FIRST KEYSTONE CORP First Keystone Corporation Management’s Discussion and Analysis of Financial Condition and Results of Operation (form 10-Q)

This quarterly report contains certain forward-looking statements, which are
included pursuant to the “safeharbor” provisions of the Private Securities
Litigation Reform Act of 1995, and reflect management’s beliefs and expectations
based on information currently available. These forward-looking statements are
inherently subject to significant risks and uncertainties, including changes in
general economic and financial market conditions, the Company’s ability to
effectively carry out its business plans and changes in regulatory or
legislative requirements. Other factors that could cause or contribute to such
differences are changes in competitive conditions, and pending or threatened
litigation. Although management believes the expectations reflected in such
forward-looking statements are reasonable, actual results may differ materially.

CRITICAL ACCOUNTING ESTIMATES

The Company has chosen accounting policies that it believes are appropriate to
accurately and fairly report its operating results and financial position, and
the Company applies those accounting policies in a consistent manner. The
Significant Accounting Policies are summarized in Note 1 to the consolidated
financial statements included in the 2021 Annual Report on Form 10-K. There have
been no changes to the Critical Accounting Estimates since the Company filed its
Annual Report on Form 10-K for the year ended December 31, 2021.

RESULTS OF OPERATIONS

Quarter ended June 30, 2022 compared to quarter ended June 30, 2021

First Keystone Corporation realized earnings for the three months ended
June 30, 2022 of $3,822,000, an increase of $217,000, or 6.0% from the second
quarter of 2021. The increase in net income for the three months ended
June 30, 2022 was primarily due to an increase in interest income, mainly due to
increased interest rates and growth in commercial real estate loans and
increased interest and dividend income earned on securities.

On a per share basis, for the three months ended June 30, 2022, net income was
$0.64 versus $0.61 for the same three month period of 2021. Cash dividends
amounted to $0.28 and $0.27 per share for the three months ended June 30, 2022
and 2021, respectively.

NET INTEREST INCOME

The major source of operating income for the Company is net interest income,
defined as interest income less interest expense. In the three months ended
June 30, 2022, interest income amounted to $11,111,000, an increase of $852,000
or 8.3% from the three months ended June 30, 2021, while interest expense
amounted to $1,330,000 in the three months ended June 30, 2022, an increase of
$42,000 or 3.3% from the three months ended June 30, 2021. As a result, net
interest income increased $810,000 or 9.0% to $9,781,000 from $8,971,000 for the
same period in 2021.

The Company’s net interest margin for the three months ended June 30, 2022 was
3.36% compared to 3.23% for same period in 2021. The increase in net interest
margin was primarily a result of increases in yields earned on securities and
commercial loans.

PROVISION FOR LOAN LOSSES

The provision for loan losses for the three months ended June 30, 2022 and 2021
was $218,000 and $135,000, respectively. The increase in the provision for loan
losses resulted from the Company’s analysis of the current loan portfolio,
including historic losses, past-due trends, current economic conditions, loan
portfolio growth, and other relevant factors. The provision for loan losses for
the three months ended June 30, 2022 is also reflective of management’s
assessment of the continued credit risk associated with the uncertainty
surrounding geopolitical and economic concerns. Charge-off and recovery activity
in the allowance for loan losses resulted in net recoveries of $5,000


                                       39

and net charge-offs of $58,000 for the the three months ended June 30, 2022 and
2021, respectively. See Allowance for Loan Losses on page 45 for further
discussion.

NON-INTEREST INCOME

Total non-interest income was $1,514,000 for the three months ended
June 30, 2022, as compared to $1,865,000 for the same period in 2021, a decrease
of $351,000, or 18.8%.

Net securities (losses) gains decreased $96,000 to ($68,000) for the three
months ended June 30, 2022 as compared to the three months ended June 30, 2021.
This decrease was due to the Company recognizing $68,000 in net losses on held
equity securities in the second quarter of 2022 as compared to recognizing
$28,000 in net gains on held equity securities in the second quarter of 2021.
Trust department income increased $3,000 or 1.1% to $268,000 for the three
months ended June 30, 2022 as compared to the same period in 2021.

Service charges and fee income increased $68,000 or 14.1%. The increase was
mainly due to increases in overdraft fees as compared to the same period in
2021. ATM fees and debit card income decreased $10,000 or 1.8% to $558,000 for
the three months ended June 30, 2022.

Net (losses) gains on sales of mortgage loans decreased $308,000 or 100.0% to $0
due to no sales of mortgage loans in the second quarter of 2022 as the rate
environment has led to many loans being sold at a loss and there have been fewer
mortgages originated with intent to sell. Other non-interest income decreased
$6,000 or 9.2% to $59,000 for the three months ended June 30, 2022.

NON-INTEREST EXPENSE

Total non-interest expense was $6,595,000 for the three months ended
June 30, 2022, as compared to $6,547,000 for the three months ended
June 30, 2021

Expenses associated with employees (salaries and employee benefits) continue to
be the largest category of non-interest expense. Salaries and benefits amounted
to $3,462,000 or 52.5% of total non-interest expense for the three months ended
June 30, 2022, as compared to $3,461,000 or 52.9% for the three months ended
June 30, 2021.

Net occupancy, furniture and equipment, and computer expense amounted to
$983,000 for the three months ended June 30, 2022, an increase of $43,000 or
4.6% which was due to the implementation of several new software programs
throughout 2021 and early 2022 to increase security and efficiency. Professional
services increased $97,000 or 35.5% to $370,000 as of June 30, 2022. The
increase was mainly the result of an increase in consulting expense as the
result of strategic planning and consulting services associated with
implementing new internal systems contracts along with normal increases in
annual audit expenses. Pennsylvania shares tax expense amounted to $324,000 for
the three months ended June 30, 2022, an increase of $11,000 or 3.5% as compared
to the three months ended June 30, 2021.

Federal Deposit Insurance Corporation (“FDIC”) insurance expense amounted to
$120,000 for the three months ended June 30, 2022 and 2021. FDIC insurance
expense varies with changes in net asset size, risk ratings, and FDIC derived
assessment rates.

ATM and debit card fees expense amounted to $242,000 for the three months ended
June 30, 2022, a decrease of $41,000 or 14.5% as compared to the three months
ended June 30, 2021. The decrease was the result of negotiations of new internal
systems contracts resulting in vendor relationship credits that were applied to
the expenses related to those systems. Data processing expenses amounted to
$251,000 for the three months ended June 30, 2022 as compared to $323,000 for
the same period of 2021, a decrease of $72,000 or 22.3%. This decrease was also
the result of the negotiations of new systems contracts.

Advertising expense amounted to $118,000 in the second quarter of 2022, an
increase of $9,000 or 8.3% as compared to the three months ended June 30, 2021.
Other non-interest expense amounted to $725,000 for the three months ended
June 30, 2022 and 2021.


                                       40

INCOME TAXES

Income tax expense amounted to $660,000 for the three months ended
June 30, 2022, as compared to $549,000 for the three months ended June 30, 2021,
an increase of $111,000. The effective total income tax rate was 14.7% for the
three months ended June 30, 2022 as compared to 13.2% for the three months ended
June 30, 2021. The increase in the effective tax rate was mainly due to higher
overall operating income. The Company recognized $58,000 and $101,000 of tax
credits from low-income housing partnerships in the three months ended
June 30, 2022 and 2021, respectively.

Six months ended June 30, 2022 compared to six months ended June 30, 2021

First Keystone Corporation realized earnings for the six months ended
June 30, 2022 of $7,365,000, a decrease of $118,000, or 1.6% from the same
period in 2021. The decrease in net income for the six months ended
June 30, 2022 was primarily due to less PPP loan fees and a decrease in
non-interest income, mainly due to fewer sales of mortgage loans and net
securities losses.

On a per share basis, net income was $1.24 for the six months ended
June 30, 2022 versus $1.27 for the same period in 2021. Cash dividends amounted
to $0.56 and $0.55 per share for the six months ended June 30, 2022 and 2021,
respectively.




NET INTEREST INCOME



The major source of operating income for the Company is net interest income,
defined as interest income less interest expense. For the six months ended
June 30, 2022, interest income amounted to $21,740,000, an increase of
$1,206,000 or 5.9% from the six months ended June 30, 2021, while interest
expense amounted to $2,503,000 in the six months ended June 30, 2022, a decrease
of $90,000 or 3.5% from the six months ended June 30, 2021. As a result, net
interest income increased $1,296,000 or 7.2% to $19,237,000 from $17,941,000 for
the same period in 2021.

The Company’s net interest margin for the six months ended June 30, 2022 was
3.28% compared to 3.30% for same period in 2021. The decrease in net interest
margin was a result of a decrease in yield earned on loans plus an increase in
cost of short term borrowings.



PROVISION FOR LOAN LOSSES


The provision for loan losses for the six months ended June 30, 2022 and 2021
was $437,000 and $270,000, respectively. The increase in the provision for loan
losses resulted from the Company’s analysis of the current loan portfolio,
including historic losses, past-due trends, current economic conditions, loan
portfolio growth, and other relevant factors. The provision for loan losses for
the six months ended June 30, 2022 is also reflective of management’s assessment
of the continued credit risk associated with the uncertainty surrounding
geopolitical and economic concerns. Charge-off and recovery activity in the
allowance for loan losses resulted in net recoveries of $43,000 and net
charge-offs of $79,000 for the six months ended June 30, 2022 and 2021,
respectively. See Allowance for Loan Losses on page 45 for further discussion.

NON-INTEREST INCOME

Total non-interest income was $2,903,000 for the six months ended June 30, 2022,
as compared to $3,740,000 for the same period in 2021, a decrease of $837,000,
or 22.4%. The decrease was due to recognizing net losses on the sales of
mortgage loans and net securities losses on held equity securities during the
first half of 2022 as compared to recognizing net gains on both during the same
period of 2021.

ATM fees and debit card income decreased $17,000 or 1.6% to $1,067,000 for the
six months ended June 30, 2022. Service charges and fee income increased
$202,000 for the six months ended June 30, 2022. The increase was mainly due to
increased overdraft fees on DDA accounts. Gains on sales of mortgage loans
decreased $696,000 or 105.1% due to a low number of individual loans sold in the
first half of 2022 and many of the loans sold in 2022 being


                                       41

sold at a loss. These factors were due to the current rate environment and fewer
loans being originated with the intent to sell in 2022.

Trust department income was $518,000 for the six months ended June 30, 2022 and
2021. Net securities (losses) gains decreased $274,000 or 191.6% to ($131,000)
for the six months ended June 30, 2022 as compared to the six months ended
June 30, 2021. The decrease was due to the Company recognizing $131,000 in net
losses on held equity securities in the first half of 2022 as compared to
recognizing $143,000 in net gains on held equity securities in the same period
in 2021.




NON-INTEREST EXPENSE



Total non-interest expense was $13,111,000 for the six months ended
June 30, 2022, as compared to $12,744,000 for the six months ended
June 30, 2021. Non-interest expense increased $367,000 or 2.9%.

Expenses associated with employees (salaries and employee benefits) continue to
be the largest category of non-interest expense. Salaries and benefits amounted
to $7,016,000 or 53.5% of total non-interest expense for the six months ended
June 30, 2022, as compared to $6,761,000 or 53.1% for the six months ended
June 30, 2021. The increase was mainly due to normal merit increases and new
hires along with an increase in medical insurance costs as compared to the first
half of 2021.

Net occupancy, furniture and equipment, and computer expense amounted to
$2,000,000 for the six months ended June 30, 2022, an increase of $155,000 or
8.4%. The increase is the result of the implementation of several new software
programs to increase security and efficiency. Professional services increased
$136,000 or 25.6% to $668,000 for the six months ended June 30, 2022. The
increase was mainly the result of an increase in consulting expense as the
result of strategic planning and consulting services associated with
implementing new internal systems contracts along with normal increases in
annual audit expenses. Pennsylvania shares tax expense amounted to $648,000 for
the six months ended June 30, 2022, an increase of $22,000 or 3.5% as compared
to the six months ended June 30, 2021.

FDIC insurance expense increased $50,000 or 24.2% for the six months ended
June 30, 2022. FDIC insurance expense varies with changes in net asset size,
risk ratings, and FDIC derived assessment rates.

ATM and debit card fees expense amounted to $370,000 for the six months ended
June 30, 2022, a decrease of $113,000 or 23.4% as compared to the six months
ended June 30, 2021. The decrease was the result of negotiations of new internal
systems contracts resulting in vendor relationship credits that were applied to
the expenses related to those systems. Data processing expenses amounted to
$509,000 for the six months ended June 30, 2022, a decrease of $108,000 or 17.5%
as compared to the six months ended June 30, 2021. This decrease was also the
result of the negotiations of new systems contracts.

Advertising expense increased $9,000 or 5.0% during the six months ended
June 30, 2022. Other non-interest expense amounted to $1,453,000 for the six
months ended June 30, 2022, a decrease of $36,000 or 2.4% as compared to the six
months ended June 30, 2021. This decrease was mainly due to a decrease in the
provision for unfunded commitments, as the result of higher line of credit usage
and lower officer commitments, along with a decrease in loan collections
expenses, as the result of legal and insurance reimbursements following the
payoff of a non-accrual commercial real estate loan.

INCOME TAXES

Income tax expense amounted to $1,227,000 for the six months ended
June 30, 2022, as compared to $1,184,000 for the six months ended June 30, 2021,
an increase of $43,000. The effective total income tax rate was 14.3% for the
six months ended June 30, 2022 as compared to 13.7% for the six months ended
June 30, 2021. The increase in the effective tax rate was mainly due to higher
overall operating income. The Company recognized $132,000 and $202,000 of tax
credits from low-income housing partnerships in the six months ended
June 30, 2022 and 2021, respectively.

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FINANCIAL CONDITION

SUMMARY

Total assets decreased to $1,304,582,000 as of June 30, 2022, a decrease of
$15,768,000 from year-end 2021. Total assets as of December 31, 2021 amounted to
$1,320,350,000.

Total debt securities available-for-sale decreased $27,656,000 or 6.3% to
$410,260,000 as of June 30, 2022 from December 31, 2021.

Total loans increased $51,979,000 or 6.9% to $804,820,000 as of June 30, 2022
from December 31, 2021. Loan demand grew in the six months ended June 30, 2022
as the Bank has realized an increase in loan originations, primarily in the
commercial real estate portfolio.

Total deposits decreased $84,361,000 or 7.8% to $993,608,000 as of June 30, 2022
from December 31, 2021. The decrease was mainly due to a decrease in highly rate
sensitive deposits and other normal fluctuations.

The Company continues to maintain and manage its asset growth. The Company’s
strong equity capital position provides an opportunity to further leverage its
asset growth. Total borrowings increased in the six months ended June 30, 2022
by $92,346,000 to $154,723,000 from $62,377,000 as of December 31, 2021.
Borrowings increased mainly due to decreased deposit balances and growth in the
loan portfolio.

Total stockholders’ equity amounted to $125,379,000 at June 30, 2022, a decrease
of $23,176,000 or 15.6% from December 31, 2021 due to a decrease in the market
value of the securities portfolio resulting in an accumulated other
comprehensive loss position.

SEGMENT REPORTING

Currently, management measures the performance and allocates the resources of
the Company as a single segment.

EARNING ASSETS

Earning assets are defined as those assets that produce interest income. By
maintaining a healthy asset utilization rate, i.e., the volume of earning assets
as a percentage of total assets, the Company maximizes income. The earning asset
ratio (average interest earning assets divided by average total assets) equaled
94.1% at June 30, 2022 and 94.0% at June 30, 2021. This indicates that the
management of earning assets is a priority and non-earning assets, primarily
cash and due from banks, fixed assets and other assets, are maintained at
minimal levels. The primary earning assets are loans and securities.

Our primary earning asset, total loans, increased to $804,820,000 as of
June 30, 2022, up $51,979,000, or 6.9% since year-end 2021. The loan portfolio
continues to be well diversified. Non-performing assets decreased since year-end
2021, and overall asset quality has remained consistent. Total non-performing
assets were $6,136,000 as of June 30, 2022, a decrease of $930,000, or 13.2%
from $7,066,000 reported in non-performing assets as of December 31, 2021. Total
allowance for loan losses to total non-performing assets was 149.28% as of
June 30, 2022 and 122.84% at December 31, 2021. See the Non-Performing Assets
section on page 47 for more information.

In addition to loans, another primary earning asset is our overall securities
portfolio, which decreased in size from December 31, 2021 to June 30, 2022. Debt
securities available-for-sale amounted to $410,260,000 as of June 30, 2022, a
decrease of $27,656,000 from year-end 2021. The decrease in debt securities
available-for-sale is mainly due to a $35,521,000 decrease in the market value
of the portfolio as a result of the current interest rate environment and
$22,444,000 in principal paydowns on debt securities, offset by the deployment
of $38,349,000 in cash to purchase debt securities, along with other portfolio
activity.


                                       43

Interest-bearing deposits in other banks decreased as of June 30, 2022, to
$783,000 from $51,738,000 at year-end 2021 due to decreased cash held at the
Federal Reserve Bank. Time deposits with other banks were $0 at June 30, 2022
and $247,000 at December 31, 2021 due to the maturity of the one remaining time
deposit.

LOANS

Total loans increased to $804,820,000 as of June 30, 2022 as compared to
$752,841,000 as of December 31, 2021. The table on page 19 provides data
relating to the composition of the Company’s loan portfolio on the dates
indicated. Total loans increased by $51,979,000 or 6.9%.

Steady demand for borrowing by businesses accounted for the 6.9% increase in the
loan portfolio from December 31, 2021 to June 30, 2022. Overall, the Commercial
and Industrial portfolio (which includes tax-free Commercial and Industrial
loans) increased $13,000 or 0.02% from $82,526,000 at December 31, 2021 to
$82,539,000 at June 30, 2022. The small increase in the Commercial and
Industrial portfolio during the six months ended June 30, 2022 was mainly the
result of a reduction of $4,748,000 in the portion of the Commercial and
Industrial portfolio attributable to SBA PPP loans, the balance of which
decreased from $4,894,000 at December 31, 2021 to $146,000 at June 30, 2022, as
a result of loan forgiveness. The portion of the Commercial and Industrial
portfolio excluding SBA PPP loans increased $4,761,000 during the six months
ended June 30, 2022, mainly resulting from $7,438,000 in new loan originations
for the six months ended June 30, 2022 and an increase in utilization of
existing Commercial and Industrial lines of credit of $1,801,000, offset by loan
payoffs of $1,587,000 and regular principal payments and other typical
fluctuations in the Commercial and Industrial portfolio during the six months
ended June 30, 2022. The Commercial Real Estate portfolio (which includes
tax-free Commercial Real Estate loans) increased $46,604,000 or 8.9% from
$521,654,000 at December 31, 2021 to $568,258,000 at June 30, 2022. The increase
is mainly attributable to new loan originations of $87,507,000 for the six
months ended June 30, 2022, offset by loan payoffs of $36,826,000 and a decrease
in utilization of existing Commercial Real Estate lines of credit of $761,000,
as well as regular principal payments and other typical amortization in the
Commercial Real Estate portfolio during the six months ended June 30, 2022.
Residential Real Estate loans increased $5,238,000 or 3.7% from $143,383,000 at
December 31, 2021 to $148,621,000 at June 30, 2022. The increase was mainly the
result of $17,062,000 in new loan originations and an increase in utilization of
existing Residential Real Estate (Home Equity) lines of credit of $2,491,000,
offset by net loans sold of $2,719,000, loan payoffs of $10,187,000 (of which
$3,600,000 was refinanced with the Bank during the six months ended June 30,2022
with the new refinanced loan balances included in the new loan origination
total), and regular principal payments and other typical amortization in the
Residential Real Estate portfolio during the six months ended June 30, 2022. Net
loans sold for the six months ended June 30, 2022 consisted of total loans sold
during the six months ended June 30, 2022 of $4,463,000, offset with loans
opened and sold in the same quarter during the first two quarters of 2022 which
amounted to $1,744,000. The Company continues to originate and sell certain
long-term fixed rate residential mortgage loans, which conform to secondary
market requirements, when the market pricing is favorable. The Company derives
ongoing income from the servicing of mortgages sold in the secondary market. The
Company continues its efforts to lend to creditworthy borrowers.

Management believes that the loan portfolio is well diversified. The total
commercial portfolio was $650,797,000 at June 30, 2022. Of total loans,
$568,258,000 or 70.6% were secured by commercial real estate, primarily lessors
of residential buildings and dwellings and lessors of non-residential buildings.
The Company continues to monitor these portfolios.

Overall, the portfolio risk profile as measured by loan grade is considered low
risk, as $781,530,000 or 97.3% of gross loans are graded Pass; $1,080,000 or
0.1% are graded Special Mention; $20,961,000 or 2.6% are graded Substandard; and
$0 are graded Doubtful. The rating is intended to represent the best assessment
of risk available at a given point in time, based upon a review of the
borrower’s financial statements, credit analysis, payment history with the Bank,
credit history and lender knowledge of the borrower. See Note 4 – Loans and
Allowance for Loan Losses for risk grading tables.

Overall, non-pass grades decreased to $22,041,000 at June 30, 2022, as compared
to $24,737,000 at December 31, 2021. Commercial and Industrial non-pass grades
decreased to $755,000 as of June 30, 2022 as compared to $796,000 as of
December 31, 2021. Commercial Real Estate non-pass grades decreased to
$20,313,000 as of


                                       44

June 30, 2022 as compared to $22,346,000 as of December 31, 2021. The
Residential Real Estate and Consumer loan non-pass grades decreased to $973,000
as of June 30, 2022 as compared to $1,595,000 as of December 31, 2021.

The decrease in Commercial Real Estate non-pass grades from December 31, 2021 to
June 30, 2022 is mainly the result of a payoff that was completed during the
second quarter of 2022 on a Substandard non-accrual loan to a contractor
specializing in modular construction that carried a balance of $1,000,000 at
December 31, 2021. Four loans to the owners/operators of an indoor family
entertainment complex that carried an aggregate balance of $753,000 at December
31, 2021
were also upgraded from Substandard to pass-grade status during the six
months ended June 30, 2022.

The Company continues to internally underwrite each of its loans to comply with
prescribed policies and approval levels established by its Board of Directors.

Total Loans

(Dollars in thousands)       June 30,       December 31,
                                2022            2021
Commercial and Industrial    $   82,539    $        82,526
Commercial Real Estate          568,258            521,654
Residential Real Estate         148,621            143,383
Consumer                          5,402              5,278
Total Loans                  $  804,820    $       752,841


ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses constitutes the amount available to absorb losses
within the loan portfolio. As of June 30, 2022, the allowance for loan losses
was $9,160,000 as compared to $8,680,000 as of December 31, 2021. The allowance
for loan losses is established through a provision for loan losses charged to
expenses. Loans are charged against the allowance for possible loan losses when
management believes that the collectability of the principal is unlikely. The
risk characteristics of the loan portfolio are managed through various control
processes, including credit evaluations of individual borrowers, periodic
reviews, and diversification by industry. Risk is further mitigated through the
application of lending procedures such as the holding of adequate collateral and
the establishment of contractual guarantees.

Management performs a quarterly analysis to determine the adequacy of the
allowance for loan losses. The methodology in determining adequacy incorporates
specific and general allocations together with a risk/loss analysis on various
segments of the portfolio according to an internal loan review process. This
assessment results in an allocated allowance. Management maintains its loan
review and loan classification standards consistent with those of its regulatory
supervisory authority.

Management considers, based upon its methodology, that the allowance for loan
losses is adequate to cover foreseeable future losses. However, there can be no
assurance that the allowance for loan losses will be adequate to cover
significant losses, if any, that might be incurred in the future. On a quarterly
basis, management evaluates the qualitative factors utilized in the calculation
of the Company’s allowance for loan losses and various adjustments are made to
these factors as deemed necessary at the time of evaluation. The uncertain
economic climate has played a large role in the qualitative factor adjustments
that have been implemented throughout 2021 and the first half of 2022.
Qualitative factors remained unchanged during the first quarter of 2021, as the
economy and unemployment levels showed marked improvement over the prior
quarter. During the second quarter of 2021, the qualitative factors related to
the local/regional economy were decreased by one basis point across all loan
segments, as the economy and job growth in the Company’s market areas
demonstrated marked improvement over the prior quarter, and the qualitative
factor related to collateral values was increased by one basis point for both
the Commercial Real Estate and Residential Real Estate portfolio segments due to
an artificial increase in market values in the real estate sector as
individuals’ willingness to pay above-average market prices has sparked
uncertainty surrounding collateral values in the real estate market.


                                       45

Qualitative factors remained unchanged during the third quarter of 2021. During
the fourth quarter of 2021, the qualitative factors related to external
factors/conditions were increased by one basis point across all loan segments
due increased inflation rates, as well as elevated unemployment levels (although
improved from 2020 and early 2021) and the uncertainty of how broad the changes
implemented by the Federal Reserve would be. The qualitative factors related to
collateral values were also increased by one basis point across all loan
segments during the fourth quarter of 2021, as collateral values continued to
artificially increase as individuals were willing to pay above-average market
prices in all sectors. During the first quarter of 2022, the qualitative factors
related to the local/regional economy were increased by one basis point across
all loan segments due to ongoing economic uncertainty resulting from supply
chain disruptions caused by the COVID-19 pandemic, conflicts in foreign
countries causing inflationary pressures due to reductions/disruptions in the
production of the commodities controlled by these countries, increased interest
rates, and the overall inflation rate continuing to rise. During the second
quarter of 2022, the qualitative factors remained unchanged. Modifications
granted in compliance with Section 4013 of the CARES Act were highest in the
Commercial Real Estate portfolio segment, the long-term effects of which are
still very unclear, as there is still economic uncertainty related to the
COVID-19 pandemic, especially in relation to this segment of the Company’s loan
portfolio. See Allowance for Loan Losses on page 15 for further discussion.

The Analysis of Allowance for Loan Losses table contains an analysis of the
allowance for loan losses indicating charge-offs and recoveries for the six
months ended June 30, 2022 and 2021. Net recoveries as a percentage of average
loans was 0.006% for the six months ended June 30, 2022 and net charge-offs as a
percentage of average loans was 0.011% for the six months ended June 30, 2021.
Net recoveries amounted to $43,000 the six months ended June 30, 2022 as
compared to net charge-offs of $79,000 for the six months ended June 30, 2021.

For the six months ended June 30, 2022, the provision for loan losses was
$437,000 as compared to $270,000 for the six months ended June 30, 2021. The
provision, net of charge-offs and recoveries, resulted in the quarter end
allowance for loan losses of $9,160,000 of which 7.4% was attributed to the
Commercial and Industrial component; 65.0% attributed to the Commercial Real
Estate
component; 17.5% attributed to the Residential Real Estate component;
0.9% attributed to the Consumer component; and 9.2% being the unallocated
component (refer to the activity in Note 4 – Loans and Allowance for Loan Losses
on page 12). The Company determined that the provision for loan losses made
during the current quarter was sufficient to maintain the allowance for loan
losses at a level necessary for the probable losses inherent in the loan
portfolio as of June 30, 2022.


                                       46

Analysis of Allowance for Loan Losses

(Dollars in thousands)

                                                        June 30,       June 30,
As of and for the six months ended:                        2022          2021
Beginning balance                                       $    8,680    $     7,933
Charge-offs:
Commercial and Industrial                                        9             13
Commercial Real Estate                                           -             29
Residential Real Estate                                          -             55
Consumer                                                         6             20
                                                                15            117
Recoveries:
Commercial and Industrial                                        2              -
Commercial Real Estate                                          38             30
Residential Real Estate                                         14              1
Consumer                                                         4              7
                                                                58             38

Net (recoveries) charge-offs                                  (43)             79
Additions charged to operations                                437            270
Balance at end of period                                $    9,160    $     8,124

Ratio of net (recoveries) charge-offs during the
period to average loans outstanding during the             (0.006) %        0.011 %

period

Allowance for loan losses to average loans                   1.177 %        1.120 %

outstanding during the period

It is the policy of management and the Company’s Board of Directors to make a
provision for both identified and unidentified losses inherent in its loan
portfolio. A provision for loan losses is charged to operations based upon an
evaluation of the potential losses in the loan portfolio. This evaluation takes
into account such factors as portfolio concentrations, delinquency trends,
trends of non-accrual and classified loans, economic conditions, and other
relevant factors.

The loan review process, which is conducted quarterly, is an integral part of
the Bank’s evaluation of the loan portfolio. A detailed quarterly analysis to
determine the adequacy of the Company’s allowance for loan losses is reviewed by
the Board of Directors.

With the Bank’s manageable level of net charge-offs and recoveries along with
the additions to the reserve from the provision out of operations, the allowance
for loan losses as a percentage of average loans amounted to 1.177% and 1.120%
at June 30, 2022 and 2021, respectively.

NON-PERFORMING ASSETS

The table on page 50 details the Company’s non-performing assets and impaired
loans as of the dates indicated. Generally, a loan is classified as non-accrual
and the accrual of interest on such a loan is discontinued when the contractual
payment of principal or interest has become 90 days past due or management has
serious doubts about further collectability of principal or interest. A loan may
remain on accrual status if it is in the process of collection and is either
guaranteed or well secured. When a loan is placed on non-accrual status, unpaid
interest credited to income in the current year is reversed and unpaid interest
accrued in prior years is charged against current period income. A modification
of a loan constitutes a TDR when a borrower is experiencing financial difficulty
and the modification constitutes a concession that the Company would not
otherwise consider. Modifications to loans classified as TDRs generally include
reductions in contractual interest rates, principal deferments and extensions of
maturity dates at a stated interest rate lower than the current market for a new
loan with similar risk characteristics. While unusual, there may be instances of
loan principal forgiveness. Any loan modifications made in response to the
COVID-19 pandemic


                                       47

are not considered TDRs as long as the criteria set forth in Section 4013 of the
CARES Act are met. Foreclosed assets held for resale represent property acquired
through foreclosure, or considered to be an in-substance foreclosure.

Total non-performing assets amounted to $6,136,000 as of June 30, 2022, as
compared to $7,066,000 as of December 31, 2021. The economy is very unstable.
Inflation is at a four-decade high. The war between Ukraine and Russia is
creating worldwide turmoil. The unemployment rate has dropped significantly
compared to the beginning of the COVID-19 pandemic, but the labor force
participation rate has also fallen. The need for workers has driven wages up in
most sectors. Inflation is causing extreme concerns in all areas of the economy.
The war abroad and its effects on various commodities are pushing inflationary
concerns. Values of new and used homes and automobiles continue to climb. The
Federal Reserve has indicated a plan to continue to raise interest rates at an
accelerated level throughout the year. There has also been a resurgence of the
COVID-19 pandemic in some areas of the country and world. These forces have had
a direct effect on the Company’s non-performing assets. The Company is closely
monitoring all segments of its loan portfolio because of the current uncertain
economic environment. Non-accrual loans totaled $5,970,000 as of June 30, 2022,
as compared to $7,066,000 as of December 31, 2021. The decrease in non-accrual
loans from December 31, 2021 to June 30, 2022 was mainly the result of the
payoff of one non-accrual loan to a contractor specializing in modular
construction which carried a balance of $1,000,000 at December 31, 2021. There
were no foreclosed assets held for resale as of June 30, 2022 and December 31,
2021
. There was one loan past-due 90 days or more and still accruing interest at
June 30, 2022 that carried a balance of $166,000 and was well-secured by
residential real estate and in the process of collection. There were no loans
past-due 90 days or more and still accruing interest as of December 31, 2021.

Non-performing assets to total loans was 0.76% at June 30, 2022 and 0.94% at
December 31, 2021. Non-performing assets to total assets was 0.47% at June 30,
2022
and 0.54% at December 31, 2021. The allowance for loan losses to total
non-performing assets was 149.28% as of June 30, 2022 as compared to 122.84% as
of December 31, 2021. Additional detail can be found on page 50 in the
Non-Performing Assets and Impaired Loans table and page 26 in the Non-Performing
Assets table. Asset quality is a priority and the Company retains a full-time
loan review officer to closely track and monitor overall loan quality, along
with a full-time loan workout department to manage collection and liquidation
efforts.

Performing substandard loans which are not deemed to be impaired have
characteristics that cause management to have doubts regarding the ability of
the borrower to perform under present loan repayment terms and which may result
in reporting these loans as non-performing loans in the future. Performing
substandard loans not deemed to be impaired amounted to $10,416,000 at
June 30, 2022, compared to $10,463,000 at December 31, 2021.

Impaired loans were $12,284,000 at June 30, 2022 and $13,673,000 at December 31,
2021
. The largest impaired loan relationship at June 30, 2022 and December 31,
2021
consisted of a non-performing loan to a student housing holding company
which is secured by commercial real estate. At June 30, 2022, the loan carried a
balance of $3,090,000, net of $1,989,000 that had been charged off to date,
compared to December 31, 2021 when the loan carried a balance of $3,090,000, net
of $1,989,000 that had been charged off to date. The second largest impaired
loan relationship at June 30, 2022 and December 31, 2021 consisted of one
performing loan to a student housing holding company, which is classified as a
TDR. The loan is secured by commercial real estate and carried a balance of
$2,829,000 as of June 30, 2022, net of $943,000 that had been charged off to
date, compared to December 31, 2021 when the loan carried a balance of
$2,864,000, net of $943,000 that had been charged off to date. The third largest
impaired loan relationship at June 30, 2022 and December 31, 2021 consisted of
five non-performing loans to a plastic processing company focused on
non-post-consumer recycling. Three loans are classified in the Commercial and
Industrial portfolio and modified as TDRs and two loans are secured by
commercial real estate. The loans carried an aggregate balance of $1,128,000 at
June 30, 2022, compared to December 31, 2021 when the loans carried an aggregate
balance of $1,176,000.

The Company estimates impairment based on its analysis of the cash flows or
collateral estimated at fair value less cost to sell. For collateral dependent
loans, the estimated appraisal or other qualitative adjustments and cost to
sell percentages are determined based on the market area in which the real
estate securing the loan is located, among other factors, and therefore, can
differ from one loan to another. Of the $12,284,000 in impaired loans at
June 30, 2022, none were located outside of the Company’s primary market area.


                                       48

The outstanding recorded investment of TDRs as of June 30, 2022 and December 31,
2021
was $7,669,000 and $8,020,000, respectively. The decrease in TDRs at June
30, 2022
as compared to December 31, 2021 is mainly attributable to regular
principal payments and paydowns on existing TDRs that were completed during the
six months ended June 30, 2022. Of the twenty-nine restructured loans at June
30, 2022
, four loans were classified in the Commercial and Industrial portfolio,
twenty-four loans were classified in the Commercial Real Estate portfolio, and
one loan was classified in the Residential Real Estate portfolio. Troubled debt
restructurings at June 30, 2022 consisted of ten term modifications beyond the
original stated term, three rate modifications, and fifteen payment
modifications. There was also one troubled debt restructuring that experienced
all three types of modifications-payment, rate, and term. TDRs are separately
evaluated for payment disclosures, and if necessary, a specific allocation is
established. There were no specific allocations attributable to the TDRs at June
30, 2022
or December 31, 2021. There were no unfunded commitments attributable
to the TDRs at June 30, 2022 and December 31, 2021.

At June 30, 2022, three Commercial and Industrial loans classified as TDRs with
a combined recorded investment of $682,000, six Commercial Real Estate loans
classified as TDRs with a combined recorded investment of $318,000, and one
Residential Real Estate loan classified as a TDR with a balance of $12,000 were
not in compliance with the terms of their restructure, compared to June 30, 2021
when three Commercial and Industrial loans classified as TDRs with a combined
recorded investment of $736,000, seven Commercial Real Estate loans classified
as TDRs with a combined recorded investment of $479,000, and one Residential
Real Estate
loan classified as a TDR with a recorded investment of $17,000 were
not in compliance with the terms of their restructure.

Of the loans that were modified as TDRs within the twelve months preceding June
30, 2022
, no loans experienced payment defaults during the three months ended
June 30, 2022. One Commercial Real Estate loan that was modified as a TDR within
the twelve months preceding June 30, 2022 experienced a payment default during
the six months ended June 30, 2022, but the loan was subsequently paid off
during the first quarter of 2022. Of the loans that were modified as TDRs during
the twelve months preceding June 30, 2021, three Commercial Real Estate loans
totaling $300,000 experienced payment defaults during the three months ended
June 30, 2021. No loans that were modified as TDRs during the twelve months
preceding June 30, 2021 experienced payment defaults during the first three
months of 2021.

The Company’s non-accrual loan valuation procedure for any loans greater than
$250,000 requires an appraisal to be obtained and reviewed annually at year end,
unless the Board of Directors waives such requirement for a specific loan, in
favor of obtaining a Certificate of Inspection instead, defined as an internal
evaluation completed by the Company. A quarterly collateral evaluation is
performed which may include a site visit, property pictures and discussions with
realtors and other similar business professionals to ascertain current values.

For non-accrual loans less than $250,000 upon classification and typically
at year end, the Company completes a Certificate of Inspection, which includes
the results of an onsite inspection, and may consider value indicators such as
insured values, tax assessed values, recent sales comparisons and a review of
the previous evaluations.

Improving loan quality is a priority. The Company actively works with borrowers
to resolve credit problems and will continue its close monitoring efforts in
2022. Excluding the assets disclosed in the Non-Performing Assets and Impaired
Loans tables below and the Troubled Debt Restructurings section in Note 4 –
Loans and Allowance for Loan Losses, management is not aware of any information
about borrowers’ possible credit problems which cause serious doubt as to their
ability to comply with present loan repayment terms.

In addition, regulatory authorities, as an integral part of their examinations,
periodically review the allowance for possible loan losses. They may require
additions to allowances based upon their judgments about information available
to them at the time of examination.

The economic climate remains in a very frail state. The war between Ukraine and
Russia has exacerbated the difficulties in the national and state economy and
experts at all levels are attempting to calculate the intermediate or long term
affects. The Company may experience difficulties collecting payments on time
from its borrowers, and certain types of loans may need to be modified, which
could cause a rise in the level of impaired loans, non-performing assets,
charge-offs, and delinquencies. Should such metrics increase, additions to the
balance of the Company’s allowance for


                                       49

loan losses could be required. The extent of the impact of these stressors on
the Company’s operational and financial performance will depend on certain
developments including inflationary controls enacted, the labor force, supply
bottlenecks, the longevity of the war, and the effectiveness in controlling the
lingering effects of the COVID-19 outbreak, etc. and any after-effects of these
factors. These factors may not immediately impact the Company’s operational and
financial performance, as the effects of these factors may lag into the future.
The Company is also susceptible to the impact of economic and fiscal policy
factors that may evolve in the current economic environment.

A concentration of credit exists when the total amount of loans to borrowers,
who are engaged in similar activities that are similarly impacted by economic or
other conditions, exceed 10% of total loans. As of June 30, 2022 and
December 31, 2021, management is of the opinion that there were no loan
concentrations exceeding 10% of total loans.

Non-Performing Assets and Impaired Loans


(Dollars in thousands)                                     June 30,       December 31,
                                                             2022             2021
Non-performing assets
Non-accrual loans                                         $     5,970    $         7,066
Foreclosed assets held for resale                                   -                  -
Loans past-due 90 days or more and still accruing
interest                                                          166                  -
Total non-performing assets                               $     6,136    $         7,066

Impaired loans
Non-accrual loans                                         $     5,970    $         7,066
Accruing TDRs                                                   6,314              6,607
Total impaired loans                                           12,284             13,673
Allocated allowance for loan losses                                 -                  -
Net investment in impaired loans                          $    12,284    $        13,673

Impaired loans with a valuation allowance                 $         -    $             -
Impaired loans without a valuation allowance                   12,284             13,673
Total impaired loans                                      $    12,284    $        13,673

Allocated valuation allowance as a percent of impaired
loans

                                                               - %                - %
Impaired loans to total loans                                    1.53 %             1.81 %
Non-performing assets to total loans                             0.76 %             0.94 %
Non-performing assets to total assets                            0.47 %             0.54 %
Allowance for loan losses to impaired loans                     74.57 %            63.48 %
Allowance for loan losses to total non-performing
assets                                                         149.28 %           122.84 %


Real estate mortgages comprise 89.1% of the loan portfolio as of June 30, 2022,
as compared to 88.3% as of December 31, 2021. Real estate mortgages consist of
both residential and commercial real estate loans. The real estate loan
portfolio is well diversified in terms of borrowers, collateral, interest rates,
and maturities. Also, the residential real estate loan portfolio is largely
comprised of fixed rate mortgages. The real estate loans are concentrated
primarily in the Company’s market area and are subject to risks associated with
the local economy. The commercial real estate loans typically reprice
approximately every three to five years and are also concentrated in the
Company’s market area. The Company’s loss exposure on its impaired loans
continues to be mitigated by collateral positions on these loans. The allocated
allowance for loan losses associated with impaired loans is generally computed
based upon the related collateral value of the loans. The collateral values are
determined by recent appraisals or Certificates of Inspection, but are generally
discounted by management based on historical dispositions, changes in market
conditions since the last valuation and management’s expertise and knowledge of
the borrower and the borrower’s business.


                                       50

DEPOSITS, OTHER BORROWED FUNDS AND SUBORDINATED DEBT

Consumer and commercial retail deposits are attracted primarily by the Bank’s
eighteen full service office locations, one loan production office and through
its internet banking presence. The Bank offers a broad selection of deposit
products and continually evaluates its interest rates and fees on deposit
products. The Bank regularly reviews competing financial institutions’ interest
rates, especially when establishing interest rates on certificates of deposit.

Total deposits decreased $84,361,000 to $993,608,000 as of June 30, 2022 as
non-interest bearing deposits decreased by $18,527,000 and interest bearing
deposits decreased by $65,834,000 from year-end 2021. The decrease in deposits
was the result of a $95,504,000 decrease in highly rate sensitive deposits and
other normal fluctuations. Total short-term and long-term borrowings increased
to $154,723,000 as of June 30, 2022, from $62,377,000 at year-end 2021, an
increase of $92,346,000 or 148.0%. The increase in total borrowings was mainly
the result of increased short-term borrowings as deposits decreased and cash
balances were deployed into earning assets.

On December 10, 2020, the Corporation issued $25,000,000 aggregate principal
amount of Subordinated Notes due December 31, 2030 (the “2020 Notes”). The 2020
Notes are intended to be treated as Tier 2 capital for regulatory capital
purposes. The 2020 Notes bear a fixed interest rate of 4.375% per year for the
first five years and then float based on a benchmark rate (as defined).

CAPITAL STRENGTH

Normal increases in capital are generated by net income, less dividends paid
out. During the six months ended June 30, 2022, net income less dividends paid
increased capital by $4,031,000. Accumulated other comprehensive (loss) income
derived from net unrealized gains on debt securities available-for-sale also
impacts capital. At December 31, 2021 accumulated other comprehensive income was
$7,588,000. Accumulated other comprehensive loss stood at $20,438,000 at
June 30, 2022, a decrease of $28,026,000. Fluctuations in interest rates have
regularly impacted the gain/loss position in the Bank’s securities portfolio, as
well as its decision to sell securities at a gain or loss. The fluctuations from
net unrealized gains on debt securities available-for-sale do not affect
regulatory capital, as the Bank elected to opt-out of the inclusion of this item
with the filing of the March 31, 2015 Call Report.

The Company held 231,611 and 231,612 shares of common stock as treasury stock at
June 30, 2022 and December 31, 2021, respectively. This had an effect of
reducing our total stockholders’ equity by $5,709,000 as of June 30, 2022 and
December 31, 2021.

Total stockholders’ equity was $125,379,000 as of June 30, 2022, and
$148,555,000 as of December 31, 2021.

At June 30, 2022 the Bank met the definition of a “well-capitalized” institution
under the regulatory framework for prompt corrective action and the minimum
capital requirements under Basel III. The following table presents the Bank’s
capital ratios as of June 30, 2022 and December 31, 2021:


                                                                                  To Be Well
                                                                                  Capitalized
                                                                                 Under Prompt
                                                 June 30,     December 31,     Corrective Action
                                                   2022           2021            Regulations
Tier 1 leverage ratio (to average assets)            10.77 %          10.14 %               5.00 %
Common Equity Tier 1 capital ratio (to
risk-weighted assets)                                15.29 %          15.52 %               6.50 %
Tier 1 risk-based capital ratio (to
risk-weighted assets)                                15.29 %          15.52 %               8.00 %
Total risk-based capital ratio                       16.34 %          16.57 %              10.00 %


Under the final capital rules that became effective on January 1, 2015, there
was a requirement for a common equity Tier 1 capital conservation buffer of 2.5%
of risk-weighted assets which is in addition to the other minimum risk-based
capital standards in the rule. Institutions that do not maintain this required
capital buffer will become subject to progressively more stringent limitations
on the percentage of earnings that can be paid out in dividends or used for
stock repurchases and on the payment of discretionary bonuses to senior
executive management. The capital buffer


                                       51

requirement was phased in over three years beginning in 2016. The capital buffer
requirement effectively raises the minimum required common equity Tier 1 capital
ratio to 7.0%, the Tier 1 capital ratio to 8.5%, and the total capital ratio to
10.5% on a fully phased-in basis as of January 1, 2019. As of June 30, 2022, the
Bank meets all capital adequacy requirements under the Basel III Capital
Rules on a fully phased-in basis.

The Corporation’s capital ratios are not materially different than those of the
Bank.

LIQUIDITY

The Company’s objective is to maintain adequate liquidity to meet funding needs
at a reasonable cost and provide contingency plans to meet unanticipated funding
needs or a loss of funding sources, while minimizing interest rate risk.
Adequate liquidity is needed to provide the funding requirements of depositors’
withdrawals, loan growth, and other operational needs.

Sources of liquidity are as follows:

? Growth in the core deposit base;

? Proceeds from sales or maturities of securities;

? Payments received on loans and mortgage-backed securities;

? Overnight correspondent bank borrowings on various credit lines, notes, etc.,

with various levels of capacity;

? Securities sold under agreements to repurchase; and

? Brokered CDs.

At June 30, 2022 the Company had $458,318,000 in maximum borrowing capacity at
FHLB (inclusive of the outstanding balances of FHLB long-term notes, FHLB
short-term borrowings, and irrevocable standby letters of credit issued by
FHLB); the maximum borrowing capacity at ACBB was $15,000,000 and the maximum
borrowing capacity of the Federal Discount Window was $2,519,000.

The Company enters into “Repurchase Agreements” in which it agrees to sell
securities subject to an obligation to repurchase the same or similar
securities. Because the agreement both entitles and obligates the Company to
repurchase the assets, the Company may transfer legal control of the securities
while still retaining effective control. As a result, the repurchase agreements
are accounted for as collateralized financing agreements (secured borrowings)
and act as an additional source of liquidity. Securities sold under agreements
to repurchase were $25,311,000 at June 30, 2022.

Asset liquidity is provided by securities maturing in one year or less, other
short-term investments, federal funds sold, and cash and due from banks. The
liquidity is augmented by repayment of loans and cash flows from mortgage-backed
and asset-backed securities. Liability liquidity is accomplished primarily by
maintaining a core deposit base, acquired by attracting new deposits and
retaining maturing deposits. Also, short-term borrowings provide funds to meet
liquidity needs.

Net cash flows provided by operating activities were $7,606,000 and $8,676,000
at June 30, 2022 and 2021, respectively. Net income amounted to $7,365,000 for
the six months ended June 30, 2022 and $7,483,000 for the six months ended June
30, 2021
. During the six months ended June 30, 2022 and 2021, net premium
amortization on securities amounted to $1,633,000 and $1,366,000, respectively.
Net losses on sales of mortgage loans amounted to $34,000 for the six months
ended June 30, 2022, compared to net gains on sales of mortgage loans of
$662,000 for the six months ended June 30, 2021. Originations from sales of
mortgage loans originated for resale exceeded proceeds (net of gains/losses)
from sales of mortgage loans originated for resale by $1,639,000 for the six
months ended June 30, 2022, and proceeds (net of gains/losses) from sales of
mortgage loans originated for resale exceeded originations of mortgage loans
originated for resale by $937,000 for the six months ended June 30, 2021. Net
securities losses amounted to $131,000 for the six months ended June 30, 2022,
compared to net securities gains of $143,000 for the six months ended June 30,
2021
. Accrued interest receivable increased by $112,000 and decreased by
$170,000 during the six months ended June 30, 2022 and 2021, respectively. Other
assets increased by $639,000 and $1,116,000 during the six


                                       52

months ended June 30, 2022 and 2021, respectively. Other liabilities increased
by $37,000 during the six months ended June 30, 2022 and increased by $241,000
during the six months ended June 30, 2021.

Investing activities used cash of $64,171,000 and $56,580,000 during the six
months ended June 30, 2022 and 2021, respectively. Net activity in the
available-for-sale securities portfolio (including proceeds from sale,
maturities, and redemptions, net against purchases) used cash of $9,283,000
during the six months ended June 30, 2022, compared to $34,469,000 for the six
months ended June 30, 2021. Changes in restricted investment in bank stocks used
cash of $3,834,000 and $359,000 during the six months ended June 30, 2022 and
2021, respectively. Net cash used to originate loans amounted to $50,331,000 for
the six months ended June 30, 2022, compared to $21,649,000 for the six months
ended June 30, 2021.

Financing activities provided cash of $5,451,000 and $120,348,000 during the six
months ended June 30, 2022 and 2021, respectively. Deposits decreased by
$84,361,000 during the six months ended June 30, 2022, compared to an increase
of $125,859,000 during the six months ended June 30, 2021. Short-term borrowings
increased by $102,346,000 and $7,005,000 during the six months ended June 30,
2022
and 2021, respectively. Repayment of long-term borrowings used cash of
$10,000,000 at both June 30, 2022 and 2021, respectively. Dividends paid
amounted to $3,334,000 for the six months ended June 30, 2022, compared to
$3,240,000 for the six months ended June 30, 2021.

Managing liquidity remains an important segment of asset/liability management.
The overall liquidity position of the Company is maintained by an active
asset/liability management committee. The Company believes that its core deposit
base is stable even in periods of changing interest rates. Liquidity and funds
management are governed by policies and are measured on a monthly basis. These
measurements indicate that liquidity generally remains stable and exceeds the
Company’s minimum defined levels of adequacy. Other than the trends of continued
competitive pressures and volatile interest rates, there are no known demands,
commitments, events or uncertainties that will result in, or that are reasonably
likely to result in, liquidity increasing or decreasing in any material way.
Given our financial strength, we expect to be able to maintain adequate
liquidity as we manage through the current environment, utilizing current
funding options and possibly utilizing new options.

MARKET RISK

Market risk is the risk of loss arising from adverse changes in the fair value
of financial instruments due to changes in interest rates, exchange rates and
equity prices. The Company’s market risk is composed primarily of interest rate
risk. The Company’s interest rate risk results from timing differences in the
repricing of assets, liabilities, off-balance sheet instruments, and changes in
relationships between rate indices and the potential exercise of explicit or
embedded options.

Increases in the level of interest rates also may adversely affect the fair
value of the Company’s securities and other earning assets. Generally, the fair
value of fixed-rate instruments fluctuates inversely with changes in interest
rates. As a result, increases in interest rates have and could result in further
decreases in the fair value of the Company’s interest-earning assets, which
could adversely affect the Company’s results of operations if sold, or, in the
case of interest-earning assets classified as available-for-sale, the Company’s
stockholders’ equity, if retained. Under FASB ASC 320-10, Investments – Debt
Securities
, changes in the unrealized gains and losses, net of taxes, on debt
securities classified as available-for-sale are reflected in the Company’s
stockholders’ equity. The Company does not own any trading assets.

Asset/Liability Management

The principal objective of asset/liability management is to manage the
sensitivity of the net interest margin to potential movements in interest rates
and to enhance profitability through returns from managed levels of interest
rate risk. The Company actively manages the interest rate sensitivity of its
assets and liabilities. Several techniques are used for measuring interest rate
sensitivity. Interest rate risk arises from the mismatches in the repricing of
rates on assets and liabilities within a given time period, referred to as a
rate sensitivity gap. If more assets than liabilities mature or reprice within
the time frame, the Company is asset sensitive. This position would contribute
positively to net interest income in a rising rate environment. Conversely, if
more liabilities mature or reprice, the Company is liability sensitive. This


                                       53

position would contribute positively to net interest income in a falling rate
environment. The Company’s cumulative gap at one year indicates the Company is
liability sensitive at June 30, 2022.

Earnings at Risk

The Bank’s Asset/Liability Committee (“ALCO”) is responsible for reviewing the
interest rate sensitivity position and establishing policies to monitor and
limit exposure to interest rate risk. The guidelines established by ALCO are
reviewed by the Company’s Board of Directors. The Company recognizes that more
sophisticated tools exist for measuring the interest rate risk in the balance
sheet beyond interest rate sensitivity gap. Although the Company continues to
measure its interest rate sensitivity gap, the Company utilizes additional
modeling for interest rate risk in the overall balance sheet. Earnings at risk
and economic values at risk are analyzed.

Earnings simulation modeling addresses earnings at risk and net present value
estimation addresses economic value at risk. While each of these interest rate
risk measurements has limitations, taken together they represent a reasonably
comprehensive view of the magnitude of interest rate risk to the Company.

Earnings Simulation Modeling

The Company’s net income is affected by changes in the level of interest rates.
Net income is also subject to changes in the shape of the yield curve. For
example, a flattening of the yield curve would result in a decline in earnings
due to the compression of earning asset yields and increased liability rates,
while a steepening would result in increased earnings as earning asset and
interest-bearing liability yields widen.

Earnings simulation modeling is the primary mechanism used in assessing the
impact of changes in interest rates on net interest income. The model reflects
management’s assumptions related to asset yields and rates paid on liabilities,
deposit sensitivity, size and composition of the balance sheet. The assumptions
are based on what management believes at that time to be the most likely
interest rate environment. Earnings at risk is the change in net interest income
from a base case scenario under various scenarios of rate shock increases and
decreases in the interest rate earnings simulation model.

The table on the next page presents an analysis of the changes in net interest
income and net present value of the balance sheet resulting from various
increases or decreases in the level of interest rates, such as two percentage
points (200 basis points) in the level of interest rates. The calculated
estimates of change in net interest income and net present value of the balance
sheet are compared to current limits approved by ALCO and the Board of
Directors. The earnings simulation model projects net interest income would
decrease 8.63%, 16.56% and 24.40% in the 100, 200 and 300 basis point increasing
rate scenarios presented. In addition, the earnings simulation model projects
net interest income would increase 2.41% and decrease 0.35% in the 100 and 200
basis point decreasing rate scenarios presented. All of these forecasts are
within the Company’s one year policy guidelines.

The analysis and model used to quantify the sensitivity of net interest income
becomes less reliable in a decreasing rate scenario given the current low
interest rate environment with federal funds trading in the 150 – 175 basis
point range. Results of the decreasing basis point declining scenarios are
affected by the fact that many of the Company’s interest-bearing liabilities are
at rates below 1% and therefore likely may not decline 100 or more basis points.
However, the Company’s interest-sensitive assets are able to decline by these
amounts. For the six months ended June 30, 2022, the cost of interest-bearing
liabilities averaged 0.54%, and the yield on interest-earning assets, on a fully
taxable equivalent basis, averaged 3.68%.

Net Present Value Estimation

The net present value measures economic value at risk and is used for helping to
determine levels of risk at a point in time present in the balance sheet that
might not be taken into account in the earnings simulation model. The net
present value of the balance sheet is defined as the discounted present value of
asset cash flows minus the discounted present value of liability cash flows. At
June 30, 2022, net present value is projected to decrease 1.65%, 8.10%, and
16.34% in the 100, 200, and 300 basis point immediate increase scenarios,
respectively. Additionally, the 100 and 200


                                       54

basis point immediate decrease scenarios are estimated to affect net present
value with a decrease of 7.51% and 26.68%, respectively. All of these scenarios
presented are within the Company’s policy limits.

The computation of the effects of hypothetical interest rate changes are based
on many assumptions. They should not be relied upon solely as being indicative
of actual results, since the computations do not account for actions management
could undertake in response to changes in interest rates.

Effect of Change in Interest Rates


                                                Projected Change
Effect on Net Interest Income
1-Year Net Income Simulation Projection
+300 bp Shock vs. Stable Rate                            (24.40) %
+200 bp Shock vs. Stable Rate                            (16.56) %
+100 bp Shock vs. Stable Rate                             (8.63) %
Flat rate
-100 bp Shock vs. Stable Rate                               2.41 %
-200 bp Shock vs. Stable Rate                             (0.35) %

Effect on Net Present Value of Balance Sheet
Static Net Present Value Change
+300 bp Shock vs. Stable Rate                            (16.34) %
+200 bp Shock vs. Stable Rate                             (8.10) %
+100 bp Shock vs. Stable Rate                             (1.65) %
Flat rate
-100 bp Shock vs. Stable Rate                             (7.51) %
-200 bp Shock vs. Stable Rate                            (26.68) %

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