interest
 
Rate
 
Average
 
Income/
 
Earned/
 
Average
 
Income/
 
Earned/
 
Balance
 
Expense
 
Paid
 
Balance
 
Expense
 
Paid
Interest-Bearing Deposits at Banks
$
33,951

 
$
47

 
0.28
%
 
$
19,850

 
$
29

 
0.29
%
Investment Securities:
 
 
 
 
 
 
 
 
 
 
 
Fully Taxable
419,792

 
3,965

 
1.90

 
425,913

 
4,057

 
1.92

Exempt from Federal Taxes
267,825

 
4,780

 
3.60

 
307,517

 
5,054

 
3.31

Loans
1,439,365

 
27,782

 
3.89

 
1,306,766

 
26,136

 
4.03

Total Earning Assets
2,160,933

 
36,574

 
3.41

 
2,060,046

 
35,276

 
3.45

Allowance for Loan Losses
(15,566
)
 
 
 
 
 
(14,493
)
 
 
 
 
Cash and Due From Banks
30,933

 
 
 
 
 
29,497

 
 
 
 
Other Assets
106,129

 
 
 
 
 
104,796

 
 
 
 
Total Assets
$
2,282,429

 
 
 
 
 
$
2,179,846

 
 
 
 
Deposits:
 
 
 
 
 
 
 
 
 
 
 
NOW Accounts
$
918,454

 
668

 
0.15

 
$
861,622

 
959

 
0.22

Savings Deposits
539,273

 
349

 
0.13

 
515,254

 
445

 
0.17

Time Deposits of $100,000 or More
59,967

 
178

 
0.60

 
73,726

 
431

 
1.18

Other Time Deposits
139,501

 
387

 
0.56

 
163,901

 
750

 
0.92

Total Interest-Bearing Deposits
1,657,195

 
1,582

 
0.19

 
1,614,503

 
2,585

 
0.32

Short-Term Borrowings
27,555

 
25

 
0.18

 
26,550

 
31

 
0.24

FHLBNY Term Advances and Other Long-Term Debt
57,044

 
722

 
2.55

 
38,066

 
533

 
2.82

Total Interest-Bearing Liabilities
1,741,794

 
2,329

 
0.27

 
1,679,119

 
3,149

 
0.38

Demand Deposits
309,609

 
 
 
 
 
279,526

 
 
 
 
Other Liabilities
26,322

 
 
 
 
 
25,892

 
 
 
 
Total Liabilities
2,077,725

 
 
 
 
 
1,984,537

 
 
 
 
Stockholders’ Equity
204,704

 
 
 
 
 
195,309

 
 
 
 
Total Liabilities and Stockholders’ Equity
$
2,282,429

 
 
 
 
 
$
2,179,846

 
 
 
 
Net Interest Income (Tax-equivalent Basis)
 
 
34,245

 
 
 
 
 
32,127

 
 
Reversal of Tax Equivalent Adjustment
 
 
(2,177
)
 
0.20
%
 
 
 
(2,315
)
 
0.23
%
Net Interest Income
 
 
$
32,068

 
 
 
 
 
$
29,812

 
 
Net Interest Spread (Non-GAAP)
 
 
 
 
3.14
%
 
 
 
 
 
3.07
%
Net Interest Margin (Non-GAAP)
 
 
 
 
3.20
%
 
 
 
 
 
3.14
%

OVERVIEW
We reported net income for the second quarter of 2015 of $6.3 million, representing diluted earnings per share (EPS) of $0.50. This EPS result was an increase of six cents, or 13.6%, from the EPS of $0.44 reported for the second quarter of 2014. Return on average equity (ROE) for the 2015 quarter continued to be strong at 12.23%, up from an ROE of 11.28% for the quarter ended June 30, 2014. Return on average assets (ROA) for the 2015 second quarter was 1.09%, an increase from an ROA of 1.01% for the quarter ended June 30, 2014. Our net interest margin for the 2015 quarter was 3.15%, essentially unchanged from the year earlier quarter's result of 3.17%. Total assets were $2.333 billion at June 30, 2015, which represented an increase of $116.0 million, or 5.2%, from the level at December 31, 2014, and an increase of $180.3 million, or 8.4%, from the June 30, 2014 level.
The changes in net income, net interest income and net interest margin between the three- and six-month periods are more fully described under the heading "RESULTS OF OPERATIONS," beginning on page 52.
Stockholders’ equity was $206.9 million at June 30, 2015, an increase of $9.3 million, or 4.7%, from the year earlier level. Stockholders' equity was also up $6.0 million, or 3.0%, from the December 31, 2014 level of $200.9 million. The components of the change in stockholders’ equity since year-end 2014 are presented in the Consolidated Statement of Changes in Stockholders’ Equity on page 6, and are discussed in more detail in the next section.
Regulatory Capital and Increase in Stockholders' Equity: The new regulatory capital requirements, as approved by the federal bank regulatory authorities in July 2013 (the "New Capital Rules"), went into effect for the Company on January 1, 2015. At June 30, 2015, we exceeded by a substantial amount all regulatory minimum capital requirements under the New Capital Rules (including the new Common Equity Tier 1 Capital ratio) at both the holding company and bank levels. At that date, both of our banks, as well as our holding company, qualified as "well-capitalized" under the adjusted federal bank regulatory guidelines that became effective contemporaneously with the New Capital Rules. Because of our continued profitability and strong asset quality, our regulatory capital levels in recent years have

# 39



consistently remained well in excess of the various required regulatory minimums in effect from time to time, and are well in excess of the currently required minimum levels under the New Capital Rules.
At June 30, 2015, our tangible book value per share (calculated based on stockholders' equity reduced by goodwill and other intangible assets) amounted to $14.38, an increase of $0.49, or 3.5%, from the December 31, 2014 level and an increase of $0.75, or 5.5%, from the level as of June 30, 2014. Our total stockholders' equity at June 30, 2015 was 4.7%, higher than the year-earlier level, and our total book value per share was up by 4.5% over the year earlier level. In the past six months, total shareholders' equity increased 3.0% and our total book value per share increased by the same 3.0%. The increase in stockholders' equity over the first six months of 2015 principally reflected the following factors: (i) $12.2 million net income for the period and (ii) issuance of $0.4 million of common stock through our employee benefit and dividend reinvestment plans; offset in part by (iii) cash dividends of $6.3 million; and (iv) repurchases of our own common stock of $0.8 million. As of June 30, 2015, our closing stock price was $27.04, representing a trading multiple of 1.88 to our tangible book value. As adjusted for a 2% stock dividend distributed September 29, 2014, the Company paid a quarterly cash dividend of $.245 per share for each of the first three quarters of 2014, and a cash dividend of $.25 per share for the last quarter of 2014 and the first two quarters of 2015.

Loan Quality: The credit quality of our loan portfolio has continued in recent periods to be significantly stronger than the average for our peer group of U.S. bank holding companies with $1 billion to $3 billion in total assets (see page 34 for information on how we define our peer group).
Our net charge-offs for the second quarter of 2015 were $121 thousand as compared to $105 thousand for the comparable 2014 quarter. Our ratio of net charge-offs to average loans (annualized) was 0.03% for both the second quarter of 2015 and the second quarter of 2014. By contrast, our peer group's weighted average ratio of net charge-offs to average loans for the 2014 year was 0.07%. At June 30, 2015, our allowance for loan losses was $15.6 million representing 1.05% of total loans, down five basis points from the December 31, 2014 ratio, reflecting the continuing strong credit quality in the loan portfolio.
Nonperforming loans were $8.8 million at June 30, 2015, representing 0.59% of period-end loans, unchanged from our year-earlier ratio. By way of comparison, the weighted average ratio for our peer group was 0.98% at March 31, 2015, which itself was considerably lower (stronger) than the peer group's ratios of earlier years. For example, our peer group's nonperforming loans ratio was 3.60% at year-end 2010, the high-point after the onset of the 2008 recession, while our ratio has remained quite low and stable from 2008 through the date of this Report.
During the first six months of 2015, we experienced increases in outstanding balances in each of the three largest segments of our loan portfolio, without any significant deterioration in our credit quality:
Residential Real Estate Loans: These loans, including home equity loans, made up approximately 38% of our portfolio at period-end. The residential real estate market in our service area has been stable in recent periods. During the worst of the financial crisis, we did not experience a notable increase in our foreclosure or loss rates on our residential real estate loans, nor have we in ensuing periods, primarily due to the fact that we never have originated or participated in underwriting high-risk mortgage loans. We originated all of the residential real estate loans currently held in our portfolio and apply conservative underwriting standards to our originations.
Commercial and Commercial Real Estate Loans: These loans comprised approximately 31% of our loan portfolio at period-end. Current unemployment rates in our region remain slightly elevated from pre-crisis levels, although the local economy continues to be stable and in some areas recovering. Similarly, commercial property values in our region remain stable, and did not show significant deterioration even in the worst phases of the financial crisis. We update the appraisals on our nonperforming and watched commercial loan properties as deemed necessary, usually when the loan is downgraded or when we perceive significant market deterioration since our last appraisal.
Automobile (Primarily Through Indirect Lending) and Other Consumer Loans: These loans (primarily automobile) comprised approximately 31% of our loan portfolio. In the first six months of 2015, we did not experience any significant change in our delinquency rate or level of nonperforming loans in this segment.
 
Liquidity and Access to Credit Markets: We have not experienced any liquidity problems or special concerns during 2015 to date, nor did we during 2014 or 2013. The terms of our lines of credit with our correspondent banks, the FHLBNY and the Federal Reserve Bank have not changed. In general, we rely on asset-based liquidity (i.e., funds in overnight investments and cash flow from maturing investments and loans) with liability-based liquidity as a secondary source. Our main liability-based sources are overnight borrowing arrangements with our correspondent banks, term credit arrangement advances from the FHLBNY and the Federal Reserve Bank discount window. During the extended financial crisis, many financial institutions, small and large, relied extensively on the Fed's discount window to support their liquidity positions, but we had no such need. We regularly perform a liquidity stress test and periodically test our contingent liquidity plan to ensure that we can generate an adequate amount of available funds to meet a wide variety of potential liquidity crises, including a severe crisis.

Visa Class B Common Stock: Our banks, as former member banks of Visa, continue to bear some indirect contingent liability to various third parties who may have certain claims against Visa, including class action claims, to the extent that Visa's direct liabilities resulting from such claims ultimately exceed the amounts held in a litigation escrow account set up by Visa to defray such liabilities using funds which would otherwise be owed by it to its member banks in redemption of their Class B Visa shares. In July 2012, Visa and MasterCard entered into a Memorandum of Understanding ("MOU") with a class of plaintiffs to settle certain covered antitrust claims against the two card companies involving merchant discounts. In December 2013, a federal judge gave final approval to the class settlement agreement in this litigation. The total cash settlement payment was set at approximately $6.05 billion, of which Visa’s share represented approximately $4.4 billion. Visa has paid its portion of this settlement from the litigation escrow account.  However, approximately one hundred merchants have filed a challenge to the settlement based on claims of attorney misconduct  causing some uncertainty with respect to the finalization of the settlement.  In the second quarter 2012, in light of the state of covered litigation at Visa at the time, which was then winding down (as it continues to do), as well as the substantial remaining dollar amount in the litigation escrow fund, we determined to

# 40



reverse the entire amount of our 2008 VISA litigation-related accrual, which was then $294 thousand pre-tax. This reversal reduced our other operating expenses for the year ending December 31, 2012. We believed then, and continue to believe, that the balance that Visa currently maintains in its litigation escrow account is substantially sufficient to satisfy Visa's remaining direct liability to such claims, if any, without further resort to the contingent liability of the former Visa member banks. At June 30, 2015, the Company held 27,771 shares of Visa Class B common stock and we continue not to recognize any economic value for these shares.

CHANGE IN FINANCIAL CONDITION
Summary of Selected Consolidated Balance Sheet Data
(Dollars in Thousands)
 
At Period-End
 
$ Change
 
$ Change
 
% Change
 
% Change
 
June 30, 2015
 
December 31, 2014
 
June 30, 2014
 
From December
 
From June
 
From December
 
From June
Interest-Bearing Bank Balances
$
13,699

 
$
11,214

 
$
16,459

 
$
2,485

 
$
(2,760
)
 
22.2
 %
 
(16.8
)%
Securities Available-for-Sale
391,817

 
366,139

 
366,848

 
25,678

 
24,969

 
7.0
 %
 
6.8
 %
Securities Held-to-Maturity
324,116

 
302,024

 
297,437

 
22,092

 
26,679

 
7.3
 %
 
9.0
 %
Loans (1)
1,479,670

 
1,413,268

 
1,344,124

 
66,402

 
135,546

 
4.7
 %
 
10.1
 %
Allowance for Loan Losses
15,574

 
15,570

 
15,036

 
4

 
538

 
 %
 
3.6
 %
Earning Assets (1)
2,215,772

 
2,097,496

 
2,029,451

 
118,276

 
186,321

 
5.6
 %
 
9.2
 %
Total Assets
2,333,371

 
2,217,420

 
2,153,051

 
115,951

 
180,320

 
5.2
 %
 
8.4
 %
Demand Deposits
325,046

 
300,786

 
286,735

 
24,260

 
38,311

 
8.1
 %
 
13.4
 %
NOW Accounts
904,893

 
871,671

 
820,589

 
33,222

 
84,304

 
3.8
 %
 
10.3
 %
Savings Deposits
547,706

 
524,648

 
523,626

 
23,058

 
24,080

 
4.4
 %
 
4.6
 %
Time Deposits of $100,000 or More
58,284

 
61,797

 
70,600

 
(3,513
)
 
(12,316
)
 
(5.7
)%
 
(17.4
)%
Other Time Deposits
136,555

 
144,046

 
159,116

 
(7,491
)
 
(22,561
)
 
(5.2
)%
 
(14.2
)%
Total Deposits
$
1,972,484

 
$
1,902,948

 
$
1,860,666

 
$
69,536

 
$
111,818

 
3.7
 %
 
6.0
 %
Federal Funds Purchased and
  Securities Sold Under Agreements
  to Repurchase
$
24,273

 
$
19,421

 
$
16,896

 
$
4,852

 
$
7,377

 
25.0
 %
 
43.7
 %
FHLB Advances - Overnight
29,500

 
41,000

 
24,000

 
(11,500
)
 
5,500

 
(28.0
)%
 
22.9
 %
FHLB Advances - Term
55,000

 
10,000

 
10,000

 
45,000

 
45,000

 
450.0
 %
 
450.0
 %
Stockholders' Equity
206,947

 
200,926

 
197,616

 
6,021

 
9,331

 
3.0
 %
 
4.7
 %
(1) Includes Nonaccrual Loans
Municipal Deposits: Fluctuations in balances of our NOW accounts and time deposits of $100,000 or more are largely the result of municipal deposit seasonality factors. Over the past twelve months, municipal deposits on average have ranged from 28% to over 34% of our total deposits. As of June 30, 2015, municipal deposits represented 31.8% of total deposits. Municipal deposits normally are invested in NOW accounts and time deposits of short duration. Many of our municipal deposit relationships are subject to annual renewal, by formal or informal agreement.
In general, there is a seasonal pattern to municipal deposits starting with a low point during July and August. Account balances tend to increase throughout the fall and remain elevated during the winter months, due to tax deposits, and generally receive an additional boost at the end of March from the electronic deposit of state aid to school districts. In addition to these seasonal fluctuations within accounts, the overall level of municipal deposit balances fluctuates from year-to-year as some municipalities move their accounts in or out of our banks due to competitive factors. Often, the balances of municipal deposits at the end of a quarter are not representative of the average balances for that quarter.
The extended financial crisis had a significant negative impact on municipal tax revenues in many regions, and consequently on municipal funds available for deposit. To date, this has not resulted in either a sustained decrease in municipal deposit levels at our banks, adjusted for seasonal fluctuations, or an overall increase in the average rate we pay on such deposits (despite the continuing strong competition for such deposits). However, if in the future interest rates begin to rise significantly or the competition for municipal deposits otherwise becomes more intense, we may experience either or both of these adverse developments, i.e., a sustained decrease in municipal deposit levels and/or an overall increase in the average rate we pay on such deposits.
Changes in Sources of Funds: Our total deposits increased $69.5 million, or 3.7%, from December 31, 2014 to June 30, 2015, mainly due to a 4.9% increase in our municipal deposits and a 3.1% increase in our consumer and business deposit balances. We continue to experience a general shift in balances from time deposits to savings and NOW accounts, a long-running trend matching the continuing decline in recent years in prevailing deposit rates and interest rates generally. At June 30, 2015 we borrowed $29.5 million of overnight funds from the FHLB of New York, while at December 31, 2014 and June 30, 2014 we borrowed $41.0 million and $24.0 million, respectively. At June 30, 2015, our term advances from the FHLB were $55.0 million, as we added $45 million in medium term advances during the first six months of 2015 in order to extend the average maturity of our interest-bearing liabilities.
Changes in Earning Assets: Our loan portfolio at June 30, 2015, was up by $66.4 million, or 4.7%, from the December 31, 2014 level and up by $135.5 million or 10.1%, from the June 30, 2014 level. We experienced the following trends in our three largest segments:

# 41



1.
Commercial and commercial real estate loans. Our June 30, 2015 balance for this segment increased $9.5 million, or 2.2% from the December 31, 2014 total, representing the impact of continued strong loan demand offset in part by a few of large payoffs during the six-month period.
2.
Residential real estate loans. The period-end balance increased by $39.1 million, or 7.3%, from December 31, 2014. We continued to sell some of our residential mortgage originations during the six-month period to Freddie Mac, although a smaller percentage than we sold in the same period the prior year. Demand for new mortgage loans was strong throughout the period.
3.
Consumer loans (primarily automobile loans through indirect lending). The balance of these loans at June 30, 2015, increased by $17.8 million, or 4.1%, from the December 31, 2014 balance, reflecting a continuation of strong automobile sales region-wide and an expansion of our dealer network for indirect lending, as dealer sales in the region rebounded from a slow start to the year due to the effects of a cold and snowy winter in the northeast.

Most of our incoming cash flows for the first six months of 2015 came from a combination of an increase in deposit balances and from the $45 million in new FHLB advances, mentioned earlier. We used these cash-flows to fund our loan growth and purchase investment securities.
    
Deposit Trends
The following two tables provide information on trends in the balance and mix of our deposit portfolio by presenting, for each of the last five quarters, the quarterly average balances by deposit type and the percentage of total deposits represented by each deposit type. The principal change in deposit risk over the period was the steady drop-off in time deposits, including time deposits of $100,000 or more, and corresponding steady increases in lower or no-cost deposits, including demand deposits, NOW accounts and savings deposits.
Quarterly Average Deposit Balances
(Dollars in Thousands)
 
Quarter Ended
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
9/30/2014
 
6/30/2014
Demand Deposits
$
313,618

 
$
305,557

 
$
302,184

 
$
302,079

 
$
281,150

NOW Accounts
922,532

 
914,329

 
920,592

 
801,998

 
865,910

Savings Deposits
550,150

 
528,276

 
525,609

 
530,057

 
520,028

Time Deposits of $100,000 or More
59,569

 
60,370

 
65,202

 
69,351

 
71,656

Other Time Deposits
137,778

 
141,244

 
149,111

 
157,630

 
161,655

Total Deposits
$
1,983,647

 
$
1,949,776

 
$
1,962,698

 
$
1,861,115

 
$
1,900,399

Percentage of Total Quarterly Average Deposits
 
Quarter Ended
 
6/30/2015
 
03/31/2015
 
12/31/2014
 
09/30/2014
 
06/30/2014
Demand Deposits
15.8
%
 
15.7
%
 
15.4
%
 
16.2
%
 
14.8
%
NOW Accounts
46.5

 
46.9

 
46.9

 
43.1

 
45.5

Savings Deposits
27.7

 
27.1

 
26.8

 
28.5

 
27.4

Time Deposits of $100,000 or More
3.0

 
3.1

 
3.3

 
3.7

 
3.8

Other Time Deposits
7.0

 
7.2

 
7.6

 
8.5

 
8.5

Total Deposits
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
For a variety of reasons, we typically experience little growth in average deposit balances in the first quarter of each calendar year (even though municipal balances tend to grow sharply at the very end of the first quarter), little net growth or a small contraction in the second quarter of the year (when municipal deposits normally drop off), and a return to growth in the third and fourth quarters (when municipal deposits tend to increase, sometimes substantially, to and through year-end). This pattern has held true in recent periods. Growth in average deposit balances from the first quarter of 2015 to the second quarter of 2015 came from municipal and non-municipal deposits.
Quarterly Cost of Deposits
 
Quarter Ended
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
9/30/2014
 
6/30/2014
Demand Deposits
%
 
%
 
%
 
%
 
%
NOW Accounts
0.15

 
0.15

 
0.16

 
0.19

 
0.23

Savings Deposits
0.13

 
0.13

 
0.13

 
0.16

 
0.17

Time Deposits of $100,000 or More
0.59

 
0.60

 
0.88

 
1.12

 
1.13

Other Time Deposits
0.54

 
0.58

 
0.72

 
0.84

 
0.89

Total Deposits
0.16

 
0.16

 
0.20

 
0.24

 
0.27

    
In keeping with industry trend lines, average rates paid by us on deposits decreased steadily over the five quarters ending June 30, 2015, for deposits generally and all deposit categories individually. Over the same period, our average yield on loans also decreased, for loans generally and across almost all loan categories (see "Quarterly Taxable Equivalent Yield on Loans," page 44). We make no representations that this downward trend in average deposit rates (and average yields on loans) will persist; at some point, prevailing

# 42



rates, as well as average deposit (and loan) rates across our portfolio, are likely to level off and perhaps move upward. It is widely anticipated that the Federal Reserve will begin to increase short-term rates in the very near future, which even if effected slowly and in small increments, may ultimately push longer term rates upward as well.

Non-Deposit Sources of Funds
    
We have several sources of funding other than deposits. Historically, we have borrowed funds from the Federal Home Loan Bank ("FHLB") under a variety of programs, including fixed and variable rate short-term borrowings and borrowings in the form of "structured advances." These structured advances typically have original maturities of 3 to 10 years with some advances callable by the FHLB at certain dates. If the advances are called, we may elect to receive replacement advances from the FHLB at the then prevailing FHLB rates of interest.
We have also relied in the past (most recently in 2004), on the issuance of trust preferred securities (or TRUPs) to supplement our funding needs. As a result of the Dodd-Frank Act and its denial of Tier 1 regulatory capital treatment for future-issued TRUPs, we are not likely to issue any TRUPs in the future. However, consistent with a grandfathering provision in Dodd-Frank and the New Capital Rules issued by bank regulators pursuant thereto, the $20 million principal amount of Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts (i.e., TRUPs) listed on our consolidated balance sheet as of June 30, 2015, will, subject to certain limits, continue to qualify as Tier 1 regulatory capital until such TRUPs mature or are redeemed, as is further discussed under “Capital Resources” beginning on page 48 of this Report. These trust preferred securities are subject to early redemption by us if the proceeds cease to qualify as Tier 1 capital of Arrow for any reason, or if certain other unanticipated but negative events should occur, such as any adverse change in tax laws that denies the Company the ability to deduct interest paid on these obligations for federal income tax purposes.
Loan Trends
The following two tables present, for each of the last five quarters, the quarterly average balances by loan type and the percentage of total loans represented by each loan type. Over the last five quarters, the average balances of all loan types have steadily increased, except for other consumer loans (i.e., non-automobile loans), which have remained stable and represent only 1.7% of the total portfolio.
Quarterly Average Loan Balances
(Dollars in Thousands)
 
Quarter Ended
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
9/30/2014
 
6/30/2014
Commercial and Commercial Real Estate
$
453,168

 
$
445,765

 
$
446,269

 
$
435,729

 
$
431,614

Residential Real Estate
400,190

 
387,329

 
373,186

 
358,503

 
343,816

Home Equity
120,323

 
117,857

 
116,768

 
112,880

 
107,580

Consumer Loans - Automobile
457,168

 
445,341

 
439,460

 
428,092

 
419,407

Other Consumer Loans (1)
25,685

 
25,713

 
25,918

 
26,143

 
26,222

Total Loans
$
1,456,534

 
$
1,422,005

 
$
1,401,601

 
$
1,361,347

 
$
1,328,639

Percentage of Total Quarterly Average Loans
 
Quarter Ended
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
9/30/2014
 
6/30/2014
Commercial and Commercial Real Estate
31.1
%
 
31.4
%
 
31.8
%
 
32.0
%
 
32.5
%
Residential Real Estate
27.5

 
27.2

 
26.6

 
26.3

 
25.9

Home Equity
8.3

 
8.3

 
8.3

 
8.3

 
8.1

Consumer Loans - Automobile
31.4

 
31.3

 
31.4

 
31.5

 
31.5

Other Consumer Loans (1)
1.7

 
1.8

 
1.9

 
1.9

 
2.0

Total Loans
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
(1) The category “Other Consumer Loans”, in the tables above, includes home improvement loans secured by mortgages, which are otherwise reported with residential real estate loans in tables of period-end balances.
Maintenance of High Quality in the Loan Portfolio

For many reasons, including our conservative credit underwriting standards, we largely avoided the negative impact on asset quality that many other banks suffered during the 2008-2009 financial crisis. Throughout the crisis and in the ensuing years, we did not experience a significant deterioration in the quality of our loan portfolio or any segment thereof. In general, we have underwritten our residential real estate loans to secondary market standards for prime loans and have not engaged in subprime mortgage lending as a business line. Similarly, we have historically applied high underwriting standards in our commercial and commercial real estate lending operations and generally in our indirect lending program as well. On occasion we have made loans, including indirect (automobile) loans, to borrowers having FICO scores below the highest credit quality classifications, where special circumstances such as competitive considerations justify our doing so, and occasionally we have had extensions of credit outstanding to borrowers who have developed credit problems after origination resulting in deterioration of their FICO scores.

Residential Real Estate Loans: In recent years, residential real estate and home equity loans have represented the largest single segment of our loan portfolio (comprising approximately 38% of the entire portfolio at June 30, 2015), eclipsing both our commercial and commercial real estate loans (31% of the portfolio) and automobile loans (also 31% of the portfolio). Our gross originations for residential

# 43



real estate loans (including refinancings of pre-existing mortgage loans) were $74.1 million and $59.6 million for the first six months of 2015 and 2014, respectively. These origination totals exceeded the sum of repayments and prepayments in the respective quarters, but in each period we also sold a portion of these originations on or immediately after origination. In the first six months of 2014, we sold $8.8 million of our originations. In the first six months of 2015, we sold $7.4 million, or 12.2% of our originations. During 2014, we introduced additional competitive products for variable rate (adjustable) residential real estate and construction loans. None of these variable rate loans were subprime loans. We did not sell any of these variable rate loans to the secondary market.
Even though short-term rates have remained very low since 2008, rates on conventional real estate mortgages have fluctuated somewhat over the past few years in response to several programs undertaken by the Federal Reserve, including its so-called "quantitative easing" programs. If the current historically unprecedented low-rate environment for newly originated residential real estate loans persists for an extended additional period of time, we may continue to sell a portion of our loan originations and, as a result, may even experience a decrease in our outstanding balances in this segment of our portfolio. Moreover, if our local economy suffers a major downturn or prevailing long-term interest rates spike upward, the demand for residential real estate loans in our service area may decrease, which also may negatively impact our real estate portfolio and our financial performance.

Commercial and Commercial Real Estate Loans: Over the last decade, we have experienced moderate and occasionally strong demand for commercial and commercial real estate loans. These loan balances have generally increased in dollar amount and have slightly increased as a percentage of the overall loan portfolio. For the first six months of 2015, loan growth was strong in this category, but was largely offset by a few large prepayments.
Substantially all commercial and commercial real estate loans in our portfolio originated or participated in by us were extended to businesses or borrowers located in our regional market. Many of the loans in the commercial portfolio have variable rates tied to prime, FHLBNY rates or U.S. Treasury indices. We have not experienced any significant weakening in the quality of our commercial loan portfolio in recent years.
It is entirely possible, however, that we may experience a reduction in the demand for such loans and/or a weakening in the quality of our commercial and commercial real estate loan portfolio in upcoming periods. Generally, however, the business sector, at least in our service area, appeared to be in reasonably good financial condition at period-end.

Automobile Loans (primarily through indirect lending): At June 30, 2015, our automobile loans (primarily loans originated through dealerships located in upstate New York and Vermont) represented the third largest category of loans in our portfolio, and continued to be a significant component of our business comprising almost a third of our loan portfolio.
Beginning in 2012 and continuing to the present, there has been a nation-wide resurgence in automobile sales and financing, due in the view of many to an aging fleet and a modest resurgence in consumer optimism. Our new automobile loan volume for the first six months of 2015, at $117.2 million, was higher than in the 2014 first six months ($106.7 million). Our automobile loan portfolio also grew in the first six months of 2015 by $18.2 million, or 4.3%, over our December 31, 2014 balance.
It has been widely noted that the recent upsurge in auto lending nationwide was accompanied by a general weakening of underwriting standards. To some extent this was true for us, as well. For credit quality purposes, we assign our potential automobile loan customers into one of four tiers, and in recent periods have originated a slightly higher ratio of such loans to customers in the lower two tiers. However, in the last six months of 2015, we experienced no significant change in our net charge-offs on automobile loans. Our lending staff not only utilizes credit evaluation software tools but also reviews and evaluates each loan individually. We believe our disciplined approach to evaluating risk has contributed to maintaining our strong loan quality in this segment of our portfolio. If weakness in auto demand returns, however, our portfolio is likely to experience limited, if any, overall growth, either in real terms or as a percentage of the total portfolio, regardless of whether the auto company lending affiliates continue to offer highly-subsidized loans. Of course, if the economy in our indirect loan service area should weaken significantly in upcoming periods, we would expect some negative impact on the quality of this segment of our portfolio as well as other segments.
    
The following table indicates the annualized tax-equivalent yield of each loan category for the past five quarters.
Quarterly Taxable Equivalent Yield on Loans
 
Quarter Ended
 
6/30/2015
 
3/31/2015
 
12/31/2014
 
9/30/2014
 
6/30/2014
Commercial and Commercial Real Estate
4.41
%
 
4.40
%
 
4.40
%
 
4.43
%
 
4.47
%
Residential Real Estate
4.31

 
4.43

 
4.40

 
4.40

 
4.50

Home Equity
2.96

 
2.94

 
2.97

 
2.93

 
2.93

Automobile
3.09

 
3.18

 
3.20

 
3.26

 
3.32

Other Consumer Loans
5.23

 
5.25

 
5.33

 
5.46

 
5.49

Total Loans
3.87

 
3.92

 
3.92

 
3.95

 
4.01

    
In summary, average yields in our total loan portfolio have steadily declined over the last year, dropping 14 basis points, or 3.5%, from the second quarter of 2014 to the second quarter of 2015. This decrease continued a long-term trend, resulting principally from the Federal Reserve's multi-year policy of generating and maintaining ultra-low rates in financial markets generally, on both short-term and long-term debt, as well as continuing competition for loans from other lenders. To the extent that this declining rate environment may be "bottoming out" or even in the early stages of a reversal, as recent pronouncements by the Federal Reserve would suggest is likely, we may ultimately expect to see some increase in the average yield on our loan portfolio, although any such increase will likely be accompanied, or perhaps even preceded, by a corresponding increase in our cost of deposits and other funds. In the second quarter of 2015, the average yield on our loan portfolio decreased by 5 basis points from the first quarter of 2015, reflecting the continued trend of declining yields in on our residential real estate and automobile loan portfolios, which declined in the second quarter by 12 and 9 basis points, respectively, from

# 44



the first quarter. Yields on our commercial portfolio held steady. While the average yield on our total loan portfolio in the just-completed quarter, as compared to the prior quarter, declined 5 basis points, the average cost of deposits remain unchanged from the prior quarter, as downward repricing opportunities on deposits are nearly exhausted.
Regardless of the future direction or magnitude of changes in prevailing interest rates, the yield (tax-equivalent interest income divided by average loans) on our loan portfolio will be impacted by such changes. However, the timing and degree of responsiveness, in loans generally and as between various categories of loans, will be influenced by a variety of other factors, including the extent of federal government and Federal Reserve participation in the home mortgage market, the makeup of our loan portfolio, the shape of the yield curve, consumer expectations and preferences, and the rate at which the portfolio expands. Additionally, there is a significant amount of cash flow from normal amortization and prepayments in all loan categories, and much of this cash flow reprices at current rates for credit, as new loans are generated at the current yields. Thus, even if prevailing rates for loans stabilize in upcoming periods, our average rate on our portfolio may continue to decline for some period as older credits in our portfolio bearing generally higher rates continue to mature and either roll over or are redeployed into lower priced loans.
Investment Portfolio Trends
The following table presents the changes in the period-end balances for the securities available-for-sale and the securities held-to-maturity investment portfolios from December 31, 2014 to June 30, 2015 (in thousands). The principal changes in our securities available-for-sale portfolio over the six month period were purchases of short-term U.S. Agency Securities and Mortgage-Backed Securities-Residential when yield levels were attractive, and the maturities of State and Municipal Obligations. The principal change in our held-to-maturity portfolio was the purchase of State and Municipal Obligations during the six month period.
 
Fair Value at Period-End
 
Net Unrealized Gains (Losses) For Period Ended
 
06/30/2015
 
12/31/2014
 
Change
 
06/30/2015
 
12/31/2014
 
Change
Securities Available-for-Sale:
 
 
 
 
 
 
 
 
 
 
 
U.S. Agency Securities
$
156,937

 
$
137,603

 
$
19,334

 
$
689

 
$
63

 
$
626

State and Municipal Obligations
59,303

 
81,730

 
(22,427
)
 
74

 
148

 
(74
)
Mortgage-Backed Securities-Residential
157,641

 
128,827

 
28,814

 
3,140

 
4,095

 
(955
)
Corporate and Other Debt Securities
16,691

 
16,725

 
(34
)
 
(219
)
 
(263
)
 
44

Mutual Funds and Equity Securities
1,245

 
1,254

 
(9
)
 
125

 
134

 
(9
)
Total
$
391,817

 
$
366,139

 
$
25,678

 
$
3,809

 
$
4,177

 
$
(368
)
 
 
 
 
 
 
 
 
 
 
 
 
Securities Held-to-Maturity:
 
 
 
 
 
 
 
 
 
 
 
State and Municipal Obligations
$
223,031

 
$
193,252

 
$
29,779

 
$
3,154

 
$
4,780

 
$
(1,626
)
Mortgage-Backed Securities-Residential
104,330

 
114,314

 
(9,984
)
 
1,092

 
1,762

 
(670
)
Corporate and Other Debt Securities
1,000

 
1,000

 

 

 

 

Total
$
328,361

 
$
308,566

 
$
19,795

 
$
4,246

 
$
6,542

 
$
(2,296
)
At June 30, 2015, we held no investment securities in our portfolio that consisted of or included, directly or indirectly, obligations of foreign governments or governmental agencies or foreign issuers of any sort.
As of both period-ends presented in the above table, all listed mortgage-backed securities (which includes interests in pools of mortgage-backed securities, known as collateralized mortgage obligations or CMOs), were guaranteed by U.S. agency or government sponsored enterprises (GSEs), such as Fannie Mae or Freddie Mac. Mortgage-backed securities provide to the investor monthly portions of principal and interest payments pursuant to the contractual obligations of the underlying mortgages. In the case of most CMOs, the principal and interest payments on the pooled mortgages are separated into two or more components (tranches), with each tranche having a separate estimated life, risk profile and yield. Our practice has been to purchase only those CMOs that are guaranteed by GSEs or other federal agencies and only those CMO tranches with shorter maturities and no more than moderate extension risk. Included in corporate and other debt securities are trust preferred securities issued by other financial institutions prior to May 19, 2010, the grandfathering date for TRUPs in Dodd Frank, that were highly rated at the time of purchase.
Other-Than-Temporary Impairment
Each quarter we evaluate all investment securities with a fair value less than amortized cost, both in the available-for-sale portfolio and the held-to-maturity portfolio, to determine if there exists other-than-temporary impairment for any such security as defined under generally accepted accounting principles. There were no other-than-temporary impairment losses in the first six months of 2015.
Increase in Net Unrealized Securities Gains (Losses): Nearly all of the change in our net unrealized gains or losses is attributable to changes in the yield curve between the two period-ends, that is, there has been little or no change in the credit-worthiness of the issuers.

# 45



Investment Sales, Purchases and Maturities
(In Thousands)
 
Three Months Ended
 
Six Months Ended
Sales
06/30/2015
 
06/30/2014
 
06/30/2015
 
06/30/2014
Available-For-Sale Portfolio:
 
 
 
 
 
 
 
Mortgage-Backed Securities-Residential
$

 
$

 
$
2,690

 
$

U.S. Agency Securities
18,618

 
40,729

 
18,618

 
40,729

Other

 
23

 
12

 
23

  Total
18,618

 
40,752

 
21,320

 
40,752

Net Gains on Securities Transactions
16

 
(27
)
 
106

 
(27
)
Proceeds on the Sales of Securities
$
18,634

 
$
40,725

 
$
21,426

 
$
40,725

Investment yields in the capital markets have been very volatile thus far in 2015. We regularly review our interest rate risk position along with our security holdings to evaluate if market opportunities arise where we can reposition certain securities available-for-sale to enhance portfolio performance. As reflected in the table above, during the first six months of 2015 we executed transactions to liquidate certain lower yielding U.S. Agency and Mortgage-Backed securities and reemployed those funds in higher yielding securities to improve the stability of cash flows and enhance portfolio performance.

 
Three Months Ended
 
Six Months Ended
 
06/30/2015
 
06/30/2014
 
06/30/2015
 
06/30/2014
Available-for-Sale Portfolio

 
 
 
 
 
 
 
U.S. Agency Securities
$
32,356

 
$
40,599

 
$
50,309

 
$
53,185

State and Municipal Obligations

 

 

 
4,308

Mortgage-Backed Securities-Residential
20,460

 

 
54,167

 

Other

 
11

 
12

 
22

Total Purchases
$
52,816

 
$
40,610

 
$
104,488

 
$
57,515

 
 
 
 
 
 
 
 
Maturities & Calls
$
33,342

 
$
62,385

 
$
55,976

 
$
107,292



 
Three Months Ended
 
Six Months Ended
 
06/30/2015
 
06/30/2014
 
06/30/2015
 
06/30/2014
Held-to-Maturity Portfolio
 
 
 
 
 
 
 
State and Municipal Obligations
$

 
$
1,052

 
$

 
$
6,943

Mortgage-Backed Securities-Residential
38,984

 

 
52,815

 
29,437

Total Purchases
$
38,984

 
$
1,052

 
$
52,815

 
$
36,380

 
 
 
 
 
 
 
 
Maturities & Calls
$
22,904

 
$
20,874

 
$
30,084

 
$
37,435



# 46



Asset Quality
The following table presents information related to our allowance and provision for loan losses for the past five quarters.
Summary of the Allowance and Provision for Loan Losses
(Dollars in Thousands, Loans Stated Net of Unearned Income)
 
6/30/2015

 
03/31/2015

 
12/31/2014

 
9/30/2014

 
6/30/2014

Loan Balances:
 
 
 
 
 
 
 
 
 
Period-End Loans
$
1,479,670

 
$
1,434,794

 
$
1,413,268

 
$
1,381,440

 
$
1,344,124

Average Loans, Year-to-Date
1,439,365

 
1,422,005

 
1,344,427

 
1,325,159

 
1,306,766

Average Loans, Quarter-to-Date
1,456,534

 
1,422,005

 
1,401,601

 
1,361,347

 
1,328,639

Period-End Assets
2,333,371

 
2,335,528

 
2,217,420

 
2,208,745

 
2,153,051

 
 
 
 
 
 
 
 
 
 
Allowance for Loan Losses, Year-to-Date:
 
 
 
 
 
 
 
 
 
Allowance for Loan Losses, Beginning of Period
$
15,570

 
$
15,570

 
$
14,434

 
$
14,434

 
$
14,434

Provision for Loan Losses, YTD
345

 
275

 
1,848

 
1,407

 
963

Loans Charged-off, YTD
(455
)
 
(290
)
 
(1,021
)
 
(769
)
 
(504
)
Recoveries of Loans Previously Charged-off
114

 
70

 
309

 
221

 
143

Net Charge-offs, YTD
(341
)
 
(220
)
 
(712
)
 
(548
)
 
(361
)
Allowance for Loan Losses, End of Period
$
15,574

 
$
15,625

 
$
15,570

 
$
15,293

 
$
15,036

 
 
 
 
 
 
 
 
 
 
Allowance for Loan Losses, Quarter-to-Date:
 
 
 
 
 
 
 
 
 
Allowance for Loan Losses, Beginning of Period
$
15,625

 
$
15,570

 
$
15,293

 
$
15,036

 
$
14,636

Provision for Loan Losses, QTD
70

 
275

 
441

 
444

 
505

Loans Charged-off, QTD
(165
)
 
(290
)
 
(251
)
 
(265
)
 
(168
)
Recoveries of Loans Previously Charged-off
44

 
70

 
87

 
78

 
63

Net Charge-offs, QTD
(121
)
 
(220
)
 
(164
)
 
(187
)
 
(105
)
Allowance for Loan Losses, End of Period
$
15,574

 
$
15,625

 
$
15,570

 
$
15,293

 
$
15,036

 
 
 
 
 
 
 
 
 
 
Nonperforming Assets, at Period-End:
 
 
 
 
 
 
 
 
 
Nonaccrual Loans
$
6,931

 
$
6,998

 
$
6,899

 
$
7,048

 
$
6,185

Restructured
283

 
307

 
333

 
346

 
398

Loans Past Due 90 or More Days
  and Still Accruing Interest
1,570

 
580

 
537

 
571

 
1,325

Total Nonperforming Loans
8,784

 
7,885

 
7,769

 
7,965

 
7,908

Repossessed Assets
75

 
106

 
81

 
66

 
40

Other Real Estate Owned
234

 
423

 
312

 
326

 
326

Total Nonperforming Assets
$
9,093

 
$
8,414

 
$
8,162

 
$
8,357

 
$
8,274

 
 
 
 
 
 
 
 
 
 
Asset Quality Ratios:
 
 
 
 
 
 
 
 
 
Allowance to Nonperforming Loans
177.30
%
 
198.16
%
 
200.41
%
 
192.00
%
 
190.14
%
Allowance to Period-End Loans
1.05

 
1.09

 
1.10

 
1.11

 
1.12

Provision to Average Loans (Quarter) (1)
0.02

 
0.08

 
0.12

 
0.13

 
0.15

Provision to Average Loans (YTD) (1)
0.05

 
0.08

 
0.12

 
0.14

 
0.15

Net Charge-offs to Average Loans (Quarter) (1)
0.03

 
0.06

 
0.05

 
0.05

 
0.03

Net Charge-offs to Average Loans (YTD) (1)
0.05

 
0.06

 
0.05

 
0.06

 
0.06

Nonperforming Loans to Total Loans
0.59

 
0.55

 
0.54

 
0.58

 
0.59

Nonperforming Assets to Total Assets
0.39

 
0.36

 
0.37

 
0.38

 
0.38

  (1) Annualized
 
 
 
 
 
 
 
 
 
Provision for Loan Losses
Through the provision for loan losses, an allowance is maintained that reflects our best estimate of probable incurred loan losses related to specifically identified impaired loans as well as the inherent risk of loss related to the remaining portfolio. Loan charge-offs are recorded to this allowance when loans are deemed uncollectible, in whole or in part.
In the second quarter of 2015, we made a $70 thousand provision for loan losses, compared to a provision of $505 thousand for the second quarter of 2014 and a provision of $275 for the first quarter of 2015. A variety of factors and events during the most recent 2015 quarter dictated the amount of the provision including the level of net charge-offs during the quarter, a general improvement in the credit quality of our loan portfolio (a small decrease in substandard loans), a small decrease in our historical loss factors and a decrease in the level of commercial loans outstanding. These factors contributing to a lower provision were offset in part by continuing growth during the quarter in our loan balances. See Note 3 to our unaudited interim consolidated financial statements for a discussion on how we classify our credit quality indicators as well as the balance in each category.

# 47




The ratio of the allowance for loan losses to total loans was 1.05% at June 30, 2015, down 5 basis points from 1.10% at December 31, 2014 and down 7 basis points from 1.12% at June 30, 2014.
    We consider our accounting policy relating to the allowance for loan losses to be a critical accounting policy, given the uncertainty involved in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio, and the material effect that such judgments may have on our results of operations. Our process for determining the provision for loan losses is described in Note 3 to our unaudited interim consolidated financial statements.
Risk Elements
Our nonperforming assets at June 30, 2015 amounted to $9.1 million, an increase of $931 thousand, or 11.4%, from the December 31, 2014 total and an increase of $819 thousand, or 9.9%, from the year earlier total. The increase was primarily attributable to one commercial loan, which is being restructured in conjunction with a US government agency that is guaranteeing 80% of the loan balance. Our recent ratios of nonperforming assets to total assets remain significantly below our peer group averages for the corresponding dates. At June 30, 2015, our ratio of loans past due 90 or more days plus nonaccrual loans plus other real estate owned to total assets was .39%, nearly unchanged from our ratio at June 30, 2014. Both ratios are well below the comparable ratios of our peer group at March 31, 2015 (the latest date for which peer group information is available).
The following table presents the balance of other non-current loans at period-end as to which interest income was being accrued (i.e. loans 30 to 89 days past due, as defined in bank regulatory guidelines). These non-current loans are not included in our nonperforming assets but entail heightened risk.
Loans Past Due 30-89 Days and Accruing Interest
 
6/30/2015
 
12/31/2014
 
6/30/2014
Commercial Loans
$
126

 
$
150

 
$
787

Commercial Real Estate Loans

 
200

 
200

Other Consumer Loans
57

 
34

 
36

Automobile Loans
4,339

 
5,322

 
3,480

Residential Real Estate Loans
1,138

 
1,953

 
1,608

Total Delinquent Loans
$
5,660

 
$
7,659

 
$
6,111

    
At June 30, 2015, our loans in this category totaled $5.7 million, a decrease of $2.0 million, or 26.1%, from the $7.7 million of such loans at December 31, 2014. The June 30, 2015 total of non-current loans equaled 0.38% of such loans then outstanding, whereas the year-end 2014 total equaled 0.54% of loans then outstanding. The decrease from December 31, 2014 is primarily attributable to a substantial decrease in delinquent automobile loans, which temporarily surged at year-end 2014 and then subsided.
The number and dollar amount of our performing loans that demonstrate characteristics of potential weakness from time-to-time (potential problem loans) typically is a very small percentage of our portfolio. See the table of Credit Quality Indicators in Note 3 to our unaudited interim consolidated financial statements. We consider all performing commercial and commercial real estate loans classified as substandard or lower (as reported in Note 3) to be potential problem loans. The dollar amount of such loans at June 30, 2015 ($24.4 million) was down slightly from the dollar amount of such loans at December 31, 2014 ($27.3 million). The amount of such loans depends principally on economic conditions in our geographic market area of northeastern New York State.
The economy in our market area has been relatively strong in recent years, but any general weakening of the U.S. economy in upcoming periods would likely have an adverse effect on the economy in our market area as well, and on our commercial and commercial real estate portfolio.
As of June 30, 2015, we held for sale two residential real estate properties in other real estate owned. As a result of our conservative underwriting standards, we do not expect to acquire a significant number of other real estate properties in the near term as a result of payment defaults or the foreclosure process.
We do not currently anticipate significant increases in our nonperforming assets or other non-current loans as to which interest income is still being accrued or potential problem loans, but can give no assurances in this regard.

CAPITAL RESOURCES

Please see our discussion in our Form 10-K for December 31, 2014 on the impact of the Dodd-Frank Act on regulatory capital standards for U.S. insured depository financial institutions, and specifically, on the new higher minimum capital standards set forth in the New Capital Rules that were approved by bank regulators in July 2013 and initially became effective for the Company on January 1, 2015.
In general, the New Capital Rules set higher minimum capital ratios for banks and bank holding companies, expand the risk-weighted categories of assets and add a new capital ratio, a "common equity tier 1 capital ratio" (CET1), which is applicble to our banks and bank holding company. The New Capital Rules as part of their general thrust in requiring enhanced capital for banks introduce another new component of a bank's minimum capital threshold, a so-called "capital conservation buffer" (which will equal at least 2.5% of total risk-based assets when fully phased-in by 2019). This buffer will be added to each of the other minimum capital ratios under the New Capital Rules (some of which are higher than the comparable minimum ratios under the old bank regulatory capital rules).
Under the New Capital Rules, outstanding TRUPs issued by small- to medium-sized financial institutions such as Arrow before May 19, 2010, the grandfathering date for TRUPs under Dodd-Frank, will continue to qualify as tier 1 capital, up to a limit of 25% of total tier 1 capital (including such TRUPs and other grandfathered tier 1 capital components), until the TRUPs mature or are redeemed.

# 48



We have taken the one-time election provided to banks under the New Capital Rules to exclude accumulated other comprehensive income (AOCI) from capital in the calculation of our regulatory capital ratios.
Regulatory capital, although a financial measure that is not provided for or governed by GAAP, nevertheless has been exempted by the SEC from the definition of "non-GAAP financial measures" in the SEC's Regulation G governing disclosure by registered companies of non-GAAP financial measures. Thus, certain information which is generally required to be presented in connection with our disclosure of non-GAAP financial measures need not be provided, and has not been provided, for the regulatory capital measures discussed below.

Risk-Based and Leverage Capital Standards: Under the New Capital Rules, our holding company and our subsidiary banks are currently subject to both risk-based capital guidelines and a leverage capital ratio test.
The risk-based guidelines assign risk weightings to all assets and certain off-balance sheet items of financial institutions, which generally results in a substantial discounting of low-risk or risk-free assets from their GAAP book values on the balance sheet; that is, a significant dollar amount of such assets "disappears" from the balance sheet in the risk-weighting process. The guidelines then establish three minimum ratios of capital to total risk-weighted assets, specifically, a minimum "Common Equity Tier 1 Capital" ratio (currently, 4.50%), a minimum "Tier 1 Risk-Based Capital" ratio (currently, 6.00%), and a minimum "Total Risk-Based Capital" ratio (currently, 8.00%). The first of these, the Common Equity Tier 1 Capital ratio, is a new capital measured added under the New Capital Rules. For purposes of this measure, the numerator, Common Equity Tier 1 Capital, includes only common equity items, such as common stock, related surplus and retained earnings, with risk-adjusted assets as the denominator. The other two risk-based measures under the New Capital Rules are the Tier 1 Risk-Based Capital ratio and the Total Risk-Based Capital ratio, both of which also existed under the previous regulatory capital regime but have been modified in significant ways under the New Capital Rules (most importantly, the Tier 1 Risk-Based Capital ratio has been increased from 4.00% to 6.00%). Tier 1 Risk-Based Capital under the New Capital Rules consists of Common Equity Tier 1 Capital, plus a limited amount of eligible permanent preferred stock and (for small- to medium-sized holding companies), a limited amount of grandfathered trust preferred securities (see the discussion below on Trust Preferred Securities), minus intangible assets, net of associated deferred tax liabilities, and subject to certain other deductions. Total Risk-Based Capital under the New Capital Rules consists of Tier 1 Capital plus Tier 2 Capital, the latter comprising a limited amount of eligible subordinated debt, other eligible preferred stock, certain other qualifying capital instruments, and a limited amount of the allowance for loan losses, subject to deductions. For each of the three risk-based capital ratios, the denominator--total risk-based assets--is defined under the New Capital Rules in a way that is similar to the methodology required under the old capital rules, but with significant differences. The weightings of certain asset categories, such as certain residential mortgage and commercial real estate loans, have been adjusted upward under the New Capital Rules and certain other risk-weighting changes have been made in the New Capital Rules, leading to a somewhat higher denominator for many institutions (and hence, lower risk-based ratios) than would have been the case under the old rules. The New Capital Rules also include another layer of required regulatory capital for banks and bank holding companies, a so-called capital conservation buffer, which when fully implemented in 2019, will add 2.50% to each of the three risk-based capital minimum ratios discussed above. This buffer will be phased-in in four annual increments of 0.625% each, beginning January 1, 2016.
The other regulatory capital measure under the New Capital Rules, the leverage ratio test, is also a carryover from the old rules. The leverage ratio is the ratio of Tier 1 capital (as defined under the leverage test) to total consolidated assets, without risk weighting (i.e, discounting) of assets, subject to deductions. The minimum leverage ratio under the New Capital Rules for banks and bank holding companies is 4.00%. Rapidly expanding companies may be required by bank regulators to meet substantially higher minimum leverage ratios.
Federal banking law mandates that certain actions must be taken by banking regulators ("prompt corrective action") for financial institutions that are deemed undercapitalized as measured under any of these regulatory capital guidelines. Federal banking law establishes five categories of capitalization for financial institutions ranging from "well-capitalized” (the highest ranking) to "critically undercapitalized" (the lowest ranking), with any of the lowest three rankings denoting an "undercapitalized" institution. Essentially, federal banking law ties the ability of banking organizations to engage in certain types of non-banking financial activities and to utilize certain procedures to such organizations' continuing to qualify for one of the two highest-ranking of the five capitalization categories, i.e., as "well-capitalized" or "adequately capitalized."
    
    

# 49



Capital Ratios: The table below sets forth the capital ratios of our holding company and our two subsidiary banks, Glens Falls National and Saratoga National, under the New Capital Rules, as of June 30, 2015:
 
Common
 
Tier 1
 
Total
 
 
Equity
 
Risk-Based
 
Risk-Based
Tier 1
 
Tier 1 Capital
 
Capital
 
Capital
Leverage
 
Ratio
 
Ratio
 
Ratio
Ratio
Arrow Financial Corporation
12.92
%
 
14.24
%
 
15.28
%
9.41
%
Glens Falls National Bank & Trust Co.
14.34
%
 
14.34
%
 
15.38
%
9.15
%
Saratoga National Bank & Trust Co.
11.49%

 
11.49%

 
12.48
%
8.87%

 
 
 
 
 
 
 
Current Regulatory Minimum (2015)
4.50

 
6.00

 
8.00

4.00

FDICIA's "Well-Capitalized" Standard (2015)
6.50

 
8.00

 
10.00

5.00

Final Regulatory Minimum (2019) (1)
7.00

 
8.50

 
10.50

4.00

 (1) Including the fully phased-in capital conservation buffer
 
 
 
 
 
 

At June 30, 2015 our holding company and both banks exceeded the minimum capital ratios established under the New Capital Rules and each also qualified as "well-capitalized", the highest category, in the capital classification scheme set by federal bank regulatory agencies under the "prompt corrective action" standards.
    
Capital Components; Stock Repurchases; Dividends

Stockholders' Equity: Stockholders' equity was $206.9 million at June 30, 2015, an increase of $6.0 million, or 3.0%, from the prior year-end.  The most significant contributory factors to this increase in stockholders' equity were net income of $12.2 million and equity received from our various stock-based compensation and dividend reinvestment plans of $0.4 million. These positive factors were offset, in part, by cash dividends of $6.3 million and purchases of our own common stock of $0.8 million.  See the Consolidated Statement of Changes in Stockholders' Equity on page 6 of this report for all of the changes in stockholders' equity between December 31, 2014 and June 30, 2015.

Trust Preferred Securities Under Dodd-Frank: In each of 2003 and 2004, we issued $10 million of trust preferred securities (TRUPs) in a private placement. Under the Federal Reserve Board's historical approach to regulatory capital, TRUPs typically qualified as Tier 1 capital for all bank holding companies, of any size, but only in amounts up to 25% of Tier 1 capital, net of goodwill less any associated deferred tax liability. Under the Dodd-Frank Act, this treatment continues to apply to small- and medium-sized banking organizations like ours, but only with respect to TRUPs issued before May 19, 2010, the Dodd-Frank Act's grandfathering date for TRUPs (our TRUPs were grandfathered). Any trust preferred securities issued by banking organizations like ours on or after the grandfathering date do not and will not qualify as Tier 1 capital under the new bank regulatory capital guidelines. Thus, our currently outstanding TRUPs will continue to qualify as Tier 1 capital until maturity or redemption, but no additional TRUPs issued by us would so qualify.

Stock Repurchase Program: At its regular meeting in October 2014, the Board of Directors approved a new 12-month stock repurchase program (the "2015 program") authorizing the repurchase, at the discretion of senior management, during calendar year 2015 of up to $5 million of Arrow's common stock in open market or privately negotiated transactions. This program replaced a similar $5 million stock repurchase program which had been approved by the Board in November 2013 for calendar year 2014 (the "2014 program"). Under the 2015 program, management is authorized to effect stock repurchases from time-to-time, to the extent that it believes the Company's stock is reasonably priced and such repurchases are an appropriate use of available capital and in the best interests of stockholders. Through June 30, 2015, approximately $700 thousand of Arrow's common stock (27,000 shares) had been repurchased by the Company under the 2015 program.


# 50



Dividends: Our common stock is traded on NasdaqGS® - AROW. The high and low stock prices for the past five quarters listed below represent actual sales transactions, as reported by NASDAQ. On July 29, 2015, our Board of Directors declared a 2015 third quarter cash dividend of $.25 payable on September 15, 2015. Per share amounts in the following table have been restated for our September 2014 2% stock dividend.
 
 
 
 
 
Cash
 
Market Price
 
Dividends
 
Low
 
High
 
Declared
2014
 
 
 
 
 
First Quarter
$
24.02

 
$
26.94

 
$
0.245

Second Quarter
24.31

 
26.46

 
0.245

Third Quarter
24.82

 
26.46

 
0.245

Fourth Quarter
25.10

 
27.93

 
0.250

2015
 
 
 
 
 
First Quarter
$
25.55

 
$
27.53

 
$
0.250

Second Quarter
25.28

 
28.00

 
0.250

Third Quarter (dividend payable September 15, 2015)
 
 
 
 
0.250

 
Quarter Ended June 30,
 
2015
 
2014
Cash Dividends Per Share
0.250

 
0.250

Diluted Earnings Per Share
0.5

 
0.44

Dividend Payout Ratio
50.00
%
 
56.82
%
Total Equity (in thousands)
$
206,947

 
$
197,616

Shares Issued and Outstanding (in thousands)
12,623

 
12,597

Book Value Per Share
$
16.39

 
$
15.69

Intangible Assets (in thousands)
$
25,372

 
$
25,868

Tangible Book Value Per Share
$
14.38

 
$
13.63

LIQUIDITY
The objective of effective liquidity management is to ensure that we have the ability to raise cash when we need it at a reasonable cost.  We must be capable of meeting expected and unexpected obligations to our customers at any time.  Given the uncertain nature of customer demand as well as the need to maximize earnings, we must have available reasonably priced sources of funds, both on- and off-balance sheet, that can be accessed quickly in time of need.
Our primary sources of available liquidity have been and remain overnight investments in federal funds sold, interest bearing bank balances at the Federal Reserve Bank, and cash flow from maturing investment securities and loans.  In addition, certain investment securities are selected at purchase as available-for-sale based on their marketability and collateral value, as well as their yield and maturity.  Our securities available-for-sale portfolio was $391.8 million at June 30, 2015, an increase of $25.7 million, or 7.0%, from the year-end 2014 level. Due to the potential for volatility in market values, we are not always able to assume that securities may be sold on short notice at their carrying value, even to provide needed liquidity.
In addition to liquidity from federal funds, short-term balances at the Federal Reserve Bank, and maturing or marketable investment securities and loans, we have supplemented available operating liquidity with additional off-balance sheet sources such as federal funds lines of credit and credit lines with the Federal Home Loan Bank of New York ("FHLBNY"). Our federal funds lines of credit are with two correspondent banks totaling $35 million, but we did not draw on these lines during 2014 or the first six months of 2015.
To support our borrowing capacity with the FHLBNY, we have pledged collateral, including mortgage-backed securities and residential mortgage loans. Our unused borrowing capacity at the FHLBNY was approximately $214.9 million at June 30, 2015, with approximately $84.5 million in advances then outstanding. In addition we have identified brokered deposits as an appropriate off-balance sheet source of funding accessible in a relatively short time period. Also, our two bank subsidiaries have each established a borrowing facility with the Federal Reserve Bank of New York, pledging certain consumer loans as collateral for potential "discount window" advances, which we maintain for contingency liquidity purposes. At June 30, 2015, the amount available under this facility was approximately $318.9 million, with no advances then outstanding.    
We measure and monitor our basic liquidity as a ratio of liquid assets to total short-term liabilities, both with and without the availability of borrowing arrangements. Based on the level of overnight funds investments, available liquidity from our investment securities portfolio, cash flows from our loan portfolio, our stable core deposit base and our significant borrowing capacity, we believe that our liquidity is sufficient to meet all funding needs that may arise in connection with any reasonably likely events or occurrences. At June 30, 2015, our basic liquidity ratio, including our FHLB collateralized borrowing capacity, was 9.8% of total assets, or $136 million, well in excess of our internally-set minimum target ratio of 4% of total assets.


# 51



RESULTS OF OPERATIONS
Three Months Ended June 30, 2015 Compared With
Three Months Ended June 30, 2014

Summary of Earnings Performance
(Dollars in Thousands, Except Per Share Amounts)
 
Quarter Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Net Income
$
6,305

 
$
5,524

 
$
781

 
14.1
%
Diluted Earnings Per Share
0.50

 
0.44

 
0.06

 
13.6

Return on Average Assets
1.09
%
 
1.01
%
 
0.08
%
 
7.9

Return on Average Equity
12.23
%
 
11.28
%
 
0.95
%
 
8.4

    
We reported earnings (net income) of $6.3 million and diluted earnings per share (EPS) of $.50 for the second quarter of 2015, compared to net income of $5.5 million and diluted EPS of $.44 for the second quarter of 2014.
We experienced net gains of $10 thousand, net of tax, on the sale of securities in the 2015 quarter, compared to net losses of $16 thousand, net of tax, in the 2014 quarter.

    The following narrative discusses the quarter-to-quarter changes in net interest income, noninterest income, noninterest expense and income taxes.
Net Interest Income
Summary of Net Interest Income
(Taxable Equivalent Basis, Dollars in Thousands)
 
Quarter Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Interest and Dividend Income
$
18,501

 
$
17,837

 
$
664

 
3.7
 %
Interest Expense
1,243

 
1,555

 
(312
)
 
(20.1
)
Net Interest Income
17,258

 
16,282

 
976

 
6.0

Tax-Equivalent Adjustment
1,094

 
1,142

 
(48
)
 
(4.2
)
Average Earning Assets (1)
2,195,166

 
2,063,213

 
131,953

 
6.4

Average Interest-Bearing Liabilities
1,770,023

 
1,680,149

 
89,874

 
5.3

 
 
 
 
 
 
 
 
Yield on Earning Assets (1)
3.38
%
 
3.47
%
 
(0.09
)%
 
(2.6
)
Cost of Interest-Bearing Liabilities
0.28

 
0.37

 
(0.09
)
 
(24.3
)
Net Interest Spread
3.10

 
3.10

 

 

Net Interest Margin
3.15

 
3.17

 
(0.02
)
 
(0.6
)
(1) Includes Nonaccrual Loans
Between the second quarter of 2014 and the second quarter of 2015, our net interest margin (net interest income on a tax-equivalent basis divided by average earning assets, annualized) decreased by 2 basis points, from 3.17% to 3.15%, representing a 0.6% decrease in our margin. (See the discussion under “Use of Non-GAAP Financial Measures,” on page 35, regarding our net interest margin and net interest income, which are commonly used non-GAAP financial measures.) Among other things, this decrease in net interest margin reflected the offsetting impact of a decrease in all categories in interest-bearing liabilities and a similar decrease in the yield on our loan portfolio. Our persistent multi-year experience of margin compression may well continue in upcoming periods, and if rates do begin to move broadly upward, our liabilities initially may reprice more rapidly than our assets (which typically would have a negative effect on our margins). Net interest income for the just completed quarter, on a taxable equivalent basis, increased by $0.98 million, or 6.0%, from the second quarter of 2014, as the slight decrease in our net interest margin between the periods was more than offset by a 6.4% increase in the level of our average earning assets. The impact of recent interest rate changes on our net interest margin and net interest income are discussed above in this Report under the sections entitled “Deposit Trends” and “Loan Trends.”     
As discussed previously under the heading "Asset Quality" beginning on page 47, the provision for loan losses for the second quarter of 2015 was $70 thousand, compared to a provision of $505 thousand for the 2014 quarter.

# 52



Noninterest Income
Summary of Noninterest Income
(Dollars in Thousands)
 
Quarter Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Income From Fiduciary Activities
$
2,051

 
$
1,906

 
$
145

 
7.6
 %
Fees for Other Services to Customers
2,334

 
2,377

 
(43
)
 
(1.8
)
Insurance Commissions
2,367

 
2,293

 
74

 
3.2

Net (Loss) Gain on Securities Transactions
16

 
(27
)
 
43

 
(159.3
)
Net Gain on the Sale of Loans
120

 
166

 
(46
)
 
(27.7
)
Other Operating Income
556

 
304

 
252

 
82.9

Total Noninterest Income
$
7,444

 
$
7,019

 
$
425

 
6.1

    
Total noninterest income in the just completed quarter was $7.4 million, an increase of $425 thousand, or 6.1%, from total noninterest income of $7.0 million for the second quarter of 2014.
We experienced modest increases in all major categories except for fees for other services to customers, which decreased by $43 thousand, or 1.8%, primarily due to a decrease in revenues related service charges on deposit accounts. Income from fiduciary activities in the 2014 quarter increased by $145 thousand, or 7.6%, from the comparable 2014 quarter. This source of noninterest income typically tracks the dollar value of assets under administration. At quarter-end 2015, the market value of assets under trust administration and investment management amounted to $1.247 billion, an increase of $32.0 million, or 2.6%, from June 30, 2014. The increase was generally attributable to a significant rise in the equity markets between the reporting dates and the addition of new accounts.
As mentioned above, fees for other services to customers decreased by $43 thousand, or 1.8%, compared to the prior year quarter, primarily due to a decrease in service charge fee income on deposit accounts, as customers continued to expand their utilization of electronic delivery of transaction information and thus become more effective in managing their accounts with us (i.e., fewer overdrafts). In addition to service charge income on deposits, this category also includes debit card interchange income (which increased modestly between the two period), revenues related to the sale of mutual funds to our customers by third party providers (which decreased between the two periods), and servicing income on sold loans (nearly unchanged). Effective October 1, 2011 Visa announced new, reduced debit interchange rates and related modifications to comply with new debit card interchange fee rules promulgated by the Federal Reserve under the Dodd-Frank Act. This reduced rate structure has had, and will continue to have, a slight but noticeable negative impact on our fee income. However, debit card usage by our customers continues to grow which has offset at least in part, the negative effect of reduced debit interchange rates. If this usage continues to grow, it will continue to offset the negative impact of reduced interchange fees. Generally, we do not believe that Visa's new limits on interchange fees resulting from Dodd-Frank will have a material adverse impact on our financial condition or results of operations in future periods. However, there is currently a lawsuit challenging the existing post Dodd-Frank fee structure as too high. The Federal Reserve Bank successfully asked the court to permit retention of the current fee structure until the case is settled.
The increase in other operating income in the second quarter of 2015 versus the second quarter of 2014 was primarily attributable to gains recognized in our investment in business incubator types of limited partnerships.
Noninterest Expense
Summary of Noninterest Expense
(Dollars in Thousands)
 
Quarter Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Salaries and Employee Benefits
$
8,186

 
$
7,880

 
$
306

 
3.9
 %
Occupancy Expense of Premises, Net
1,256

 
1,268

 
(12
)
 
(0.9
)
Furniture and Equipment Expense
1,088

 
1,048

 
40

 
3.8

FDIC and FICO Assessments
296

 
282

 
14

 
5.0

Amortization
80

 
94

 
(14
)
 
(14.9
)
Other Operating Expense
3,477

 
3,165

 
312

 
9.9

Total Noninterest Expense
$
14,383

 
$
13,737

 
$
646

 
4.7

Efficiency Ratio
57.94
%
 
58.48
%
 
(0.54
)%
 
(0.9
)
    
Noninterest expense for the second quarter of 2015 was $14.4 million, an increase of $646 thousand, or 4.7%, from the expense for the second quarter of 2014. For the second quarter of 2015, our efficiency ratio was 57.94%, down by 54 basis points from our ratio for the comparable 2014 quarter. This ratio, which is a commonly used non-GAAP financial measure in the banking industry, is a comparative measure of a financial institution's operating efficiency. The efficiency ratio (a ratio where lower is better) is the ratio of noninterest expense (excluding, under our definition, intangible asset amortization) to (i) net interest income (on a tax-equivalent basis) plus (ii) noninterest income (excluding net securities gains or losses). The efficiency ratio is further discussed on page 35 of this Report under the heading “Use of Non-GAAP Financial Measures.” The efficiency ratio included by the Federal Reserve Board in its "Peer Holding Company Performance Reports" excludes net securities gains or losses from the denominator (as does our calculation), but unlike our ratio does not exclude intangible asset amortization from the numerator. The favorable change in our efficiency ratio between the periods reflected the fact that our core gross income grew faster than our operating expenses. Our efficiency ratios in recent periods have also compared

# 53



favorably to the ratios of our peer group, even after adjusting for the definitional difference. For the year quarter ended March 31, 2015 (the most recent reporting period for which peer group information is available), the peer group efficiency ratio was 69.59%, and our ratio was 58.75% (not adjusted).
Salaries and employee benefits expense increased 3.9% in the second quarter of 2015 over the 2014 quarter, reflecting the combined effect of a 2.7% increase in salaries and a 7.1% increase in benefits. The increase in our benefit expenses was primarily attributable to higher pension costs during the current period.
The increase in furniture and equipment expense was attributable to increases in data processing expenses.
The increase in other operating expense between the periods was primarily attributable to an increase in legal and professional fees.
Income Taxes
Summary of Income Taxes
(Dollars in Thousands)
 
Quarter Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Provision for Income Taxes
$
2,850

 
$
2,393

 
$
457

 
19.1
%
Effective Tax Rate
31.1
%
 
30.2
%
 
0.9

 
3.0

The provisions for federal and state income taxes amounted to $2.9 million and $2.4 million for the respective three-month periods of 2015 and 2014. The increase in the effective tax rate was primarily attributable to the fact that our tax-exempt income did not increase to the same extent as our taxable income.

RESULTS OF OPERATIONS
Six Months Ended June 30, 2015 Compared With
Six Months Ended June 30, 2014

Summary of Earnings Performance
(Dollars in Thousands, Except Per Share Amounts)
 
Six Month Period Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Net Income
$
12,160

 
$
10,844

 
$
1,316

 
12.1
%
Diluted Earnings Per Share
0.96

 
0.86

 
0.10

 
11.6

Return on Average Assets
1.07
%
 
1.00
%
 
0.07
%
 
7.0

Return on Average Equity
11.98
%
 
11.20
%
 
0.78
%
 
7.0

    
We reported earnings (net income) of $12.2 million and diluted earnings per share (EPS) of $.96 for the six-month period of 2015, an improvement over net income of $10.8 million and diluted EPS of $.86 for the 2014 six-month period.
In the 2015 six-month period we experienced net losses on the sales of securities of $64 thousand, net of tax, compared to net gains of $16 thousand , net of tax, in the 2014 period. Moreover, our net gains on sales of loans, net of tax, in the 2015 six-month period were only $152 thousand, compared to $289 thousand for the 2014 period.

    The following narrative discusses the changes between the respective six-month periods in net interest income, noninterest income, noninterest expense and income taxes.
Net Interest Income
Summary of Net Interest Income
(Taxable Equivalent Basis, Dollars in Thousands)
 
Six Month Period Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Interest and Dividend Income
$
36,574

 
$
35,276

 
$
1,298

 
3.7
 %
Interest Expense
2,329

 
3,149

 
$
(820
)
 
(26.0
)%
Net Interest Income
34,245

 
32,127

 
$
2,118

 
6.6
 %
Tax-Equivalent Adjustment
2,177

 
2,315

 
$
(138
)
 
(6.0
)%
Average Earning Assets (1)
2,160,933

 
2,060,046

 
$
100,887

 
4.9
 %
Average Interest-Bearing Liabilities
1,741,794

 
1,679,119

 
$
62,675

 
3.7
 %
 
 
 
 
 
 
 

Yield on Earning Assets (1)
3.41
%
 
3.45
%
 
(0.04
)%
 
(1.2
)%
Cost of Interest-Bearing Liabilities
0.27

 
0.38

 
(0.11
)
 
(28.9
)%
Net Interest Spread
3.14

 
3.07

 
0.07

 
2.3
 %
Net Interest Margin
3.20

 
3.14

 
0.06

 
1.9
 %
(1) Includes Nonaccrual Loans

# 54



Our net interest margin (net interest income on a tax-equivalent basis divided by average earning assets, annualized) increased by 6 basis points, from 3.14% to 3.20%, between the 2014 six-month period and the 2015 six-month period, representing a 1.9% increase in the margin. All of this year-over-year margin increase for the period occurred in the respective first quarters. Our net interest margin in the second quarter of 2015 was slightly lower (by 2 basis points) than our net interest margin in the second quarter of 2014. (See the discussion under “Use of Non-GAAP Financial Measures,” on page 35, regarding our net interest margin and net interest income, which are commonly used non-GAAP financial measures.) Net interest income for the just completed six-month period, on a taxable equivalent basis, increased by $1.3 million, or 3.7%, from the 2014 six-month period, as the overall increase in our net interest margin between the periods was enhanced by the positive impact of a 4.9% increase in the level of our average earning assets. The impact of recent interest rate changes in the U.S. economy generally on our net interest margin and net interest income are discussed above in this Report under the sections entitled “Deposit Trends” and “Loan Trends.”     
As discussed previously under the heading "Asset Quality" beginning on page 47, the provisions for loan losses for the six-month periods ended June 30, 2015 and 2014 were $345 thousand and $963 thousand, respectively.
Noninterest Income
Summary of Noninterest Income
(Dollars in Thousands)
 
Six Month Period Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Income From Fiduciary Activities
$
3,984

 
$
3,779

 
$
205

 
5.4
 %
Fees for Other Services to Customers
4,573

 
4,571

 
2

 
 %
Insurance Commissions
4,506

 
4,737

 
(231
)
 
(4.9
)%
Net (Loss) Gain on Securities Transactions
106

 
(27
)
 
133

 
(492.6
)%
Net Gain on the Sale of Loans
252

 
289

 
(37
)
 
(12.8
)%
Other Operating Income
879

 
556

 
323

 
58.1
 %
Total Noninterest Income
$
14,300

 
$
13,905

 
$
395

 
2.8
 %
    
Total noninterest income in the just completed six-month period was $14.3 million, an increase of $395 thousand, or 2.8%, from total noninterest income of $13.9 million for the 2014 period. We experienced increases in all major categories, between the two six-month period, except insurance commissions (which increased in the second quarter of 2015 compared to the second quarter of 2014, but not enough to offset the decrease in insurance commissions between the first quarters of the two years). Net securities gains of $106 thousand in the current year period contrasted with a $27 thousand loss in the 2014 period. We experienced a decrease in net gains on the sale of loans between the two periods as we began to taper our sales of loans to the secondary market during the second half of 2014 and this trend continued in the first six months of 2015.
Insurance commission income decreased from $4.7 million for the first six months of 2014 to $4.5 million for the first six months of 2015, a decrease of $231 thousand, or 4.9%. This decrease, all of which was concentrated in the first quarter of 2015, was attributable to a decrease in annual contingent commission income received from certain insurance carriers in the 2015 period and from a decline in property and casualty commission income. Income from fiduciary activities increased $205 thousand, or 5.4%, from the comparable 2014 period. See our discussion on the changes in the market value of assets under trust administration and investment management, in the section above under the heading "RESULTS OF OPERATIONS -- Three Months Ended June 30, 2015 Compared with Three Months Ended June 30, 2014--Summary of Non-Interest Income."
Fees for other services to customers includes service charges on deposit accounts, debit card interchange fees, revenues related to the sale of mutual funds to our customers by third party providers and servicing income on sold loans. While the level of fees for other services to customers between the 2014 six-month period and the 2015 six-moth period was essentially unchanged, as mentioned in our earlier discussion of the quarter-to-date changes, we expect the trend where customers progressively reduce their overdraft fees by managing their deposit accounts more effectively (by utilizing electronic delivery of transaction information) to continue over the remaining two quarters of 2015. See the discussion above under the heading "RESULTS OF OPERATIONS-- Three Months Ended June 30, 2015 Compared with Three Months Ended June 30, 2014--Summary of Non-Interest Income."
The increase in other operating income in the 2015 period versus the 2014 period was primarily due to gains recognized in our investment in business incubator types of limited partnerships and an increase in income from our investment in bank-owned life insurance.

# 55



Noninterest Expense
Summary of Noninterest Expense
(Dollars in Thousands)
 
Six Month Period Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Salaries and Employee Benefits
$
15,878

 
$
15,522

 
$
356

 
2.3
 %
Occupancy Expense of Premises, Net
2,614

 
2,573

 
41

 
1.6
 %
Furniture and Equipment Expense
2,217

 
2,084

 
133

 
6.4
 %
FDIC and FICO Assessments
576

 
555

 
21

 
3.8
 %
Amortization
171

 
200

 
(29
)
 
(14.5
)%
Other Operating Expense
6,882

 
6,269

 
613

 
9.8
 %
Total Noninterest Expense
$
28,338

 
$
27,203

 
$
1,135

 
4.2
 %
Efficiency Ratio
58.15
%
 
58.63
%
 
(0.48
)%
 
(0.8
)
    
Noninterest expense for the 2015 six-month period was $28.3 million, an increase of $1.1 million, or 4.2%, over the total expense for the 2014 six-month period. For the 2015 six-month period, our efficiency ratio was 58.15% versus 58.63% in the 2014 period. This ratio, which is a commonly used non-GAAP financial measure in the banking industry, is a comparative measure of a financial institution's operating efficiency. The efficiency ratio (a ratio where lower is better) is the ratio of noninterest expense (excluding, under our definition, intangible asset amortization) to (i) net interest income (on a tax-equivalent basis) plus (ii) noninterest income (excluding net securities gains or losses). See the discussion on page 35 of this Report under the heading “Use of Non-GAAP Financial Measures.” The efficiency ratio included by the Federal Reserve Board in its "Peer Holding Company Performance Reports" excludes net securities gains or losses from the denominator (as does our calculation), but unlike our ratio does not exclude intangible asset amortization from the numerator. The favorable change in our efficiency ratio between the periods reflected the fact that our core gross income grew faster than our operating expenses. Our efficiency ratios in recent periods have also compared favorably to the ratios of our peer group, even after adjusting for the definitional difference. For the year quarter ended March 31, 2015 (the most recent reporting period for which peer group information is available), the peer group efficiency ratio was 69.59%, and our ratio was 58.75% (not adjusted).
Salaries and employee benefits expense increased by 2.3% for the 2015 six-month period, compared to the 2014 period, representing a 3.6% increase in salaries offset, in part, by a 1.1% decrease in benefits. The decrease in our benefit expenses was primarily attributable to lower health care costs in the first quarter of 2015, a trend which we did not expect to continue, and which did not continue, during the second quarter, when such costs returned to near normal levels.
The increase in furniture and equipment expense was primarily attributable to increases in data processing expenses.
The subcategory of other operating expense demonstrating the largest increase between the periods was legal and professional expenses.

Income Taxes
Summary of Income Taxes
(Dollars in Thousands)
 
Six Month Period Ended
 
 
 
 
 
06/30/2015
 
06/30/2014
 
Change
 
% Change
Provision for Income Taxes
$
5,525

 
$
4,707

 
$
818

 
17.4
%
Effective Tax Rate
31.2
%
 
30.3
%
 
0.9

 
3.0

The provisions for federal and state income taxes amounted to $5.5 million and $4.7 million for the respective six-month periods of 2015 and 2014. The increase in the effective tax rate was primarily attributable to a one-time historical rehabilitation tax credit experienced in the 2014 period and a decrease between the two period in our utilization of tax-exempt interest investments.

    
    

# 56



Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In addition to credit risk in our loan portfolio and liquidity risk, discussed on page 51 of this Report, we have market risk in our business activities. Market risk is the possibility that changes in future market rates (interest rates) or prices (fees for products and services) will make our position less valuable. The ongoing monitoring and management of market risk, principally interest rate risk, is an important component of our asset/liability management process, which is governed by policies that are reviewed and approved annually by the Board of Directors. The Board of Directors delegates responsibility for carrying out asset/liability oversight and control to management’s Asset/Liability Committee (“ALCO”). In this capacity ALCO develops guidelines and strategies impacting our asset/liability profile based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. As of the date of this report, we have not made use of derivatives, such as interest rate swaps, in our risk management process.
Interest rate risk is the exposure of our net interest income to changes in interest rates. Interest rate risk is directly related to the different maturities and repricing characteristics of interest-bearing assets and liabilities, as well as to the risk of prepayment of loans and early withdrawal of time deposits, and the fact that the speed and magnitude of responses to interest rate changes vary by product.
The ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes. While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk.
Our current simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all interest rate-sensitive assets and liabilities reflected on our consolidated balance sheet. This sensitivity analysis is compared to pre-established ALCO policy limits which specify a maximum tolerance level for net interest income exposure over a one year horizon. Our current sensitivity analysis model examines both a hypothetical upward shift of interest rates (currently, 200 basis points) and a hypothetical downward shift in interest rates (currently, 100 basis points, subject to certain zero rate limitations), and assumes no subsequent change in the balance sheet and a repricing of interest-bearing assets and liabilities at their earliest reasonably predictable repricing dates. For repricing purposes, we normally assume a parallel and pro-rata shift in rates for both assets and liabilities, over a 12 month period.
We occasionally need to make ad hoc adjustments to our model. During recent years, the Federal Reserve's targeted federal funds rate has remained within a range of 0 to .25%. The resulting abnormally low prevailing short-term rates have led us to revise our standard model for the decreasing interest rate simulation for short-term liabilities and assets. While we have applied our usual 100 basis point downward shift in interest rates for liabilities and assets on the long end of the yield curve, we have assumed an absolute floor of a zero interest rate for the modeling of our short-term liabilities and assets. Moreover, for purposes of determining the effect of a hypothetical downward shift in rates under our current simulation model, we have made no downward shift at all in interest rates for our short-term liabilities and assets, even if such rates slightly exceed zero at the measurement date. We also assume that hypothetical interest rate shifts, upward or downward, affect assets and liabilities simultaneously, depending solely upon the contractual maturities of the particular assets and liabilities in question. In practice, however, shifts in prevailing interest rates typically affect our liability portfolios (primarily deposits) more rapidly than our asset portfolios, irrespective of differences in contractual maturities (which also tend to be of longer duration on the asset side).
Applying the simulation model analysis as of June 30, 2015, a 200 basis point increase in all interest rates demonstrated a 2.53% decrease in net interest income over the ensuing 12 month period, and a 100 basis point decrease in long-term interest rates (with no decrease in short-term rates, or adjusted as discussed above) demonstrated a 1.26% decrease in net interest income, when compared with our base projection. These amounts were well within our ALCO policy limits. The preceding sensitivity analysis does not represent a forecast on our part and should not be relied upon as being indicative of expected operating results.
The hypothetical estimates underlying the sensitivity analysis are based upon numerous assumptions including: the nature and timing of changes in interest rates including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others. While assumptions are developed based upon current economic and local market conditions, we cannot make any assurance as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.
Also, as market conditions vary from those assumed in the sensitivity analysis, actual results may differ due to: prepayment/refinancing levels deviating from those assumed, the varying impact of interest rate changes on caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, unanticipated shifts in the yield curve and other internal/external variables. Furthermore, the sensitivity analysis does not reflect balance sheet growth or actions that ALCO might take in responding to or anticipating changes in interest rates.
In general, our interest-bearing liabilities will reprice more rapidly in a rising rate environment than our interest-earning assets, resulting in a further short-term decrease in net interest income in a rising rate environment, beyond that reported in the simulation analysis, above. However, many of our interest-earning assets have relatively short lives and within a relatively few quarters after the first year period following a rise in rates we would expect a corresponding positive impact from the repricing of these interest-earning assets.

Item 4.
CONTROLS AND PROCEDURES
Senior management, including the Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of Arrow's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of June 30, 2015. Based upon that evaluation, senior management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective. Further, there were no changes made in our internal control over financial reporting that occurred during the most recent fiscal quarter that had materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


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PART II - OTHER INFORMATION
Item 1.
Legal Proceedings
We are not currently the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of our business. On an ongoing basis, we are the subject of, or a party to, various legal claims by other parties against us, by us against other parties, or involving us, which arise in the normal course of our business. The various pending legal claims against us will not, in the opinion of management based upon consultation with counsel, result in any material liability.

Item 1.A.
Risk Factors
We believe that the Risk Factors identified in our Annual Report on Form 10-K for the year ended December 31, 2014, continue to represent the most significant risks to our future results of operations and financial conditions, without modification or amendment. Please refer to such Risk Factors as listed in Part I, Item 1A, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2014.

Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
Unregistered Sales of Equity Securities

None
Issuer Purchases of Equity Securities
The following table presents information about purchases by Arrow of its common stock during the quarter ended June 30, 2015:
Second Quarter
2015
Calendar Month
(A)
Total Number of
Shares Purchased 1
 
(B)
Average Price
Paid Per Share 1
 
(C)
Total Number of
Shares Purchased as
Part of Publicly
Announced
Plans or Programs 2
 
(D)
Maximum
Approximate Dollar
Value of Shares that
May Yet be
Purchased Under the
Plans or Programs 3
April
4,613

 
$
26.90

 

 
$
5,000,000

May
12,326

 
25.95

 
10,000

 
4,741,100

June
34,327

 
26.44

 
17,000

 
4,294,710

Total
51,266

 
26.37

 
27,000

 
 
1 The total number of shares of Common Stock purchased by the Company in each month in the quarter and the average price paid per share are listed in columns A and B, respectively. All shares identified in column A were shares purchased by the Company either (i) under its publicly-announced 2015 Repurchase Program, described further below, or (ii) in open market transactions under the Arrow Financial Corporation Automatic Dividend Reinvestment Plan (DRIP) by the administrator of the DRIP. In the months indicated, the total number of shares identified in column A included those shares purchased under the 2015 Repurchase Program and identified in column C, along with shares purchased under the DRIP by the administrator as follows: April – 4,613 shares; May – 2,326 shares; and June – 17,327 shares.
2 All 27,000 shares repurchased by the Company in the quarter were repurchased under the publicly-announced 2015 Repurchase Program (i.e., the $5 million stock repurchase program authorized by the Board of Directors in October 2014 and effective January 1, 2015).
3 Represents the dollar amount of repurchase authority remaining at each month-end during the quarter under the 2015 Repurchase Program.
Item 3.
Defaults Upon Senior Securities - None
Item 4.
Mine Safety Disclosures - None
Item 5.
Other Information - None


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Item 6.
Exhibits
Exhibit Number
Exhibit
15
Awareness Letter
31.1
Certification of Chief Executive Officer under SEC Rule 13a-14(a)/15d-14(a)
31.2
Certification of Chief Financial Officer under SEC Rule 13a-14(a)/15d-14(a)
32
Certification of Chief Executive Officer under 18 U.S.C. Section 1350 and
   Certification of Chief Financial Officer under 18 U.S.C. Section 1350
101.INS
XBRL Instance Document
101.SCH
XBRL Taxonomy Extension Schema Document
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
101.LAB
XBRL Taxonomy Extension Labels Linkbase Document
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
 



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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
ARROW FINANCIAL CORPORATION
Registrant
 
 
August 6, 2015
/s/Thomas J. Murphy
Date
Thomas J. Murphy, President and
 
Chief Executive Officer
 
 
August 6, 2015
/s/Terry R. Goodemote
Date
Terry R. Goodemote, Executive Vice President,
 
Treasurer and Chief Financial Officer
 
(Principal Financial Officer and
 
Principal Accounting Officer)



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