BANK OF THE JAMES FINANCIAL GROUP INC - Quarter Report: 2017 September (Form 10-Q)

Large accelerated filer

Accelerated filer

Non-accelerated filer

☐ (do not check if a smaller reporting company)

Smaller reporting company

Emerging growth company

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2017

BANK OF THE JAMES FINANCIAL GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)


Virginia	001-35402	20-0500300
(State or other jurisdiction of incorporation or organization)	(Commission file number)	(I.R.S. Employer Identification No.)

828 Main Street, Lynchburg, VA		24504
(Address of principal executive offices)		(Zip Code)

(434) 846-2000

(Registrant’s telephone number, including area code)

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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

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

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 4,378,436 shares of Common Stock, par value $2.14 per share, were outstanding at November 7, 2017.

Table of Contents


PART I – FINANCIAL INFORMATION		1

Item 1.	Consolidated Financial Statements	1

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	32

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	51

Item 4.	Controls and Procedures	51

PART II – OTHER INFORMATION		52

Item 1.	Legal Proceedings	52

Item 1A.	Risk Factors	52

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	65

Item 3.	Defaults Upon Senior Securities	65

Item 4.	Mine Safety Disclosures	65

Item 5.	Other Information	66

Item 6.	Exhibits	66

SIGNATURES		68

PART I – FINANCIAL INFORMATION

Item 1.

Consolidated Financial Statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Balance Sheets

(dollar amounts in thousands, except per share amounts) (2017 unaudited)


	September 30,			December 31,
	2017			2016
Assets

Cash and due from banks	$	22,806		$	16,938
Federal funds sold		13,534			11,745

Total cash and cash equivalents		36,340			28,683

Securities held-to-maturity (fair value of $3,263 in 2017 and $3,273 in 2016)		3,282			3,299

Securities available-for-sale, at fair value		49,664			40,776
Restricted stock, at cost		1,505			1,373

Loans, net of allowance for loan losses of $6,020 in 2017 and $5,716 in 2016		493,764			464,353
Loans held for sale		1,502			3,833
Premises and equipment, net		11,920			10,947
Interest receivable		1,596			1,378
Cash value - bank owned life insurance		12,932			12,673
Other real estate owned		2,639			2,370
Income taxes receivable		1,275			1,214
Deferred tax asset, net		2,065			2,374
Other assets		852			922

Total assets	$	619,336		$	574,195

Liabilities and Stockholders’ Equity

Deposits
Noninterest bearing demand	$	122,201		$	102,654
NOW, money market and savings		255,784			255,429
Time		182,530			165,029

Total deposits		560,515			523,112

Capital notes		5,000			—
Interest payable		100			88
Other liabilities		1,929			1,574

Total liabilities	$	567,544		$	524,774

Commitments and Contingencies
Stockholders’ equity
Preferred stock; authorized 1,000,000 shares; none issued and outstanding	$	—		$	—

Common stock $2.14 par value; authorized 10,000,000 shares; issued and outstanding 4,378,436 as of September 30, 2017 and December 31, 2016		9,370			9,370
Additional paid-in-capital		31,495			31,495
Retained earnings		11,930			10,156
Accumulated other comprehensive (loss)		(1,003	)		(1,600	)

Total stockholders’ equity	$	51,792		$	49,421

Total liabilities and stockholders’ equity	$	619,336		$	574,195

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Income

(dollar amounts in thousands, except per share amounts) (unaudited)


	For the Three Months Ended September 30,				For the Nine Months Ended September 30,
	2017		2016		2017		2016
Interest Income
Loans	$	5,683	$	5,227	$	16,336	$	15,212
Securities

US Government and agency obligations		131		104		365		368
Mortgage backed securities		71		46		214		166
Municipals - taxable		81		63		230		132
Municipals - tax exempt		7		10		28		31
Dividends		7		6		42		39
Other (Corporates)		24		4		81		13
Interest bearing deposits		21		13		53		28
Federal Funds sold		45		4		81		16

Total interest income		6,070		5,477		17,430		16,005

Interest Expense
Deposits
NOW, money market savings		186		153		530		428
Time Deposits		537		457		1,488		1,268
Federal Funds purchased		—		—		—		4
Reverse repurchase agreements		13		—		13		—
Capital notes 6% due 4/1/2017		—		—		—		8
Capital notes 4% due 1/24/2022		50		—		137		—

Total interest expense		786		610		2,168		1,708

Net interest income		5,284		4,867		15,262		14,297

Provision for loan losses		200		145		745		595

Net interest income after provision for loan losses		5,084		4,722		14,517		13,702

Noninterest income
Gain on sales of loans held for sale		694		593		1,663		1,765
Service charges, fees and commissions		479		373		1,377		1,107
Increase in cash value of life insurance		86		75		259		205
Other		9		30		42		84
Gain on sales and calls of securities, net		51		210		113		444

Total noninterest income		1,319		1,281		3,454		3,605

Noninterest expenses
Salaries and employee benefits		2,538		2,318		7,314		6,717
Occupancy		390		333		1,127		970
Equipment		360		316		1,146		949
Supplies		133		119		390		346

Professional, data processing, and other outside expense		735		696		2,112		2,059
Marketing		212		178		596		498
Credit expense		155		110		456		299
Other real estate expenses		42		52		78		57
FDIC insurance expense		94		92		285		275
Other		255		235		733		723

Total noninterest expenses		4,914		4,449		14,237		12,893

Income before income taxes		1,489		1,554		3,734		4,414

Income tax expense		474		499		1,172		1,421

Net Income	$	1,015	$	1,055	$	2,562	$	2,993

Weighted average shares outstanding - basic		4,378,436		4,378,436		4,378,436		4,378,436

Weighted average shares outstanding - diluted		4,378,519		4,378,436		4,378,524		4,378,436

Earnings per common share - basic	$	0.23	$	0.24	$	0.59	$	0.68

Earnings per common share - diluted	$	0.23	$	0.24	$	0.59	$	0.68

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

For the Three and Nine Months Ended September 30, 2017 and 2016

(dollar amounts in thousands) (unaudited)


	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2017			2016			2017			2016
Net Income	$	1,015		$	1,055		$	2,562		$	2,993

Other comprehensive income (loss):
Unrealized gains (losses) on securities available-for-sale		25			(293	)		1,019			1,366
Tax effect		(9	)		100			(347	)		(465	)
Reclassification adjustment for gains included in net income (1)		(51	)		(209	)		(113	)		(437	)
Tax effect (2)		17			71			38			149

Other comprehensive income (loss), net of tax		(18	)		(331	)		597			613

Comprehensive income	$	997		$	724		$	3,159		$	3,606

(1)	Gains are included in “gain on sales and calls of securities, net” on the consolidated statements of income.

(2)	The tax effect on these reclassifications is reflected in “income tax expense” on the consolidated statements of income.

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Nine Months Ended September 30, 2017 and 2016

(dollar amounts in thousands) (unaudited)


	For the Nine Months Ended September 30,
	2017			2016
Cash flows from operating activities
Net Income	$	2,562		$	2,993

Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		601			579

Net amortization and accretion of premiums and discounts on securities		280			419
Gain on sales of available-for-sale securities		(113	)		(437	)
Gain on call of held-to-maturity securities		—			(7	)
Gain on sales of loans held for sale		(1,663	)		(1,765	)
Provision for loan losses		745			595
Gain on sale of other real estate owned		—			(1	)
Impairment of other real estate owned		60			50
Increase in cash value of life insurance		(259	)		(205	)
Increase in interest receivable		(218	)		(59	)
Increase in other assets		69			269
Increase in income taxes receivable		(61	)		(130	)
Increase in interest payable		12			16
Increase in other liabilities		355			187
Proceeds from sales of loans held for sale		63,271			62,491
Origination of loans held for sale		(59,277	)		(61,810	)

Net cash provided by operating activities	$	6,364		$	3,185

Cash flows from investing activities
Purchases of securities held-to-maturity	$	—		$	(1,290	)
Proceeds from maturities and calls of securities held-to-maturity		—			500
Purchases of securities available-for-sale		(20,728	)		(31,576	)
Proceeds from maturities, calls and paydowns of securities available-for-sale		2,655			8,675
Proceeds from sale of securities available-for-sale		9,941			19,934
Purchase of bank owned life insurance		—			(2,600	)
Purchase of Federal Reserve Bank stock		(90	)		—
Purchase of Federal Home Loan Bank stock		(42	)		(60	)
Proceeds from sale of other real estate owned		515			21
Improvements to other real estate owned		(29	)		—
Origination of loans, net of principal collected		(30,971	)		(27,761	)
Purchases of premises and equipment		(1,574	)		(752	)
Proceeds from sale of other assets		1			—

Net cash (used in) investing activities	$	(40,322	)	$	(34,909	)

Cash flows from financing activities
Net increase in deposits	$	37,403		$	39,787
Dividends paid to common stockholders		(788	)		(787	)
Proceeds from sale of 4% capital notes due 1/24/2022		5,000			—
Retirement of 6% capital notes due 4/1/2017		—			(10,000	)

Net cash provided by financing activities	$	41,615		$	29,000

Increase (decrease) in cash and cash equivalents		7,657			(2,724	)

Cash and cash equivalents at beginning of period	$	28,683		$	28,655

Cash and cash equivalents at end of period	$	36,340		$	25,931

Non cash transactions
Transfer of loans to other real estate owned	$	815		$	475
Fair value adjustment for securities		906			929

Cash transactions
Cash paid for interest	$	2,156		$	1,692
Cash paid for taxes		1,275			1,550

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity

For the Nine Months Ended September 30, 2017 and 2016

(dollars in thousands, except per share amounts) (unaudited)


										Accumulated
					Additional					Other
	Shares		Common		Paid-in		Retained			Comprehensive
	Outstanding		Stock		Capital		Earnings			Income (Loss)			Total
Balance at December 31, 2015		4,378,436	$	9,370	$	31,495	$	7,920		$	(589	)	$	48,196

Net Income		—		—		—		2,993			—			2,993
Dividends paid on common stock ($0.18 per share)		—		—		—		(787	)		—			(787	)
Other comprehensive income		—		—		—		—			613			613

Balance at September 30, 2016		4,378,436	$	9,370	$	31,495	$	10,126		$	24		$	51,015

Balance at December 31, 2016		4,378,436	$	9,370	$	31,495	$	10,156		$	(1,600	)	$	49,421

Net Income		—		—		—		2,562			—			2,562
Dividends paid on common stock ($0.18 per share)		—		—		—		(788	)		—			(788	)
Other comprehensive income		—		—		—		—			597			597

Balance at September 30, 2017		4,378,436	$	9,370	$	31,495	$	11,930		$	(1,003	)	$	51,792

See accompanying notes to these consolidated financial statements

Notes to Consolidated Financial Statements

Note 1 – Basis of Presentation

The unaudited consolidated financial statements have been prepared by Bank of the James Financial Group, Inc. (“Financial” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission. In management’s opinion the accompanying financial statements, which unless otherwise noted are unaudited, reflect all adjustments, consisting solely of normal recurring accruals, necessary for a fair presentation of the financial information as of September 30, 2017 and for the three and nine months ended September 30, 2017 and 2016 in conformity with accounting principles generally accepted in the United States of America. Additional information concerning the organization and business of Financial, accounting policies followed, and other related information is contained in Financial’s Annual Report on Form 10-K for the year ended December 31, 2016. These financial statements should be read in conjunction with the audited consolidated financial statements and footnotes for the year ended December 31, 2016 included in Financial’s Annual Report on Form 10-K. Results for the three and nine month periods ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017.

The Company’s primary market area consists of the area commonly referred to as Region 2000 which encompasses the seven jurisdictions of the Town of Altavista, Amherst County, Appomattox County, the Town of Bedford, Bedford County, Campbell County, and the City of Lynchburg. Recently, the Company has expanded into Charlottesville, Roanoke, and Harrisonburg.

Financial’s critical accounting policies include the evaluation of the allowance for loan losses which is based on management’s estimate of an amount that is adequate to absorb probable losses inherent in the loan portfolio of Bank of the James (the “Bank”), Financial’s wholly-owned subsidiary. The allowance for loan losses is established through a provision for loan loss based on available information including the composition of the loan portfolio, historical loan losses, specific impaired loans, availability and quality of collateral, age of the various portfolios, changes in local economic conditions, and loan performance and quality of the portfolio. Different assumptions used in evaluating the adequacy of the Bank’s allowance for loan losses could result in material changes in Financial’s financial condition and results of operations. The Bank’s policy with respect to the methodology for determining the allowance for loan losses involves a higher degree of complexity and requires management to make subjective judgments that often require assumptions or estimates about uncertain matters. This critical policy and its assumptions are periodically reviewed with the Board of Directors.

Financial also considers valuation of other real estate owned (OREO) a critical accounting policy. OREO consists of properties acquired through foreclosure or deed in lieu of foreclosure. These properties are carried at fair value less estimated costs to sell at the date of foreclosure. Losses from the acquisition of property in full or partial satisfaction of loans are charged against the allowance for loan losses. Subsequent write-downs, if any, are charged against expense. Gains and losses on the sales of foreclosed properties are included in determining net income in the year of the sale. Operating costs after acquisition are expensed.

Note 2 – Use of Estimates

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Note 3 – Earnings Per Common Share (EPS)

Currently, only the option shares granted to certain officers and other employees of Financial pursuant to the Amended and Restated Stock Option Plan of 1999 Financial (the “1999 Plan”) are considered in calculating diluted earnings per share. The following is a summary of the earnings per share calculation for the three and nine months ended September 30, 2017 and 2016.


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2017		2016		2017		2016
Net income	$	1,015,000	$	1,055,000	$	2,562,000	$	2,993,000

Weighted average number of shares		4,378,436		4,378,436		4,378,436		4,378,436
Options effect of incremental shares		83		—		88		—

Weighted average diluted shares		4,378,519		4,378,436		4,378,524		4,378,436

Basic EPS (weighted avg shares)	$	0.23	$	0.24	$	0.59	$	0.68

Diluted EPS (Including Option Shares)	$	0.23	$	0.24	$	0.59	$	0.68

The following table sets forth the option shares that were not included in calculating the diluted earnings because their effect was anti-dilutive:

Three Months Ended

Nine Months Ended

September 30,

2017

2016

2017

2016

Options excluded from calculating diluted EPS because their effect was anti-dilutive

—

636

—

636

The foregoing shares were anti-dilutive because the exercise price of the options was greater than the market price on September 30, 2016.

Note 4 – Stock Based Compensation

Accounting standards require companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock, based on the fair value of those awards at the date of grant.

Note 4 – Stock Based Compensation (continued)

Stock option plan activity for the nine months ended September 30, 2017 is summarized below:


					Weighted
			Weighted		Average
			Average		Remaining		Intrinsic
			Exercise		Contractual		Value
	Shares		Price		Life (in years)		(in thousands)
Options outstanding, January 1, 2017		636	$	12.79
Granted		—		—
Exercised		—		—
Forfeited		—		—

Options outstanding, September 30, 2017		636	$	12.79		0.67	$	1

Options exercisable, September 30, 2017		636	$	12.79		0.67	$	1

Intrinsic value is calculated by subtracting the exercise price of option shares from the market price of underlying shares as of September 30, 2017 and multiplying that amount by the number of options outstanding. No intrinsic value exists where the exercise price is greater than the market price on a given date.

All compensation expense related to the foregoing stock option plan has been recognized. The Company’s ability to grant additional options shares under the 1999 Plan has expired.

Note 5 – Fair Value Measurements

Determination of Fair Value

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the Fair Value Measurements and Disclosures topic of FASB ASC, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

Note 5 – Fair Value Measurements (continued)

Fair Value Hierarchy

In accordance with this guidance, the Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

•

Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

•

Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

•

Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement.

Following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:

Fair Value on a Recurring Basis

Securities Available-for-Sale

Fair values of securities, excluding restricted investments in Federal Reserve Bank stock, Federal Home Loan Bank stock, and Community Bankers’ Bank stock are based on quoted prices available in an active market. If quoted prices are available, these securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow.

Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Currently, all of the Company’s securities are considered to be Level 2 securities.

The following table summarizes the Company’s financial assets that were measured at fair value on a recurring basis during the period.

Restricted securities noted above are classified as such because their ownership is restricted to certain types of entities and there is no established market for their resale. When the stock is repurchased, the shares are repurchased at the stock’s book value; therefore, the carrying amount of restricted securities approximate fair value. Restricted securities are considered to be Level 2.

Note 5 – Fair Value Measurements (continued)


			Carrying Value at September 30, 2017 (in thousands)
Description	Balance as of September 30, 2017		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
US Treasuries	$	1,874	$	—	$	1,874	$	—
US agency obligations		17,461		—		17,461		—
Mortgage-backed securities		14,038		—		14,038		—
Municipals		12,298		—		12,298		—
Corporates		3,993		—		3,993		—

Total available-for-sale securities	$	49,664	$	—	$	49,664	$	—


			Carrying Value at December 31, 2016 (in thousands)
Description	Balance as of December 31, 2016		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
US Treasuries	$	1,833	$		$	1,833	$
US agency obligations		13,113		—		13,113		—
Mortgage-backed securities		12,005		—		12,005		—
Municipals		9,947		—		9,947		—
Corporates		3,878		—		3,878		—

Total available-for-sale securities	$	40,776	$	—	$	40,776	$	—

Fair Value on a Non-recurring Basis

Impaired loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected when due. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2). However, in situations where the collateral is a house or building in the process of construction, the appraisal is more than 12 months old, management has determined the fair value of the collateral is further impaired below the appraised value, or the appraisal is not based solely on market comparables adjusted for observable inputs, the value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Note 5 – Fair Value Measurements (continued)

Loans held for sale

Loans held for sale are carried at cost which approximates estimated fair value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the period ended September 30, 2017. Gains and losses on the sale of loans are recorded within gains on sales of loans held for sale, net on the Consolidated Statements of Income.

Other real estate owned

Certain assets such as other real estate owned (OREO) are measured at fair value less cost to sell. We believe that the fair value component in its valuation follows the provisions of ASC 820.

Real estate acquired through foreclosure is transferred to OREO. The measurement of loss associated with OREO is based on the fair value of the collateral compared to the unpaid loan balance and anticipated costs to sell the property. The value of OREO property is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2).

Any fair value adjustments are recorded in the period incurred and expensed against current earnings. However, in situations where the collateral is a house or building in the process of construction, the appraisal is more than 12 months old, management has determined the fair value of the collateral is further impaired below the appraised value, or the appraisal is not based solely on market comparables adjusted for observable inputes, the value is considered Level 3.

The following table summarizes the Company’s impaired loans, loans held for sale, and OREO measured at fair value on a nonrecurring basis during the period (in thousands).


			Carrying Value at September 30, 2017
Description	Balance as of September 30, 2017		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans*	$	2,523	$	—	$	—	$	2,523
Loans held for sale		1,502		—		1,502		—
Other real estate owned		2,639		—		—		2,639

*	Includes loans charged down to the net realizable value of the collateral.


			Carrying Value at December 31, 2016
Description	Balance as of December 31, 2016		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans*	$	2,830	$	—	$	—	$	2,830
Loans held for sale		3,833		—		3,833		—
Other real estate owned		2,370		—		—		2,370

*	Includes loans charged down to the net realizable value of the collateral.

Note 5 – Fair Value Measurements (continued)

The following table sets forth information regarding the quantitative inputs used to value assets classified as Level 3:


	Quantitative information about Level 3 Fair Value Measurements for September 30, 2017 (dollars in thousands)
	Fair Value		Valuation Technique(s)	Unobservable Input	Range (Weighted Average)
Assets
Impaired loans	$	2,523	Discounted appraised value	Selling cost		5% - 10% (6	%)
				Discount for lack of marketability and age of appraisal		0% - 25% (15	%)

OREO		2,639	Discounted appraised value	Selling cost		5% - 10% (6	%)
				Discount for lack of marketability and age of appraisal		0% - 25% (15	%)

	Quantitative information about Level 3 Fair Value Measurements for December 31, 2016 (dollars in thousands)
	Fair Value		Valuation Technique(s)	Unobservable Input	Range (Weighted Average)
Assets
Impaired loans	$	2,830	Discounted appraised value	Selling cost		5% - 10% (6	%)
				Discount for lack of marketability and age of appraisal		0% - 25% (15	%)

OREO		2,370	Discounted appraised value	Selling cost		5% - 10% (6	%)
				Discount for lack of marketability and age of appraisal		0% - 25% (15	%)

Financial Instruments

Cash, cash equivalents and Federal Funds sold

The carrying amounts of cash and short-term instruments approximate fair values.

Loans

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for certain fixed rate loans are based on quoted market prices of similar loans adjusted for differences in loan characteristics. Fair values for other loans such as commercial real estate and commercial and industrial loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values of impaired loans are estimated as described above. The carrying values of all loans are considered to be Level 3.

Bank Owned Life Insurance (BOLI)

The carrying amount approximates fair value. The carrying values of all BOLI is considered to be Level 2.

Note 5 – Fair Value Measurements (continued)

Deposits

Fair values disclosed for demand deposits (e.g., interest and noninterest checking, savings, and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed rate certificates of deposit are estimated using discounted cash flow analyses that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits. The carrying values of all deposits are considered to be Level 2.

FHLB borrowings

The fair value of FHLB borrowings is estimated using discounted cash flow analysis based on the rates currently offered for borrowings of similar remaining maturities and collateral requirements. The carrying values of all FHLB borrowings are considered to be Level 2.

Short-term borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days approximate fair value. The carrying values of all short-term borrowings are considered to be Level 2.

Capital notes

Fair values of capital notes are based on market prices for debt securities having similar maturity and interest rate characteristics. The carrying values of all capital notes are considered to be Level 2.

Accrued interest

The carrying amounts of accrued interest approximate fair value. The carrying values of all accrued interest is considered to be Level 2.

Off-balance sheet credit-related instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. Fair value of off-balance sheet credit-related instruments were deemed to be immaterial at September 30, 2017 and December 31, 2016 and therefore are not included in the table below.

Note 5 – Fair Value Measurements (continued)

The estimated fair values, and related carrying or notional amounts, of Financial’s financial instruments are as follows (in thousands):


			Fair Value Measurements at September 30, 2017 using
			Quoted Prices		Significant
			in Active		Other		Significant
			Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
	Amounts		(Level 1)		(Level 2)		(Level 3)		Balance
Assets
Cash and due from banks	$	22,806	$	22,806	$	—	$	—	$	22,806
Fed funds sold		13,534		13,534		—		—		13,534
Securities
Available-for-sale		49,664		—		49,664		—		49,664
Held-to-maturity		3,282		—		3,263		—		3,263
Restricted stock		1,505				1,505		—		1,505
Loans, net		493,764		—		—		496,875		496,875
Loans held for sale		1,502		—		1,502		—		1,502
Interest receivable		1,596		—		1,596		—		1,596
BOLI		12,932		—		12,932		—		12,932

Liabilities
Deposits	$	560,515	$	—	$	561,450	$	—	$	561,450
Capital notes		5,000		—		5,217		—		5,217
Interest payable		100		—		100		—		100


			Fair Value Measurements at December 31, 2016 using
			Quoted Prices		Significant
			in Active		Other		Significant
			Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
	Amounts		(Level 1)		(Level 2)		(Level 3)		Balance
Assets
Cash and due from banks	$	16,938	$	16,938	$	—	$	—	$	16,938
Fed funds sold		11,745		11,745						11,745
Securities
Available-for-sale		40,776		—		40,776		—		40,776
Held-to-maturity		3,299		—		3,273		—		3,273
Restricted stock		1,373		—		1,373				1,373
Loans, net		464,353		—		—		468,393		468,393
Loans held for sale		3,833		—		3,833		—		3,833
Interest receivable		1,378		—		1,378		—		1,378
BOLI		12,673		—		12,673		—		12,673

Liabilities
Deposits	$	523,112	$	—	$	524,222	$	—	$	524,222
Interest payable		88		—		88		—		88

Note 5 – Fair Value Measurements (continued)

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time Financial’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of Financial’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment, and therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on-balance-sheet and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets that are not considered financial assets include deferred income taxes and bank premises and equipment; a significant liability that is not considered a financial liability is accrued post-retirement benefits. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

Financial assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of Financial’s financial instruments will change when interest rate levels change, and that change may be either favorable or unfavorable to Financial. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment.

Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate Financial’s overall interest rate risk.

Note 6 – Capital Notes

As of December 31, 2015, Financial had $10,000,000 categorized as “Capital Notes” which represented the proceeds of the private placement of $10,000,000 in unregistered debt securities as previously disclosed (the “2012 Notes”). The 2012 Notes bore interest at the rate of 6% per year with interest payable quarterly in arrears. On December 3, 2015, Financial closed a private placement of common stock pursuant to which it received gross proceeds of $11,520,000 by selling an aggregate of 1,000,000 shares of Financials’ Common Stock at a price of $11.52 per share, as part of a private placement (the “Common Stock Private Placement”). Financial used $10,000,000 of the proceeds from the Common Stock Private Placement to prepay in full the 2012 Notes on January 5, 2016.

On January 25, 2017, Financial closed a private placement of unregistered debt securities (the “2017 Offering”) pursuant to which Financial issued $5,000,000 in principal of notes (the “2017 Notes”). The 2017 Notes bear interest at the rate of 4% per year with interest payable quarterly in arrears. The 2017 Notes are to mature on January 24, 2022, but are subject to prepayment in whole or in part on or after January 24, 2018 at Financial’s sole discretion on 30 days written notice to the holders. Of the proceeds, $3,000,000 was injected into the Bank as equity capital in March 2017. It is anticipated the remaining $2,000,000 will remain at the holding company level for debt service on the 2017 Notes.

Note 7 - Securities

The following tables summarize the Bank’s holdings for both securities held-to-maturity and securities available-for-sale as of September 30, 2017 and December 31, 2016 (amounts in thousands):


	September 30, 2017
	Amortized		Gross Unrealized					Fair Value
	Costs		Gains		(Losses)			Fair Value
Held-to-Maturity
US agency obligations	$	3,282	$	21	$	(40	)	$	3,263

Available-for-Sale
US Treasuries		1,955		—		(81	)		1,874
US agency obligations		18,252		6		(797	)		17,461
Mortgage-backed securities		14,263		2		(227	)		14,038
Municipals		12,591		32		(325	)		12,298
Corporates		4,121		—		(128	)		3,993

	$	51,182	$	40	$	(1,558	)	$	49,664


	December 31, 2016
	Amortized		Gross Unrealized					Fair Value
	Costs		Gains		(Losses)			Fair Value
Held-to-Maturity
US agency obligations	$	3,299	$	65	$	(91	)	$	3,273

Available-for-Sale
US Treasuries		1,952		—		(119	)		1,833
US agency obligations		14,332		5		(1,224	)		13,113
Mortgage-backed securities		12,358		—		(353	)		12,005
Municipals		10,426		55		(534	)		9,947
Corporates		4,132		—		(254	)		3,878

	$	43,200	$	60	$	(2,484	)	$	40,776

Note 7 – Securities (continued)

The following tables show the gross unrealized losses and fair value of the Bank’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2017 and December 31, 2016 (amounts in thousands):


	Less than 12 months				More than 12 months				Total
September 30, 2017	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Description of securities
Held-to-maturity
US agency obligations	$	1,237	$	40	$	—	$	—	$	1,237	$	40

Available-for-sale
US Treasuries		1,874		81		—		—		1,874		81
US agency obligations		4,935		88		12,520		709		17,455		797
Mortgage-backed securities		10,468		195		2,654		32		13,122		227
Municipals		5,461		67		3,742		258		9,203		325
Corporates		1,978		53		2,015		75		3,993		128

Total	$	25,953	$	524	$	20,931	$	1,074	$	46,884	$	1,598


	Less than 12 months				More than 12 months				Total
December 31, 2016	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Description of securities
Held-to-maturity
US agency obligations	$	1,193	$	91	$	—	$	—	$	1,193	$	91

Available-for-sale
US Treasuries		1,833		119		—		—		1,833		119
US agency obligations		13,109		1,224		—		—		13,109		1,224
Mortgage-backed securities		11,331		353		—		—		11,331		353
Municipals		7,170		534		—		—		7,170		534
Corporates		3,878		254		—		—		3,878		254

Total	$	38,514	$	2,575	$	—	$	—	$	38,514	$	2,575

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and may do so more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) the intent of Financial, if any, to sell the security; (4) whether Financial more likely than not will be required to sell the security before recovering its cost; and (5) whether Financial does not expect to recover the security’s entire amortized cost basis (even if Financial does not intend to sell the security).

Note 7 – Securities (continued)

At September 30, 2017, the Company did not consider the unrealized losses as other-than-temporary losses due to the nature of the securities involved. As of September 30, 2017, the Bank owned 47 securities in an unrealized loss position that were being evaluated for other than temporary impairment. Eleven of these securities were S&P rated AAA, 33 were rated AA and three were rated A. As of September 30, 2017, 27 of these securities were direct obligations of the U.S. government or government sponsored entities, 15 were municipal issues, and five were investments in domestic corporate issued securities.

Based on the analysis performed by management as mandated by the Bank’s investment policy, management believes the default risk to be minimal. Because management does not intend to sell and it is likely that management will not be required to sell the securities prior to their anticipated recovery, and the decline in fair value is largely due to change in interest rates and other market conditions, no declines currently are deemed to be other-than-temporary.

Gross gains on available-for-sale securities were $51 and $113 during the three and nine month periods ended September 30, 2017 compared to $209 and $437 for the same respective periods in 2016. There were no losses on sales of available-for-sale securities and no sales of held-to-maturity securities during the three and nine month periods ended September 30, 2017 and 2016.

Note 8 – Business Segments

The Company has two reportable business segments: (i) a traditional full service community banking segment and, (ii) a mortgage loan origination business. The community banking business segment includes Bank of the James which provides loans, deposits, investments and insurance to retail and commercial customers throughout Region 2000 and other areas within Central Virginia. The mortgage segment provides a variety of mortgage loan products principally within Region 2000. Mortgage loans are originated and sold in the secondary market through purchase commitments from investors with servicing released. Because of the pre-arranged purchase commitments, there is minimal risk to the Company.

Both of the Company’s reportable segments are service based. The mortgage business is a gain on sale business while the Bank’s primary source of revenue is net interest income. The Bank also provides a referral network for the mortgage origination business. The mortgage business may also be in a position to refer its customers to the Bank for banking services when appropriate.

Note 8 – Business Segments (continued)

Information about reportable business segments and reconciliation of such information to the consolidated financial statements for the three and nine months ended September 30, 2017 and 2016 was as follows (dollars in thousands):

Business Segments


	Community Banking		Mortgage		Total
Nine months ended September 30, 2017
Net interest income	$	15,262	$	—	$	15,262
Provision for loan losses		745		—		745

Net interest income after provision for loan losses		14,517		—		14,517
Noninterest income		1,791		1,663		3,454
Noninterest expenses		12,880		1,357		14,237

Income before income taxes		3,428		306		3,734
Income tax expense		1,068		104		1,172

Net income	$	2,360	$	202	$	2,562

Total assets	$	617,720	$	1,616	$	619,336

Nine months ended September 30, 2016
Net interest income	$	14,297	$	—	$	14,297
Provision for loan losses		595		—		595

Net interest income after provision for loan losses		13,702		—		13,702
Noninterest income		1,816		1,789		3,605
Noninterest expenses		11,466		1,427		12,893

Income before income taxes		4,052		362		4,414
Income tax expense		1,298		123		1,421

Net income	$	2,754	$	239	$	2,993

Total assets	$	556,824	$	3,128	$	559,952


	Community Banking		Mortgage		Total
Three months ended September 30, 2017
Net interest income	$	5,284	$	—	$	5,284
Provision for loan losses		200		—		200

Net interest income after provision for loan losses		5,084		—		5,084
Noninterest income		625		694		1,319
Noninterest expenses		4,321		593		4,914

Income before income taxes		1,388		101		1,489
Income tax expense		438		36		474

Net income	$	950	$	65	$	1,015

Total assets	$	617,720	$	1,616	$	619,336

Three months ended September 30, 2016
Net interest income	$	4,867	$	—	$	4,867
Provision for loan losses		145		—		145

Net interest income after provision for loan losses		4,722		—		4,722
Noninterest income		688		593		1,281
Noninterest expenses		3,985		464		4,449

Income before income taxes		1,425		129		1,554
Income tax expense		455		44		499

Net income	$	970	$	85	$	1,055

Total assets	$	556,824	$	3,128	$	559,952

Note 9 – Loans, allowance for loan losses and OREO

Management has an established methodology used to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. For purposes of determining the allowance for loan losses, the Bank has segmented certain loans in the portfolio by product type. Within these segments, the Bank has sub-segmented its portfolio into classes, based on the associated risks. The classifications set forth below do not correspond directly to the classifications set forth in the call report (Form FFIEC 041). Management has determined that the classifications set forth below are more appropriate for use in identifying and managing risk in the loan portfolio.


Loan Segments:		Loan Classes:
	Commercial		Commercial and industrial loans

	Commercial real estate		Commercial mortgages – owner occupied

			Commercial mortgages – non-owner occupied

			Commercial construction

	Consumer		Consumer unsecured

			Consumer secured

	Residential		Residential mortgages

			Residential consumer construction

A summary of loans, net is as follows (dollars in thousands):


	As of:
	September 30, 2017		December 31, 2016
Commercial	$	102,880	$	88,085
Commercial real estate		249,441		237,638
Consumer		83,542		85,099
Residential		63,921		59,247

Total loans (1)		499,784		470,069

Less allowance for loan losses		6,020		5,716

Net loans	$	493,764	$	464,353

(1)	Includes net deferred costs and premiums of $903 and $182 as of September 30, 2017 and December 31, 2016, respectively.

The Bank’s internal risk rating system is in place to grade commercial and commercial real estate loans. Category ratings are reviewed periodically by lenders and the credit review area of the Bank based on the borrower’s individual situation. Additionally, internal and external monitoring and review of credits are conducted on an annual basis.

Note 9 – Loans, allowance for loan losses and OREO (continued)

Below is a summary and definition of the Bank’s risk rating categories:


RATING 1		Excellent
RATING 2		Above Average
RATING 3		Satisfactory
RATING 4		Acceptable / Low Satisfactory
RATING 5		Monitor
RATING 6		Special Mention
RATING 7		Substandard
RATING 8		Doubtful
RATING 9		Loss

We segregate loans into the above categories based on the following criteria and we review the characteristics of each rating at least annually, generally during the first quarter. The characteristics of these ratings are as follows:

•

“Pass.” These are loans having risk ratings of 1 through 4. Pass loans are to persons or business entities with an acceptable financial condition, appropriate collateral margins, appropriate cash flow to service the existing loan, and an appropriate leverage ratio. The borrower has paid all obligations as agreed and it is expected that this type of payment history will continue. When necessary, acceptable personal guarantors support the loan.

•

“Monitor.” These are loans having a risk rating of 5. Monitor loans have currently acceptable risk but may have the potential for a specific defined weakness in the borrower’s operations and the borrower’s ability to generate positive cash flow on a sustained basis. The borrower’s recent payment history may currently or in the future be characterized by late payments. The Bank’s risk exposure is mitigated by collateral supporting the loan. The collateral is considered to be well-margined, well maintained, accessible and readily marketable.

•

“Special Mention.” These are loans having a risk rating of 6. Special Mention loans have weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the bank’s credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. These loans do warrant more than routine monitoring due to a weakness caused by adverse events.

•

“Substandard.” These are loans having a risk rating of 7. Substandard loans are considered to have specific and well-defined weaknesses that jeopardize the viability of the Bank’s credit extension. The payment history for the loan has been inconsistent and the expected or projected primary repayment source may be inadequate to service the loan. The estimated net liquidation value of the collateral pledged and/or ability of the personal guarantor(s) to pay the loan may not adequately protect the Bank. There is a distinct possibility that the Bank will sustain some loss if the deficiencies associated with the loan are not corrected in the near term. A substandard loan would not automatically meet our definition of impaired unless the loan is significantly past due and the borrower’s performance and financial condition provides evidence that it is probable that the Bank will be unable to collect all amounts due.

•

“Doubtful.” These are loans having a risk rating of 8. Doubtful rated loans have all the weaknesses inherent in a loan that is classified substandard but with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high.

Note 9 – Loans, allowance for loan losses and OREO (continued)

•

“Loss.” These are loans having a risk rating of 9. Loss rated loans are not considered collectible under normal circumstances and there is no realistic expectation for any future payment on the loan. Loss rated loans are fully charged off.

Loans on Non-Accrual Status

(dollars in thousands)


	As of
	September 30, 2017		December 31, 2016
Commercial	$	674	$	915
Commercial Real Estate:
Commercial Mortgages-Owner Occupied		183		855
Commercial Mortgages-Non-Owner Occupied		68		—
Commercial Construction		169		256
Consumer
Consumer Unsecured		—		—
Consumer Secured		414		80
Residential:
Residential Mortgages		765		1,292
Residential Consumer Construction		61		67

Totals	$	2,334	$	3,465

We also classify other real estate owned (OREO) as a nonperforming asset. OREO represents real property owned by the Bank either through purchase at foreclosure or received from the borrower through a deed in lieu of foreclosure. OREO increased to $2,639 on September 30, 2017 from $2,370 on December 31, 2016. The following table represents the changes in OREO balance during the nine months ended September 30, 2017 and year ended December 31, 2016.

OREO Changes

(dollars in thousands)


	Nine months ended September 30, 2017			Year ended December 31, 2016
Balance at the beginning of the year (net)	$	2,370		$	1,965
Transfers from loans		815			470
Capitalized costs		29			—
Valuation adjustments		(60	)		(45	)
Sales proceeds		(515	)		(21	)
Gain (loss) on disposition		—			1

Balance at the end of the period (net)	$	2,639		$	2,370

At September 30, 2017 and December 31, 2016, the Company had $0 and $294 of consumer mortgage loans secured by residential real estate for which foreclosure was in process. The Company held three residential real estate properties carried on the books at a value of $509 in other real estate owned as of September 30, 2017 and no residential real estate property in other real estate owned as of December 31, 2016.

Note 9 – Loans, allowance for loan losses and OREO (continued)


	Impaired Loans
	(dollars in thousands)
	As of and For the Nine Months Ended September 30, 2017
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
2017	Investment		Balance		Allowance		Investment		Recognized
With No Related Allowance Recorded:
Commercial	$	783	$	962	$	—	$	741	$	28
Commercial Real Estate
Commercial Mortgages-Owner Occupied		1,075		1,111		—		2,047		86
Commercial Mortgage Non-Owner Occupied		411		417		—		380		15
Commercial Construction		—		—		—		—		—
Consumer
Consumer Unsecured		—		—		—		—		—
Consumer Secured		56		56		—		37		2
Residential
Residential Mortgages		1,451		1,543		—		1,503		38
Residential Consumer Construction		—		—		—		—		—

With An Allowance Recorded:
Commercial	$	1,675	$	1,872	$	1,301	$	1,598	$	41
Commercial Real Estate
Commercial Mortgages-Owner Occupied		1,709		1,709		192		1,648		68
Commercial Mortgage Non-Owner Occupied		73		73		19		74		4
Commercial Construction		169		685		79		169		—
Consumer
Consumer Unsecured		2		2		2		1		—
Consumer Secured		432		445		305		271		11
Residential
Residential Mortgages		151		173		4		425		3
Residential Consumer Construction		—		—		—		—		—

Totals:
Commercial	$	2,458	$	2,834	$	1,301	$	2,339	$	69
Commercial Real Estate
Commercial Mortgages-Owner Occupied		2,784		2,820		192		3,695		154
Commercial Mortgage Non-Owner Occupied		484		490		19		454		19
Commercial Construction		169		685		79		169		—
Consumer
Consumer Unsecured		2		2		2		1		—
Consumer Secured		488		501		305		308		13
Residential
Residential Mortgages		1,602		1,716		4		1,928		41
Residential Consumer Construction		—		—		—		—		—

	$	7,987	$	9,048	$	1,902	$	8,894	$	296

Note 9 – Loans, allowance for loan losses and OREO (continued)


	Impaired Loans
	(dollars in thousands)
	As of and For the Year Ended December 31, 2016
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
2016	Investment		Balance		Allowance		Investment		Recognized
With No Related Allowance Recorded:
Commercial	$	698	$	698	$	—	$	349	$	37
Commercial Real Estate
Commercial Mortgages-Owner Occupied		3,019		3,077		—		3,051		142
Commercial Mortgage Non-Owner Occupied		349		349		—		263		23
Commercial Construction		—		—		—		14		—
Consumer
Consumer Unsecured		—		—		—		—		—
Consumer Secured		18		18		—		19		1
Residential
Residential Mortgages		1,555		1,687		—		1,776		55
Residential Consumer Construction		—		—		—		86		—

With An Allowance Recorded:
Commercial	$	1,521	$	1,521	$	1,233	$	1,351	$	81
Commercial Real Estate
Commercial Mortgages-Owner Occupied		1,587		1,618		249		1,232		81
Commercial Mortgage Non-Owner Occupied		74		74		20		373		6
Commercial Construction		169		657		76		255		—
Consumer
Consumer Unsecured		—		—		—		16		—
Consumer Secured		110		110		110		150		8
Residential
Residential Mortgages		699		736		83		675		30
Residential Consumer Construction		—		—		—		—		—

Totals:
Commercial	$	2,219	$	2,219	$	1,233	$	1,700	$	118
Commercial Real Estate
Commercial Mortgages-Owner Occupied		4,606		4,695		249		4,283		223
Commercial Mortgage Non-Owner Occupied		423		423		20		636		29
Commercial Construction		169		657		76		269		—
Consumer
Consumer Unsecured		—		—		—		16		—
Consumer Secured		128		128		110		169		9
Residential
Residential Mortgages		2,254		2,423		83		2,451		85
Residential Consumer Construction		—		—		—		86		—

	$	9,799	$	10,545	$	1,771	$	9,610	$	464

Note 9 – Loans, allowance for loan losses and OREO (continued)


	Allowance for Loan Losses and Recorded Investment in Loans (dollars in thousands) As of and For the Nine Months Ended September 30, 2017
				Commercial
2017	Commercial			Real Estate			Consumer			Residential			Total
Allowance for Loan Losses:
Beginning Balance	$	2,192		$	2,109		$	954		$	461		$	5,716
Charge-offs		(315	)		(17	)		(114	)		(105	)		(551	)
Recoveries		5			24			42			39			110
Provision		537			(233	)		272			169			745

Ending Balance	$	2,419		$	1,883		$	1,154		$	564		$	6,020

Ending Balance: Individually evaluated for impairment	$	1,301		$	290		$	307		$	4		$	1,902

Ending Balance: Collectively evaluated for impairment		1,118			1,593			847			560			4,118

Totals:	$	2,419		$	1,883		$	1,154		$	564		$	6,020

Loans:

Ending Balance: Individually evaluated for impairment	$	2,458		$	3,437		$	490		$	1,602		$	7,987

Ending Balance: Collectively evaluated for impairment		100,422			246,004			83,052			62,319			491,797

Totals:	$	102,880		$	249,441		$	83,542		$	63,921		$	499,784

Note 9 – Loans, allowance for loan losses and OREO (continued)


	Allowance for Loan Losses and Recorded Investment in Loans (dollars in thousands) As of and For the Year Ended December 31, 2016
2016	Commercial			Commercial Real Estate			Consumer			Residential			Total
Allowance for Loan Losses:
Beginning Balance	$	1,195		$	1,751		$	1,073		$	664		$	4,683
Charge-offs		(328	)		(156	)		(275	)		—			(759	)
Recoveries		7			127			44			2			180
Provision		1,318			387			112			(205	)		1,612

Ending Balance	$	2,192		$	2,109		$	954		$	461		$	5,716

Ending Balance: Individually evaluated for impairment	$	1,233		$	345		$	110		$	83		$	1,771

Ending Balance: Collectively evaluated for impairment		959			1,764			844			378			3,945

Totals:	$	2,192		$	2,109		$	954		$	461		$	5,716

Loans:

Ending Balance: Individually evaluated for impairment	$	2,219		$	5,198		$	128		$	2,254		$	9,799

Ending Balance: Collectively evaluated for impairment		85,866			232,440			84,971			56,993			460,270

Totals:	$	88,085		$	237,638		$	85,099		$	59,247		$	470,069

Note 9 – Loans, allowance for loan losses and OREO (continued)


	Age Analysis of Past Due Loans as of
	September 30, 2017
	(dollars in thousands)
2017	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days		Total Past Due		Current		Total Loans		Recorded Investment > 90 Days & Accruing
Commercial	$	824	$	—	$	674	$	1,498	$	101,382	$	102,880	$	—
Commercial Real Estate:
Commercial Mortgages- Owner Occupied		1,115		—		183		1,298		92,532		93,830		—
Commercial Mortgages-Non-Owner Occupied		365		186		68		619		138,148		138,767		—
Commercial Construction		—		—		169		169		16,675		16,844		—
Consumer:
Consumer Unsecured		1		—		—		1		7,107		7,108		—
Consumer Secured		469		260		368		1,097		75,337		76,434		—
Residential:
Residential Mortgages		520		69		483		1,072		53,363		54,435		—
Residential Consumer Construction		—		—		61		61		9,425		9,486		—

Total	$	3,294	$	515	$	2,006	$	5,815	$	493,969	$	499,784	$	—


	Age Analysis of Past Due Loans as of
	December 31, 2016
	(dollars in thousands)
2016	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days		Total Past Due		Current		Total Loans		Recorded Investment > 90 Days & Accruing
Commercial	$	283	$	5	$	78	$	366	$	87,719	$	88,085	$	—
Commercial Real Estate:
Commercial Mortgages-Owner Occupied		1,136		72		855		2,063		88,698		90,761		—
Commercial Mortgages-Non-Owner Occupied		140		—		—		140		134,262		134,402		—
Commercial Construction		—		—		256		256		12,219		12,475		—
Consumer:
Consumer Unsecured		9		—		—		9		8,558		8,567		—
Consumer Secured		531		301		—		832		75,700		76,532		—
Residential:
Residential Mortgages		539		161		1,063		1,763		49,525		51,288		—
Residential Consumer Construction		—		—		67		67		7,892		7,959		—

Total	$	2,638	$	539	$	2,319	$	5,496	$	464,573	$	470,069	$	—

Note 9 – Loans, allowance for loan losses and OREO (continued)


	Credit Quality Information - by Class
	September 30, 2017
	(dollars in thousands)
2017	Pass		Monitor		Special Mention		Substandard		Doubtful		Totals
Commercial	$	99,555	$	688	$	5	$	2,033	$	599	$	102,880
Commercial Real Estate:
Commercial Mortgages-Owner Occupied		83,772		6,758		452		2,848		—		93,830
Commercial Mortgages-Non Owner Occupied		136,166		1,918		74		609		—		138,767
Commercial Construction		15,631		—		1,044		169		—		16,844
Consumer
Consumer Unsecured		7,106		—		—		2		—		7,108
Consumer Secured		75,612		93		—		729		—		76,434
Residential:
Residential Mortgages		52,237		—		242		1,956		—		54,435
Residential Consumer Construction		9,425		—		—		61		—		9,486

Totals	$	479,504	$	9,457	$	1,817	$	8,407	$	599	$	499,784


	Credit Quality Information - by Class
	December 31, 2016
	(dollars in thousands)
2016	Pass		Monitor		Special Mention		Substandard		Doubtful		Totals
Commercial	$	83,912	$	1,473	$	301	$	1,484	$	915	$	88,085
Commercial Real Estate:
Commercial Mortgages-Owner Occupied		83,008		2,975		101		4,677		—		90,761
Commercial Mortgages-Non Owner Occupied		129,794		3,525		525		558		—		134,402
Commercial Construction		11,774		—		445		256		—		12,475
Consumer
Consumer Unsecured		8,567		—		—		—		—		8,567
Consumer Secured		76,215		—		—		317		—		76,532
Residential:
Residential Mortgages		48,366		—		245		2,677		—		51,288
Residential Consumer Construction		7,892		—		—		67		—		7,959

Totals	$	449,528	$	7,973	$	1,617	$	10,036	$	915	$	470,069

Note 9 – Loans, allowance for loan losses and OREO (continued)

Troubled Debt Restructurings (TDR)

There were no loan modifications that would have been classified as TDRs during the three and nine months ended September 30, 2017 and 2016.

There were no loan modifications classified as TDRs within the last twelve months that defaulted during the three and nine months ended September 30, 2017 and 2016.

At September 30, 2017 and December 31, 2016, the Bank had no outstanding commitments to disburse additional funds on loans classified as TDRs.

Note 10 – Recent accounting pronouncements

In January 2016, the FASB issued ASU 2016-01, “Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” The amendments in ASU 2016-01, among other things: 1) Requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. 2) Requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. 3) Requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables). 4) Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. The amendments in this ASU are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently assessing the impact that ASU 2016-01 will have on its consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842).” Among other things, in the amendments in ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (1) A lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Company is in the process of gathering and analyzing lease data and will use this this information to assess the impact that ASU 2016-02 will have on its consolidated financial statements.

During June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The amendments in this ASU, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be

Note 10 – Recent accounting pronouncements (continued)

permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments in this ASU are effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company is currently assessing the impact that ASU 2016-13 will have on its consolidated financial statements. The Company has been in discussions with its core processor to coordinate a plan for implementation.

During August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments”, to address diversity in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The amendments should be applied using a retrospective transition method to each period presented. If retrospective application is impractical for some of the issues addressed by the update, the amendments for those issues would be applied prospectively as of the earliest date practicable. Early adoption is permitted, including adoption in an interim period. The Company does not expect the adoption of ASU 2016-15 to have a material impact on its consolidated financial statements.

During January 2017, the FASB issued ASU No. 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business”. The amendments in this ASU clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. Under the current implementation guidance in Topic 805, there are three elements of a business—inputs, processes, and outputs. While an integrated set of assets and activities (collectively referred to as a “set”) that is a business usually has outputs, outputs are not required to be present. In addition, all the inputs and processes that a seller uses in operating a set are not required if market participants can acquire the set and continue to produce outputs. The amendments in this ASU provide a screen to determine when a set is not a business. If the screen is not met, the amendments (1) require that to be considered a business, a set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output and (2) remove the evaluation of whether a market participant could replace missing elements. The ASU provides a framework to assist entities in evaluating whether both an input and a substantive process are present. The amendments in this ASU are effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods. The amendments in this ASU should be applied prospectively on or after the effective date. No disclosures are required at transition. The Company does not expect the adoption of ASU 2017-01 to have a material impact on its consolidated financial statements.

During January 2017, the FASB issued ASU No. 2017-04, “Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment”. The amendments in this ASU simplify how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. Instead, under the amendments in this ASU, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Public business entities that are U.S. Securities and Exchange Commission (SEC) filers should adopt the amendments in this ASU for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASU 2017-04 to have a material impact on its consolidated financial statements.

Note 10 – Recent accounting pronouncements (continued)

During March 2017, the FASB issued ASU 2017-07, “Compensation — Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.” The amendments in this ASU require an employer that offers defined benefit pension plans, other postretirement benefit plans, or other types of benefits accounted for under Topic 715 to report the service cost component of net periodic benefit cost in the same line item(s) as other compensation costs arising from services rendered during the period. The other components of net periodic benefit cost are required to be presented in the income statement separately from the service cost component. If the other components of net periodic benefit cost are not presented on a separate line or lines, the line item(s) used in the income statement must be disclosed. In addition, only the service cost component will be eligible for capitalization as part of an asset, when applicable. The amendments are effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods. Early adoption is permitted. The Company does not expect the adoption of ASU 2017-07 to have a material impact on its consolidated financial statements.

During March 2017, the FASB issued ASU 2017-08, “Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities.” The amendments in this ASU shorten the amortization period for certain callable debt securities purchased at a premium. Upon adoption of the standard, premiums on these qualifying callable debt securities will be amortized to the earliest call date. Discounts on purchased debt securities will continue to be accreted to maturity. The amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. Upon transition, entities should apply the guidance on a modified retrospective basis, with a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption and provide the disclosures required for a change in accounting principle. The Company is currently assessing the impact that ASU 2017-08 will have on its consolidated financial statements.

During May 2017, the FASB issued ASU 2017-09, “Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting.” The amendments provide guidance on determining which changes to the terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718. The amendments are effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted, including adoption in any interim period, for reporting periods for which financial statements have not yet been issued. The Company is currently assessing the impact that ASU 2017-09 will have on its consolidated financial statements.

During August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” The amendments in this ASU modify the designation and measurement guidance for hedge accounting as well as provide for increased transparency regarding the presentation of economic results on both the financial statements and related footnotes. Certain aspects of hedge effectiveness assessments will also be simplified upon implementation of this update. The amendments are effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2018. Early adoption is permitted, including adoption in any interim period. The Company does not expect the adoption of ASU 2017-12 to have a material impact on its consolidated financial statements.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements that constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995. The words “believe,” “estimate,” “expect,” “intend,” “anticipate,” “plan” and similar expressions and variations thereof identify certain of such forward-looking statements which speak only as of the dates on which they were made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Readers are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those indicated in the forward-looking statements as a result of various factors. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets in which we operate); competition for our customers from other providers of financial services; government legislation and regulation relating to the banking industry (which changes from time to time and over which we have no control) including but not limited to the Dodd-Frank Wall Street Reform and Consumer Protection Act; changes in the value of real estate securing loans made by the Bank; changes in interest rates; and material unforeseen changes in the liquidity, results of operations, or financial condition of our customers. Other risks, uncertainties and factors could cause our actual results to differ materially from those projected in any forward-looking statements we make.

GENERAL

Critical Accounting Policies

Bank of the James Financial Group, Inc.’s (“Financial”) financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss ratios as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in estimating risk. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

Financial’s critical accounting policies include the evaluation of the allowance for loan losses which is based on management’s estimate of an amount that is adequate to absorb probable losses inherent in the loan portfolio of the Bank. The allowance for loan losses is established through a provision for loan loss based on available information including the composition of the loan portfolio, historical loan losses, specific impaired loans, availability and quality of collateral, age of the various portfolios, changes in local economic conditions, and loan performance and quality of the portfolio. Different assumptions used in evaluating the adequacy of the Bank’s allowance for loan losses could result in material changes in Financial’s financial condition and results of operations.

The allowance is based on two basic principles of accounting: (i) ASC 450 “Contingencies”, which requires that losses be accrued when they are probable of occurring and are reasonably estimable and (ii) ASC 310 “Impairment of a Loan”, which requires that losses on impaired loans be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Guidelines for determining allowances for loan losses are also provided in the SEC Staff Accounting Bulletin No. 102 – “Selected Loan Loss Allowance

Methodology and Documentation Issues” and the Federal Financial Institutions Examination Council’s interagency guidance, “Interagency Policy Statement on the Allowance for Loan and Lease Losses” (the “FFIEC Policy Statement”).

The Bank’s policy with respect to the methodology for determining the allowance for loan losses involves a higher degree of complexity and requires management to make subjective judgments that often require assumptions or estimates about uncertain matters. This critical policy and its assumptions are periodically reviewed with the Board of Directors.

See “Management Discussion and Analysis Results of Operations – Allowance for Loan Losses and Loan Loss Reserve” below for further discussion of the allowance for loan losses.

Overview

Financial is a bank holding company headquartered in Lynchburg, Virginia. Our primary business is retail banking which we conduct through our wholly-owned subsidiary, Bank of the James (which we refer to as the “Bank”). We conduct three other business activities: mortgage banking through the Bank’s Mortgage division (which we refer to as “Mortgage division”), investment services through the Bank’s Investment division (which we refer to as “Investment division”), and insurance activities through BOTJ Insurance, Inc., a subsidiary of the Bank, (which we refer to as “Insurance business”). Of these three other business activities, only the Mortgage division is material to the Bank’s results and operations.

The Bank is a Virginia banking corporation headquartered in Lynchburg, Virginia. The Bank was incorporated under the laws of the Commonwealth of Virginia as a state chartered bank in 1998 and began banking operations in July 1999. The Bank was organized to engage in general retail and commercial banking business. The Bank is a community-oriented financial institution that provides varied banking services to individuals, small and medium-sized businesses, and professional concerns. Historically, our primary market area has been the Central Virginia, Region 2000 area, which encompasses the seven jurisdictions of the Town of Altavista, Amherst County, Appomattox County, the Town of Bedford, Bedford County, Campbell County, and the City of Lynchburg. Within the past three years, the Bank has begun to expand to other areas in Virginia, specifically Roanoke, Charlottesville, and Harrisonburg. The Bank strives to provide its customers with products comparable to statewide regional banks located in its market area, while maintaining the prompt response time and level of service of a community bank. Management believes this operating strategy has particular appeal in the Bank’s market areas.

The Bank’s principal office is located at 828 Main Street, Lynchburg, Virginia 24504 and its telephone number is (434) 846-2000. The Bank also maintains a website at www.bankofthejames.bank.

Our operating results depend primarily upon the Bank’s net interest income, which is determined by the difference between (i) interest and dividend income on earning assets, which consist primarily of loans, investment securities and other investments, and (ii) interest expense on interest-bearing liabilities, which consist principally of deposits and other borrowings. The Bank’s net income also is affected by its provision for loan losses, as well as the level of its non-interest income, including loan fees and service charges, and its non-interest expenses, including salaries and employee benefits, occupancy expense, data processing expenses, Federal Deposit Insurance Corporation premiums, expense in complying with the Sarbanes-Oxley Act of 2002, miscellaneous other expenses, franchise taxes, and income taxes.

The Bank intends to enhance its profitability by increasing its market share in our service areas, providing additional services to its customers, and controlling costs.

The Bank services its banking customers through the following locations in Virginia:

Full Service Branches

•

The main office located at 828 Main Street in Lynchburg (the “Main Street Office”),

•

A branch located at 615 Church Street in Lynchburg (the “Church Street Branch”),

•

A branch located at 5204 Fort Avenue in Lynchburg (the “Fort Avenue Branch”),

•

A branch located at 4698 South Amherst Highway in Amherst County (the “Madison Heights Branch”),

•

A branch located at 17000 Forest Road in Forest (the “Forest Branch”),

•

A branch located at 4935 Boonsboro Road, Suites C and D in Lynchburg (the “Boonsboro Branch”),

•

A branch located at 164 South Main Street, Amherst, Virginia (the “Amherst Branch”),

•

A branch located at 1405 Ole Dominion Boulevard in the Town of Bedford, Virginia, located off of Independence Boulevard (the “Bedford Branch”),

•

A branch located at 1110 Main Street, Altavista, Virginia (the “Altavista Branch”),

•

A branch located at 1391 South High Street, Harrisonburg, VA (the “Harrisonburg Branch”),

•

A branch located at 180 Old Courthouse Rd, Appomattox, VA (the “Appomattox Branch”),

•

A branch located at 225 Merchant Walk Avenue, Charlottesville, VA (the “5^th Street Station Branch”), and

•

A branch located at 3562 Electric Road, Roanoke, VA (the “Roanoke Branch”).

Limited Service Branches

•

Westminster-Canterbury facilities located at 501 VES Road, Lynchburg, Virginia,

•

Westminster-Canterbury facilities located at 250 Pantops Mountain Road, Charlottesville, Virginia,

•

Luxor Office Park LLC, 1430 Rolkin Court Suite 203, Charlottesville, Virginia (the “Charlottesville Branch”).

Loan Production Offices

•

Residential mortgage loan production office located at the Forest Branch,

•

Commercial, consumer and mortgage loan production office located at the Charlottesville Branch.

The Investment division and the Insurance business operate primarily out of offices located at the Church Street Branch.

The Bank continuously evaluates areas located within our service areas to identify additional viable branch locations. Based on this ongoing evaluation, the Bank may acquire one or more additional suitable sites.

Subject to regulatory approval, the Bank anticipates opening additional branches during the next two fiscal years. Although numerous factors could influence the Bank’s expansion plans, the following discussion provides a general overview of the additional branch locations that the Bank currently is considering, including the following properties that we own and are holding for expansion:

•

Real property located in the Timberlake Road area of Campbell County (Lynchburg), Virginia. The Timberlake property is not suitable for its intended use as a branch bank. Management anticipates that it will be necessary to raze the current structures and replace it with appropriate new construction.

•

Real property located at 5 Village Highway (near the intersection of Routes 501 and 24) in Rustburg, Virginia. The structure on the property has been demolished and removed. The Bank does not anticipate opening a branch at this location prior to 2018.

•

Real property located near the intersection of Confederate Boulevard and Moses Avenue in Appomattox, Virginia. The Bank began construction of a permanent full service location in April 2017 and the Bank will open the branch during the fourth quarter of 2017. In connection with the opening, the Bank will relocate its temporary location (180 Old Courthouse Road referenced in the location table above) to this permanent location.

•

Real property located at 45 South Main Street, Lexington, Virginia. The bank does not anticipate opening a branch at this location prior to 2018.

The Bank estimates that the cost of improvements, furniture, fixtures, and equipment necessary to upfit each property will be between $900,000 and $1,500,000 per location.

Although the Bank cannot predict with certainty the financial impact of each new branch, management generally anticipates that each new branch will become profitable within 12 to 18 months of operation.

Except as set forth herein, the Bank does not expect to purchase any significant property or equipment in the upcoming 12 months. Future branch openings are subject to regulatory approval.

OFF-BALANCE SHEET ARRANGEMENTS

The Bank is a party to various financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Such commitments involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amount recognized in the balance sheets and could impact the overall liquidity and capital resources to the extent customers accept and/or use these commitments.

The Bank’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 amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments is as follows:


	September 30, 2017 (in thousands)
Commitments to extend credit	$	100,914
Letters of Credit		2,810

Total	$	103,724

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. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on the Bank’s credit evaluation of the customer.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on the Bank’s credit evaluation of the customer.

The Bank has rate lock commitments to originate mortgage loans through its Mortgage Division. The Bank has entered into corresponding commitments with third party investors to sell each of these loans that close. No other obligation exists. As a result of these contractual relationships with these investors, the Bank is not exposed to losses nor will it realize gains related to its rate lock commitments due to changes in interest rates.

SUMMARY OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion represents management’s discussion and analysis of the financial condition of Financial as of September 30, 2017 and December 31, 2016 and the results of operations of Financial for the three and nine month periods ended September 30, 2017 and 2016. This discussion should be read in conjunction with the financial statements included elsewhere herein.

All financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.

Financial Condition Summary

September 30, 2017 as Compared to December 31, 2016

Total assets were $619,336,000 on September 30, 2017 compared with $574,195,000 at December 31, 2016, an increase of 7.86%. The increase in total assets was primarily due to growth in the loan portfolio funded by an increase in deposits and the issuance of $5,000,000 of notes (the “2017 Notes”) in a private placement that closed on January 25, 2017.

Total deposits increased from $523,112,000 as of December 31, 2016 to $560,515,000 on September 30, 2017, an increase of 7.15%. The increase resulted in large part from increases in non-interest bearing demand and time deposits and a slight increase in NOW, money market, and savings accounts. NOW, money market, and savings deposits increased from $255,429,000 on December 31, 2016 to $255,784,000 on September 30, 2017. Noninterest bearing demand deposits increased from $102,654,000 on December 31, 2016 to $122,201,000 on September 30, 2017. Time deposits increased from $165,029,000 on December 31, 2016 to $182,530,000 on September 30, 2017.

Total loans, excluding loans held for sale, increased to $499,784,000 on September 30, 2017 from $470,069,000 on December 31, 2016. Loans, excluding loans held for sale and net of deferred fees and costs and the allowance for loan losses, increased to $493,764,000 on September 30, 2017 from $464,353,000 on December 31, 2016, an increase of 6.33%. The following summarizes the position of the Bank’s loan portfolio as of the dates indicated by dollar amount and percentages (dollar amounts in thousands):


	September 30, 2017					December 31, 2016
	Amount		Percentage			Amount		Percentage
Commercial	$	102,880		20.58	%	$	88,085		18.74	%
Commercial Real Estate		249,441		49.91	%		237,638		50.55	%
Consumer		83,542		16.72	%		85,099		18.11	%
Residential		63,921		12.79	%		59,247		12.60	%

Total loans	$	499,784		100.00	%	$	470,069		100.00	%

Total nonperforming assets, which consist of non-accrual loans, loans past due 90 days or more and still accruing, and other real estate owned (“OREO”) decreased to $4,973,000 on September 30, 2017 from $5,835,000 on December 31, 2016. OREO increased to $2,639,000 on September 30, 2017 from $2,370,000 on December 31, 2016. This increase was due to the Bank’s foreclosure on seven properties (including one in the third quarter) in the nine months ended September 30, 2017. Non-performing loans decreased from $3,465,000 at December 31, 2016 to $2,334,000 at September 30, 2017. As discussed in more detail below under “Results of Operations—Allowance for Loan Losses,” management had provided for the anticipated losses on these loans in the allowance for loan losses. Loan payments received on non-accrual loans are first applied to principal. When a loan is placed on non-accrual status there are several negative implications. First, all interest accrued but unpaid at the time of the classification is reversed and deducted from the interest income totals for the Bank. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. Third, there may be actual losses that necessitate additional provisions for loan losses charged against earnings.

OREO represents real property acquired by the Bank for debts previously contracted, including through foreclosure, deeds in lieu of foreclosure or repossession. On December 31, 2016, the Bank was carrying six OREO properties on its books at a value of $2,370,000. During the nine months ended September 30, 2017, the Bank acquired seven additional OREO properties and disposed of six OREO properties, and as of September 30, 2017 the Bank is carrying seven OREO properties at a value of $2,639,000. The OREO properties are available for sale and are being actively marketed on the Bank’s website and through other means.

The Bank had loans in the amount of $444,000 at September 30, 2017 classified as performing Troubled Debt Restructurings (“TDRs”) as compared to $455,000 at December 31, 2016. None of these TDRs were included in non-accrual loans. These loans have had their original terms modified to facilitate payment by the borrower. The loans have been classified as TDRs primarily due to a change to interest only payments and the maturity of these modified loans is primarily less than one year.

Cash and cash equivalents increased to $36,340,000 on September 30, 2017 from $28,683,000 on December 31, 2016. Cash and cash equivalents consist of cash due from correspondents, cash in vault, and overnight investments (including federal funds sold). The decrease in cash and cash equivalents was due primarily to a decrease in federal funds sold, the proceeds of which were used to purchase securities available-for-sale. In addition, cash and cash equivalents are subject to routine fluctuations in deposits, including fluctuations in transactional accounts and professional settlement accounts.

Securities held-to-maturity decreased to $3,282,000 on September 30, 2017 from $3,299,000 on December 31, 2016. Securities available-for-sale increased to $49,664,000 on September 30, 2017, from $40,776,000 on December 31, 2016. The increase resulted from the Bank’s desire to build on-balance sheet liquidity and because of a slight increase in interest rates. During the nine months ended September 30, 2017 the Bank received $2,655,000 in proceeds from calls, maturities, and paydowns of securities available-for-sale and $9,941,000 in proceeds from the sale of securities available-for-sale. The Bank purchased $20,728,000 in securities available-for sale during the same period.

Financial’s investment in Federal Home Loan Bank of Atlanta (FHLBA) stock totaled $607,000 at September 30, 2017 and $565,000 at December 31, 2016, an increase of $42,000. This increase is attributable to the FHLBA’s increase in minimum ownership requirements. FHLBA stock is generally viewed as a long-term investment and because there is no market for the stock other than other Federal Home Loan Banks or member institutions, FHLBA stock is viewed as a restricted security. Therefore, when evaluating FHLBA stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value.

Liquidity and Capital

At September 30, 2017, Financial, on a consolidated basis, had liquid assets of $86,004,000 in the form of cash, interest-bearing and noninterest-bearing deposits with banks, and available-for-sale investments. Of this amount, approximately $12,592,000 (representing current book value) of the available-for-sale securities are pledged as collateral with $9,085,000 pledged as security for public deposits, and $3.507,000 pledged as security on a line of credit the Bank may draw on from time to time to meet liquidity needs. This line of credit currently has a zero balance. Management believes that liquid assets were adequate at September 30, 2017. Management anticipates that additional liquidity will be provided by the growth in deposit accounts and loan repayments at the Bank. In addition, if additional liquidity is needed, the Bank has the ability to purchase federal funds on the open market, borrow from the FHLBA using loans or investments within the Bank’s portfolio as collateral, and to borrow from the Federal Reserve Bank’s discount window.

Management is not aware of any trends, events or uncertainties that are reasonably likely to have a material negative impact on Financial’s short-term or long-term liquidity. Based in part on recent loan growth, the Bank is monitoring liquidity to ensure it is able to fund future loans.

As of December 31, 2015, Financial had $10,000,000 categorized as “Capital Notes” which represents the proceeds of the private placement of $10,000,000 in unregistered debt securities as previously disclosed (the “2012 Notes”). The 2012 Notes bore interest at the rate of 6% per year with interest payable quarterly in arrears. On December 3, 2015, Financial closed a private placement of common stock pursuant to which it received gross proceeds of $11,520,000 by selling an aggregate of 1,000,000 shares of Financials’ Common Stock at a price of $11.52 per share, as part of a private placement (the “Common Stock Private Placement”). Financial used $10,000,000 of the proceeds from the Common Stock Private Placement to prepay in full the 2012 Notes on January 5, 2016.

after January 24, 2018 at Financial’s sole discretion on 30 days written notice to the holders. Of the proceeds, $3,000,000 was injected into the Bank as equity capital in March 2017. It is anticipated the remaining $2,000,000 will remain at the holding company level for debt service on the 2017 Notes and other general corporate purposes.

At September 30, 2017, the Bank had a leverage ratio of approximately 9.25%, a Tier 1 risk-based capital ratio and a CET1 ratio of approximately 11.02% and a total risk-based capital ratio of approximately 12.19%. As of September 30, 2017 and December 31, 2016 the Bank’s regulatory capital levels exceeded those established for well-capitalized institutions. The following table sets forth the minimum capital requirements and the Bank’s capital position as of September 30, 2017 and December 31, 2016:

Bank Level Only Capital Ratios


	September 30,		December 31,
Analysis of Capital (in 000’s)	2017		2016
Tier 1 capital
Common Stock	$	3,742	$	3,742
Surplus		22,325		19,325
Retained earnings		30,381		27,582

Total Tier 1 capital	$	56,448	$	50,649

Common Equity Tier 1 Capital (CET1)	$	56,448	$	50,649

Tier 2 capital
Allowance for loan losses	$	6,020	$	5,716

Total Tier 2 capital:	$	6,020	$	5,716

Total risk-based capital	$	62,468	$	56,365

Risk weighted assets	$	512,307	$	488,607
Average total assets	$	610,456	$	566,399


	Actual						Regulatory Benchmarks
	September 30, 2017			December 31, 2016			For Capital Adequacy Purposes (1)			For Well Capitalized Purposes
Capital Ratios:
Tier 1 capital to average total assets		9.247	%		8.942	%		4.000	%		5.000	%
Common Equity Tier 1 Ratio		11.018	%		10.366	%		5.750	%		6.500	%
Tier 1 risk-based capital ratio		11.018	%		10.366	%		7.250	%		8.000	%
Total risk-based capital ratio		12.193	%		11.536	%		9.250	%		10.000	%

(1)	Minimum capital requirements for CET1, Tier 1, and Total Capital ratios include the capital conservation buffer of 1.25%, which is being phased in until January, 2019.

The above tables set forth the capital position and analysis for the Bank only. Because total assets on a consolidated basis are less than $1,000,000,000, Financial is not subject to the consolidated capital requirements imposed by the Bank Holding Company Act. Consequently, Financial does not calculate its financial ratios on a consolidated basis. If calculated, the capital ratios for the Company on a consolidated basis at September 30, 2017 would be slightly lower than those of the Bank.

In July 2013, the Federal Reserve Board approved a final rule establishing a regulatory capital framework for smaller, less complex financial institutions. The rule implements in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The phase-in period for this rule began in January 2015. Under the final rule, minimum requirements were increased for both the quantity and quality of capital held by banking organizations. The rule included a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets that applies to all supervised financial institutions. The capital conservation buffer began its phase-in on January 1, 2016 at 0.625% and increases by an additional 0.625% annually until it reaches 2.5% on January 1, 2019. This will result in an effective Tier 1 capital ratio of 8.5% upon full implementation. The capital conservation buffer will limit capital distributions, stock redemptions, and certain discretionary bonuses. Beginning January 1, 2016, failure to maintain the capital conservation buffer will limit the ability of the Bank and Financial to pay dividends, repurchase shares or pay discretionary bonuses. The rule also raised the minimum ratio of Tier 1 capital to risk-weighted assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking organizations.

Results of Operations

Comparison of the Three and Nine Months Ended September 30, 2017 and 2016

Earnings Summary

Financial had net income including all operating segments of $1,015,000 and $2,562,000 for the three and nine months ended September 30, 2017, compared to $1,055,000 and $2,993,000 for the comparable periods in 2016. Basic and diluted earnings per common share for the three and nine months ended September 30, 2017 were $0.23 and $0.59, respectively, compared to basic and diluted earnings per share of $0.24 and $0.68 for the three and nine months ended September 30, 2016.

The decrease in net income for the three months ended September 30, 2017 as compared to the prior year was due primarily to an increase in the allowance for loan loss provision, an increase in interest expense, and an increase in non-interest expense and was partially offset by an increase in non-interest income. The decrease in net income for the nine months ended September 30, 2017 as compared to the prior year was due primarily to an increase in the allowance for loan loss provision, a decrease in non-interest income, an increase in interest expense, and an increase in non-interest expense. The increases in both periods were partially offset by an increase in interest income. Non-interest expense increased in large part because of the Bank’s recent expansion into Charlottesville, Harrisonburg, and Roanoke. These expansions resulted in increases in personnel expense, occupancy expense, and marketing expense.

These operating results represent an annualized return on average stockholders’ equity of 7.75% and 6.65% for the three and nine months ended September 30, 2017, compared with 8.34% and 8.10% for the three and nine months ended September 30, 2016. This decrease for the three and nine months was a direct result of the decrease in net income. The Company had an annualized return on average assets of 0.66% and 0.58% for the three and nine months ended September 30, 2017 compared with 0.76% and 0.75% for the same periods in 2016. The decrease for the three and nine months ended September 30, 2017 largely resulted from an increase in average assets since September 30, 2016 along with a decrease in net income.

See “Non-Interest Income” below for mortgage business segment discussion.

Interest Income, Interest Expense, and Net Interest Income

Interest income increased to $6,070,000 and $17,430,000 for the three and nine months ended September 30, 2017 from $5,477,000 and $16,005,000 for the same periods in 2016, increases of 10.83% and 8.90%, respectively. Interest income increased primarily because of increased balances in the loan and investment portfolios. The average rate received on earning assets increased from 4.23% to 4.24% for the three months ended September 30, 2017 from the comparable period in 2016 and decreased for the nine months ended September 30, 2017 from 4.26% to 4.20% for the comparable period in 2016. The rate on total average earning assets increased for the three months ended September 30, 2017 as compared to the three months ended September 30, 2016 resulted primarily because the increase in short term rates by the FOMC resulted in increased rates paid to the bank, primarily on floating rate loans.

Interest expense increased to $786,000 and $2,168,000 for the three and nine months ended September 30, 2017 from $610,000 and $1,708,000 for the same periods in 2016, increases of 28.85% and 26.93%, respectively. The increase in interest expense resulted primarily from an increase on the rates paid and balances on deposits along with the interest paid on the 2017 Notes. The Bank’s average rate paid on interest bearing deposits was 0.67% and 0.64% during the three and nine month periods ended September 30, 2017 as compared to 0.61% and 0.58% for the same periods in 2016.

The fundamental source of the Bank’s net revenue is net interest income, which is determined by the difference between (i) interest and dividend income on interest earning assets, which consist primarily of loans, investment securities and other investments, and (ii) interest expense on interest-bearing liabilities, which consist principally of deposits and other borrowings. Net interest income for the three and nine months ended September 30, 2017 was $5,284,000 and $15,262,000 as compared to $4,867,000 and $14,297,000 for the same periods in 2016, an increase of 8.57% and 6.75%. The increase in net interest income for the three and nine months ended September 30, 2017 as compared with the comparable periods in 2016 primarily is attributable to the increase in interest income resulting from increased loan balances and, in the third quarter, the previously discussed increase in short term rates by the FOMC. The net interest margin was 3.65% and 3.68% for the three and nine months ended September 30, 2017, as compared to 3.76% and 3.80% for the same periods a year ago.

Financial’s net interest margin analysis and average balance sheets are shown in Schedule I below.

Non-Interest Income

Non-interest income is comprised primarily of fees and charges on transactional deposit accounts, gains on sales of mortgage loans held for sale, commissions on sales of investments and the Bank’s ownership interest in a title insurance agency. Non-interest income increased to $1,319,000 for the three months ended September 30, 2017 from $1,281,000 for the three months ended September 30, 2016.

This increase for the three months ended September 30, 2017 as compared to the same period last year was due primarily due to an increase in gains on sales of loans held for sale from $593,000 for the three months ended September 30, 2016 to $694,000 for the period ended September 30, 2017 as well increases in service charges, fees, and commissions and an increase in the cash value of life insurance from the comparable periods ended September 30, 2016. The increase for the three months ended September 30, 2017 was partially offset by a decrease in gains on sales and calls of securities from $210,000 for the three months ended September 30, 2016 to $51,000 for the same period this year.

Non-interest income decreased to $3,454,000 for the nine months ended September 30, 2017 from $3,605,000 for the nine months ended September 30, 2016. This decrease for the nine months ended September 30, 2017 as compared to the same period last year was due primarily due to a decrease in gains on sales of loans held for sale from $1,765,000 to $1,663,000 as well as a decrease in gains on sales and calls of securities from $444,000 to $113,000 for the same periods this year. The decrease for the nine months ended September 30, 2017 was partially offset by increases in service charges, fees, and commissions and an increase in the cash value of life insurance from the comparable periods ended September 30, 2016. These areas increased due to customer activity and utilization of services and additional purchases of BOLI in the third quarter of 2016.

The Bank, through its Mortgage division, originates both conforming and non-conforming consumer residential mortgage loans in the markets we serve. As part of the Bank’s overall risk management strategy, all of the loans originated and closed by the Mortgage division are presold to major national mortgage banking or financial institutions. The Mortgage division assumes, except in limited circumstances such as first payment default, no credit or interest rate risk on these mortgages.

Purchase mortgage originations totaled $16,860,728 and $39,015,600, or 67.00% and 65.82% respectively, of the total mortgage loans originated in the three and nine months ended September 30, 2017 as compared to $11,921,674 and $38,401,785, or 54.43% and 62.13%, respectively, of the total mortgage loans originated in the same periods in 2016. The increase in amount of purchase mortgage originations for the first nine months of 2017 resulted from the Bank’s increased presence in the Charlottesville, Harrisonburg and Roanoke markets as well as continually favorable longer-term interest rates. However, despite the increase in longer-term rates, refinancing activity continued primarily due to the relatively low interest rate environment as compared to long-term historical interest rate levels. Management anticipates that purchase mortgage originations going forward will represent a majority of mortgage originations as they have in the recent past.

Despite the recent fluctuations in rates, management anticipates that residential mortgage rates will remain near the current historic lows for the remainder of 2017. Management expects that attractive rates coupled with the Mortgage division’s reputation in Region 2000, steady residential real estate inventory and the recent hiring of additional mortgage loan originators in Roanoke, Harrisonburg and Charlottesville will result in strong mortgage originations through the remainder of 2017. In addition, Management believes that regulatory pressure may result in a decreased number of competitors to the Mortgage division and this could result in an increase in market share. Management also believes that in the event that interest rates rise, revenue from the mortgage segment could be under pressure.

Our Investment division provides brokerage services through an agreement with a third-party broker-dealer. Pursuant to this arrangement, the third party broker-dealer operates a service center adjacent to one of the branches of the Bank. The center is staffed by dual employees of the Bank and the broker-dealer. Investment receives commissions on transactions generated and in some cases ongoing management fees such as mutual fund 12b-1 fees. The Investment division’s financial impact on our consolidated revenue has been immaterial. Although management cannot predict the financial impact of Investment with certainty, management anticipates the Investment division’s impact on noninterest income will remain immaterial in 2017.

The Bank provides insurance and annuity products to Bank customers and others, through the Bank’s Insurance subsidiary. The Bank has three full-time employees that are dedicated to selling insurance products through Insurance. Insurance generates minimal revenue and its financial impact on our consolidated revenue has been immaterial. Management anticipates that Insurance’s impact on noninterest income will remain immaterial in 2017.

Non-Interest Expense

Non-interest expense for the three and nine months ended September 30, 2017 increased to $4,914,000 and $14,237,000 from $4,449,000 and $12,893,000, increases of 10.45% and 10.42% from the comparable periods in 2016. These increases resulted from increases for personnel expense primarily related to the expansion into Charlottesville, Harrisonburg, and Roanoke, as well as increases in credit expense, marketing expenses, occupancy expenses, equipment expenses, and supplies expense. Total personnel expense was $2,538,000 and $7,314,000 for the three and nine month periods ended September 30, 2017 as compared to $2,318,000 and $6,717,000 for the same periods in 2016.

Allowance for Loan Losses

The allowance for loan losses represents an amount that, in our judgment, will be adequate to absorb probable losses inherent in the loan portfolio. The provision for loan losses increases the allowance, and loans charged off, net of recoveries, reduce the allowance. The provision to the allowance for loan losses is charged to earnings to bring the total allowance to a level deemed appropriate by management and is based upon two components – specific impairment and general reserves. As discussed below, loans having a risk rating of 7 or below that are significantly past due, and the borrower’s performance and financial condition provide evidence that it is probable that the Bank will be unable to collect all amounts when due, are evaluated for specific impairment. The general reserve component is based on an evaluation of general economic conditions, actual and expected credit losses, and loan performance measures. Based on the application of the loan loss calculation, the Bank provided $200,000 and $745,000 to the allowance for loan losses for the three and nine month periods ended September 30, 2017. This compares to the provision of $145,000 and $595,000 for the comparable periods in 2016, representing increases of 37.93% and 25.21%, respectively.

Charged-off loans, which are loans that management deems uncollectible, are charged against the allowance for loan losses and constitute a realized loss. Charged-off loans were $325,000 for the three months ended September 30, 2017 as compared to $114,000 for the comparable period in 2016. While a charged off loan may subsequently be collected, such recoveries generally are realized over an extended period of time. In the three months ended September 30, 2017, the Bank had recoveries of charged off loans of $13,000 as compared with $35,000 for the comparable period in 2016.

In light of the current economic environment, management continues its ongoing assessment of specific impairment in the Bank’s loan portfolio. As set forth in the tables below, the Bank’s allowance arising from the specific impairment evaluation as of September 30, 2017 increased as compared to December 31, 2016.

For the nine months ended September 30, 2017, the Bank had a minimal change in asset quality from December 31, 2016. As shown in the table below, although the total balance in the reserve increased, the allowance for loan losses to total loans decreased slightly to 1.20% as of September 30, 2017 from 1.22% as of December 31, 2016 due to an increase the Bank’s loan balances. The overall balance in the allowance for loan losses increased from $5,716,000 as of December 31, 2016 to $6,020,000 on September 30, 2017. The inherent risks associated with the increasing industry concentrations and commercial real estate concentrations within the portfolio have increased the qualitative portion of the general reserve. Management believes that the current allowance for loan losses is adequate.

The following tables summarize the allowance activity for the periods indicated:


	Allowance for Loan Losses and Recorded Investment in Loans (dollars in thousands)
	As of and For the Nine Months Ended September 30, 2017
2017	Commercial			Commercial Real Estate			Consumer			Residential			Total
Allowance for Loan Losses:
Beginning Balance	$	2,192		$	2,109		$	954		$	461		$	5,716
Charge-offs		(315	)		(17	)		(114	)		(105	)		(551	)
Recoveries		5			24			42			39			110
Provision		537			(233	)(1)		272			169			745

Ending Balance	$	2,419		$	1,883		$	1,154		$	564		$	6,020

Ending Balance: Individually evaluated for impairment	$	1,301		$	290		$	307		$	4		$	1,902

Ending Balance: Collectively evaluated for impairment		1,118			1,593			847			560			4,118

Totals:	$	2,419		$	1,883		$	1,154		$	564		$	6,020

Loans:

Ending Balance: Individually evaluated for impairment	$	2,458		$	3,437		$	490		$	1,602		$	7,987

Ending Balance: Collectively evaluated for impairment		100,422			246,004			83,052			62,319			491,797

Totals:	$	102,880		$	249,441		$	83,542		$	63,921		$	499,784

(1)

Despite an increased concentration of loan balances in the commercial real estate segment, the allowance related to the segment decreased which resulted in a decrease in the provision for this category. Management has a process for the ongoing evaluation of our loans and the specific risks associated with concentrations in each segment.


	Allowance for Loan Losses and Recorded Investment in Loans (dollars in thousands)
	As of and For the Year Ended December 31, 2016
2016	Commercial			Commercial Real Estate			Consumer			Residential			Total
Allowance for Loan Losses:
Beginning Balance	$	1,195		$	1,751		$	1,073		$	664		$	4,683
Charge-offs		(328	)		(156	)		(275	)		—			(759	)
Recoveries		7			127			44			2			180
Provision		1,318	(2)		387	(2)		112			(205	)(1)		1,612

Ending Balance	$	2,192		$	2,109		$	954		$	461		$	5,716

Ending Balance: Individually evaluated for impairment	$	1,233		$	345		$	110		$	83		$	1,771

Ending Balance: Collectively evaluated for impairment		959			1,764			844			378			3,945

Totals:	$	2,192		$	2,109		$	954		$	461		$	5,716

Loans:

Ending Balance: Individually evaluated for impairment	$	2,219		$	5,198		$	128		$	2,254		$	9,799

Ending Balance: Collectively evaluated for impairment		85,866			232,440			84,971			56,993			460,270

Totals:	$	88,085		$	237,638		$	85,099		$	59,247		$	470,069

(1)	The experience within the historical charge-off period used to calculate the allowance has improved which reduced the need for a provision relating to this segment.

(2)

The increased concentration of loan balances in the commercial segments resulted in an increase in the provision for these categories. Management has a process for the ongoing evaluation of our loans and the specific risks associated with concentrations in each segment. Specific reserves increases accounted for the majority of the increase related to the commercial segment.

The following sets forth the reconciliation of the allowance for loan loss:


	Three months ended September 30, (in thousands)						Nine months ended September 30, (in thousands)
	2017			2016			2017			2016
Balance, beginning of period	$	6,132		$	4,887		$	5,716		$	4,683
Provision for loan losses		200			145			745			595
Loans charged off		(325	)		(114	)		(551	)		(492	)
Recoveries of loans charged off		13			35			110			167

Net (charge offs)		(312	)		(79	)		(441	)		(325	)

Balance, end of period	$	6,020		$	4,953		$	6,020		$	4,953

No nonaccrual loans were excluded from impaired loan disclosure at September 30, 2017 and December 31, 2016. If interest on these loans had been accrued, such income cumulatively would have approximated $408,000 and $391,000 on September 30, 2017 and December 31, 2016, respectively. Loan payments received on nonaccrual loans are applied to principal. When a loan is placed on nonaccrual status there are several negative implications. First, all interest accrued but unpaid at the time of the classification is deducted from the interest income totals for the Bank. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. Third, there may be actual losses that necessitate additional provisions for credit losses charged against earnings.

Below is a summary and definition of the Bank’s risk rating categories:


RATING 1		Excellent
RATING 2		Above Average
RATING 3		Satisfactory
RATING 4		Acceptable / Low Satisfactory
RATING 5		Monitor
RATING 6		Special Mention
RATING 7		Substandard
RATING 8		Doubtful
RATING 9		Loss

•

pledged and/or ability of the personal guarantor(s) to pay the loan may not adequately protect the Bank. There is a distinct possibility that the Bank will sustain some loss if the deficiencies associated with the loan are not corrected in the near term. A substandard loan would not automatically meet our definition of impaired unless the loan is significantly past due and the borrower’s performance and financial condition provides evidence that it is probable that the Bank will be unable to collect all amounts due.

•

Income Taxes

For the three and nine months ended September 30, 2017, Financial had an income tax expense of $474,000 and $1,172,000 as compared to $499,000 and $1,421,000 for the same periods in 2016. This represents an effective tax rate of 31.83% and 31.39% for the three and nine months ended September 30, 2017 as compared with 32.11% and 32.19% for the three and nine months ended September 30, 2016. Our effective rate was lower than the statutory corporate tax rate in both quarters because of federal income tax benefits resulting from the tax treatment of earnings on bank owned life insurance and certain tax free municipal securities. The changes in effective tax rates from year to year are primarily the result of slightly lower pre-tax earnings and relatively comparable levels of these tax-exempt sources of income.

Schedule I

Net Interest Margin Analysis

Average Balance Sheets

For the Quarter Ended September 30, 2017 and 2016

(dollars in thousands)


	2017								2016
	Average Balance Sheet			Interest Income/ Expense		Average Rates Earned/ Paid			Average Balance Sheet			Interest Income/ Expense		Average Rates Earned/ Paid
ASSETS
Loans, including fees (1) (2)	$	493,179		$	5,654		4.55	%	$	460,505		$	5,186		4.52	%
Loans held for sale		3,169			29		3.63	%		4,082			41		4.03	%
Fed funds sold		14,570			45		1.23	%		7,237			4		0.22	%
Interest bearing bank balances		7,000			21		1.19	%		6,000			13		0.87	%
Securities (3)		54,791			318		2.30	%		40,890			232		2.28	%
Federal agency equities		1,389			7		2.00	%		1,257			6		1.91	%
CBB equity		116			—		—			116			—		—

Total earning assets		574,214			6,074		4.20	%		520,087			5,482		4.23	%

Allowance for loan losses		(6,128	)							(4,963	)
Non-earning assets		44,361								37,223

Total assets	$	612,447							$	552,347

LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Demand interest bearing	$	146,745		$	129		0.35	%	$	130,523		$	93		0.29	%
Savings		104,738			57		0.22	%		109,028			60		0.22	%
Time deposits		177,147			537		1.20	%		161,781			457		1.13	%

Total interest bearing deposits		428,630			723		0.67	%		401,332			610		0.61	%

Other borrowed funds
Repurchase agreements		2,880			13		1.79	%		—			—		—
Capital Notes		5,000			50		3.97	%		—			—		—

Total interest-bearing liabilities		436,510			786		0.71	%		401,332			610		0.61	%

Non-interest bearing deposits		122,999								99,839
Other liabilities		954								1,016

Total liabilities		560,463								502,187
Stockholders’ equity		51,984								50,160

Total liabilities and Stockholders’ equity	$	612,447							$	552,347

Net interest income				$	5,288							$	4,872

Net interest margin							3.65	%							3.76	%

Interest spread							3.49	%							3.62	%

(1)	Net accretion or amortization of deferred loan fees and costs are included in interest income.

(2)	Nonperforming loans are included in the average balances. However, interest income and yields calculated do not reflect any accrued interest associated with non-accrual loans.

(3)	The interest income and yields calculated on securities have been tax affected to reflect any tax exempt interest on municipal securities. An assumed income tax rate of 34% was used in the calculation.

Net Interest Margin Analysis

Average Balance Sheets

For the Nine Months Ended September 30, 2017 and 2016

(dollars in thousands)


	2017								2016
	Average Balance Sheet			Interest Income/ Expense		Average Rates Earned/ Paid			Average Balance Sheet			Interest Income/ Expense		Average Rates Earned/ Paid
ASSETS
Loans, including fees (1) (2)	$	480,317		$	16,266		4.53	%	$	446,637		$	15,115		4.52	%
Loans held for sale		2,309			70		4.05	%		3,615			97		3.59	%
Federal funds sold		10,276			81		1.05	%		5,814			16		0.37	%
Interest bearing bank balances		7,000			53		1.01	%		6,000			28		0.62	%
Securities (3)		53,293			932		2.34	%		39,851			726		2.44	%
Federal agency equities		1,331			42		4.22	%		1,237			39		4.22	%
CBB equity		116			—		—			116			—		—

Total earning assets		554,642			17,444		4.20	%		503,270			16,021		4.26	%

Allowance for loan losses		(5,862	)							(4,803	)
Non-earning assets		44,194								36,109

Total assets	$	592,974							$	534,576

LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Demand interest bearing	$	143,087		$	357		0.33	%	$	124,942		$	248		0.27	%
Savings		107,044			173		0.22	%		111,011			180		0.22	%
Time deposits		170,206			1,488		1.17	%		152,003			1,268		1.12	%

Total interest bearing deposits		420,337			2,018		0.64	%		387,956			1,696		0.58	%
Other borrowed funds
Fed funds purchased		—			—		—			494			4		1.08	%
Repurchase agreements		1,062			13		1.64	%		—			—		—
Capital Notes		4,560			137		4.00	%		109			8		6.00	%

Total interest-bearing liabilities		425,959			2,168		0.68	%		388,559			1,708		0.59	%

Non-interest bearing deposits		114,866								95,291
Other liabilities		667								1,309

Total liabilities		541,492								485,159
Stockholders’ equity		51,482								49,417

Total liabilities and Stockholders’ equity	$	592,974							$	534,576

Net interest income				$	15,276							$	14,313

Net interest margin							3.68	%							3.80	%

Interest spread							3.52	%							3.66	%

(1)	Net deferred loan fees and costs are included in interest income.

(2)	Nonperforming loans are included in the average balances. However, interest income and yields calculated do not reflect any accrued interest associated with non-accrual loans.

(3)	The interest income and yields calculated on securities have been tax affected to reflect any tax exempt interest on municipal securities. An assumed income tax rate of 34% was used in the calculation.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Not applicable

Item 4.

Controls and Procedures

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

Financial’s management, including Financial’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, Financial’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that Financial files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

There have been no significant changes during the three months ended September 30, 2017, in the Company’s internal controls over financial reporting (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) or in other factors that could have significantly affected those controls subsequent to the date of our most recent evaluation of internal controls over financial reporting, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II – OTHER INFORMATION

Item 1.

Legal Proceedings

The Company is not involved in any pending legal proceedings at this time, other than routine litigation incidental to its business.

Item 1A.

Risk Factors

RISK FACTORS

In addition to the other information included in this Quarterly Report on Form 10-Q, the following risk factors should be carefully considered in connection with evaluating our business and any forward-looking statements contained herein. Our business, financial condition, results of operations and cash flows could be harmed by any of the risk factors described below, or other risks that have not been identified or which we believe are immaterial or unlikely. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, our business, financial condition, operating results and cash flows could be materially adversely affected.

RISKS RELATED TO OUR BUSINESS

Our profitability depends significantly on local economic conditions.

Our success depends primarily on the general economic conditions of the primary markets in Virginia in which we operate and where our loans are concentrated. Unlike nationwide banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in the Lynchburg metropolitan statistical area (“MSA”). Lynchburg’s MSA, which is often referred to as Region 2000, consists of approximately 2,122 square miles, and includes the City of Lynchburg and the Counties of Bedford, Campbell, Amherst and Appomattox. To a lesser extent, our lending market includes the Roanoke, Charlottesville and Harrisonburg MSAs. Our branches in localities outside of Region 2000 have a short operating history. As of August 2017, the Lynchburg MSA had an unemployment rate (not adjusted seasonally) of 4.6%, as compared to a statewide average unemployment rate of 3.8%.

The local economic conditions in these areas have a significant impact on the Company’s commercial and industrial, real estate and construction loans, the ability of its borrowers to repay their loans and the value of the collateral securing these loans. In addition, if the population or income growth in the Company’s market areas is slower than projected, income levels, deposits and housing starts could be adversely affected and could result in a reduction of the Company’s expansion, growth and profitability. If the Company’s market areas experience a downturn or a recession for a prolonged period of time, the Company could experience significant increases in nonperforming loans, which could lead to operating losses, impaired liquidity and eroding capital. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreaks of hostilities or other international or domestic calamities, unemployment, monetary and fiscal policies of the federal government or other factors could impact these local economic conditions and could negatively affect the Company’s financial condition, results of operations and cash flows.

A significant portion of our loan portfolio is secured by real estate, and events that negatively impact the real estate market could hurt our business.

At September 30, 2017, a substantial majority of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of

repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. Because most of our loans are concentrated in the Region 2000 area in and surrounding the City of Lynchburg, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are more geographically diverse. A weakening of the real estate market in our primary market areas could result in an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, which in turn could have an adverse effect on our profitability and asset quality. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. Additionally, acts of nature, including hurricanes, tornados, earthquakes, fires and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact our financial condition.

Our loan portfolio contains a number of real estate loans with relatively large balances.

At September 30, 2017, a significant portion of our total loan portfolio contained real estate loans with balances in excess of $1,000,000. The deterioration of one or a few of these loans could cause a significant increase in nonperforming loans, which could result in a net loss of earnings, an increase in the provision for loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on our financial condition and results of operations.

Commercial real estate loans increase our exposure to credit risk.

At September 30, 2017, a majority of our loan portfolio was secured by commercial real estate. Loans secured by commercial real estate are generally viewed as having more risk of default than loans secured by residential real estate or consumer loans because repayment of the loans often depends on the successful operation of the property, the income stream of the borrowers, the accuracy of the estimate of the property’s value at completion of construction and the estimated cost of construction. An adverse development with respect to one lending relationship can expose us to a significantly greater risk of loss as compared with a single-family residential mortgage loan because we typically have more than one loan with such borrowers. Additionally, these loans typically involve larger loan balances to single borrowers or groups of related borrowers compared with single-family residential mortgage loans. Therefore, the deterioration of one or a few of these loans could cause a significant decline in the related asset quality. These loans represent higher risk and could result in a sharp increase in loans charged-off and could require us to significantly increase our allowance for loan losses, which could have a material adverse impact on our business, financial condition, results of operations and cash flows.

A percentage of the loans in our portfolio currently include exceptions to our loan policies and supervisory guidelines.

All of the loans that we make are subject to written loan policies adopted by our board of directors and to supervisory guidelines imposed by our regulators. Our loan policies are designed to reduce the risks associated with the loans that we make by requiring our loan officers to take certain steps that vary depending on the type and amount of the loan, prior to closing a loan. These steps include, among other things, making sure the proper liens are documented and perfected on property securing a loan, and requiring proof of adequate insurance coverage on property securing loans. Loans that do not fully comply with our loan policies are known as “exceptions.” We categorize exceptions as policy exceptions, financial statement exceptions and document exceptions. As a result of these exceptions, such loans may have a higher risk of loan loss than the other loans in our portfolio that fully comply with our loan policies. In addition, we may be subject to regulatory action by federal or state banking authorities if they believe the number of exceptions in our loan portfolio represents an unsafe banking practice.

As a community bank, we have different lending risks than larger banks. We provide services to individuals and small to medium-sized businesses in our local markets who may have fewer financial resources to weather a downturn in the economy.

Our ability to diversify our economic risks is limited by our own local markets and economies. We lend primarily to small to medium-sized businesses, professionals and individuals, which may expose us to greater lending risks than those of banks lending to larger, better-capitalized businesses with longer operating histories. For instance, small to medium-sized businesses frequently have smaller market share than their competition, may be more vulnerable to economic downturns, have fewer financial resources in terms of capital or borrowing capacity than larger entities, often need substantial additional capital to expand or compete and may experience significant volatility in operating results. Any one or more of these factors may impair the borrower’s ability to repay a loan. In addition, the success of a small to medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay a loan. Economic downturns and other events that negatively impact the Company’s market areas could cause the Company to incur substantial credit losses that could negatively affect the Company’s results of operations and financial condition.

We depend on the accuracy and completeness of information about clients and counterparties, and our financial condition could be adversely affected if we rely on misleading information.

In deciding whether to extend credit or to enter into other transactions with clients and counterparties, we may rely on information furnished to us by or on behalf of clients and counterparties, including financial statements and other financial information, which we do not independently verify as a matter of course. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to customers, we may assume that a customer’s audited financial statements conform with U.S. Generally Accepted Accounting Principles (“GAAP”) and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer. Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that do not comply with GAAP or are materially misleading.

If we suffer loan losses from a decline in credit quality, our earnings will decrease.

We could sustain losses if borrowers, guarantors or related parties fail to perform in accordance with the terms of their loans. We have adopted underwriting and credit monitoring procedures and policies, including the establishment and review of the allowance for loan losses, that we believe are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying our credit portfolio. These policies and procedures, however, may not prevent unexpected losses that could materially adversely affect our results of operations.

These policies and procedures necessarily rely on our making various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we review our loans and our loss and delinquency experience, and we evaluate economic conditions. If our assumptions are incorrect, our allowance for loan losses may not be sufficient to cover probable incurred losses in our loan portfolio, resulting in additions to our allowance. Any future additions to our allowance could materially decrease our net income.

In addition, the Federal Reserve Bank of Richmond and the Virginia Bureau of Financial Institutions (the “BFI”) periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Any increase in our allowance for loan losses or loan charge-offs as required by regulatory authorities might have a material adverse effect on our financial condition and results of operations.

The markets for our deposit and lending products and services are highly competitive, and we face substantial competition.

The banking and financial services industry is highly competitive. We compete as a financial intermediary with other commercial banks, savings banks, credit unions, finance companies, mutual funds, insurance companies and brokerage and investment banking firms soliciting business from residents of and businesses located in the Virginia localities where the Bank has a presence, surrounding areas and elsewhere. Many of these competing institutions have nationwide or regional operations and have greater resources than we have. We also face competition from local community institutions, such as ones that serve local markets only. Many of our competitors enjoy competitive advantages, including greater name recognition, financial resources, a wider geographic presence or more accessible branch office locations, the ability to offer additional services, greater marketing resources, more favorable pricing alternatives for loans and deposits and lower origination and operating costs. We are also subject to lower lending limits than our larger competitors. Our profitability depends upon our continued ability to successfully compete in our market areas. Increased deposit competition could increase our cost of funds and could adversely affect our ability to generate the funds necessary for our lending operations. If we must raise interest rates paid on deposits or lower interest rates charged on our loans, our net interest margin and profitability could be adversely affected. Competition could result in a decrease in loans we originate and could negatively affect our ability to grow and our results of operations.

Technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services.

We have increased and plan to continue to increase our levels of commercial and industrial loans. We may not be successful in continuing to penetrate this market segment, which has helped to drive some of our recent earnings.

At September 30, 2017, a significant percentage of our loans were commercial and industrial loans. Our portfolio of commercial and industrial loans has increased during the past year.

While we intend to originate these types of loans in a manner that is consistent with safety and soundness, these non-residential loans generally expose us to greater risk of loss than one- to four-family residential mortgage loans, as repayment of such commercial and industrial loans generally depends, in large part, on the borrower’s business to cover operating expenses and debt service. In addition, these types of loans typically involve larger loan balances to single borrowers or groups of related borrowers, as compared to one- to four-family residential mortgage loans. Changes in economic conditions that are beyond our or the borrower’s control could adversely affect the value of the security for the loan, including the future cash flow of the affected business. As we increase our portfolio of these loans, we may experience higher levels of non-performing assets or loan losses, or both.

Opening new branches may not result in increased assets or revenues for us, or may negatively impact our earnings.

We opened a new branch in Harrisonburg, Virginia on October 1, 2015, in Charlottesville, Virginia on December 1, 2016, and in Roanoke, Virginia on February 21, 2017. The additional costs to open and operate these new branches may negatively impact our earnings and efficiency ratio in the short term. There is a risk that we will be unable to manage our growth, as the process of opening new branches may divert our time and resources. There is also a risk that these new branches may not be profitable, which would negatively impact our results of operations.

Our plans for future expansion depend, in some instances, on factors beyond our control, and an unsuccessful attempt to achieve growth could have a material adverse effect on our business, financial condition, results of operations and future prospects.

We expect to continue to engage in new branch expansion in the future. We may also seek to acquire other financial institutions, or parts of those institutions, though we have no present plans in that regard. Expansion involves a number of risks, including, without limitation:

•

the time and costs of evaluating new markets, hiring experienced local management and opening new offices;

•

the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;

•

our entrance into new markets where we lack experience;

•

the introduction of new products and services with which we have no prior experience into our business;

•

failure to culturally integrate an acquisition target or new branches or failing to identify and select the optimal candidate for integration or expansion; and

•

failure to identify and retain experienced key management members with local expertise and relationships in new markets.

We may continue to acquire and hold other real estate owned (OREO) properties, which could lead to increased operating expenses and vulnerability to additional declines in the market value of real estate in our areas of operations.

From time-to-time, we foreclose upon and take title to the real estate serving as collateral for our loans as part of our business. If our OREO balance increases, management expects that our earnings will be negatively affected by various expenses associated with OREO, including personnel costs, insurance and taxes, completion and repair costs, valuation adjustments and other expenses associated with property ownership. Also, at the time that we foreclose upon a loan and take possession of a property, we estimate the value of that property using third-party appraisals and opinions and internal judgments. OREO property is valued on our books at the estimated market value of the property, less the estimated costs to sell (or “fair value”). Upon foreclosure, a charge-off to the allowance for loan losses is recorded for any excess between the value of the asset on our books over its fair value. Thereafter, we periodically reassess our judgment of fair value based on updated appraisals or other factors, including, at times, at the request of our regulators. Any further declines in our estimate of fair value for OREO will result in additional valuation adjustments, with a corresponding expense in our statements of income that is recorded under the line item for “Other real estate expenses.” As a result, our results of operations are vulnerable to additional declines in the market for residential and commercial real estate in the areas in which we operate. The expenses associated with OREO and any further property write downs could have a material adverse effect on our results of operations and financial condition. Any increase in nonaccrual loans may lead to further increases in our OREO balance in the future.

Additional growth and regulatory requirements may require us to raise additional capital in the future, and capital may not be available when it is needed or may have unfavorable terms, which could adversely affect our financial condition and results of operations.

We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. While the boards of the Company and the Bank intend to take steps to ensure that the capital plan aligns with the Bank’s strategic plan, that all material risks to the Bank are identified and measured and that capital limits are appropriate for the institution’s risk profile, failure to successfully implement such steps could have a material adverse effect on our financial condition and results of operations. We may at some point need to raise additional capital to support our continued growth. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside of our control, and on our financial performance. Accordingly, we can make no assurances of our ability to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations could be materially impaired.

Our corporate culture has contributed to our success, and if we cannot maintain this culture as we grow, we could lose the teamwork and increased productivity fostered by our culture, which could harm our business.

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters teamwork and increased productivity. As our organization grows and we are required to implement more complex organizational management structures, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future success.

If we fail to retain our key employees, our growth and profitability could be adversely affected.

Our success is, and is expected to remain, highly dependent on our executive management team. Four of our key executives are Robert R. Chapman III (President of the Company and President and CEO of the Bank), J. Todd Scruggs (Secretary-Treasurer of the Company and Executive Vice President and CFO of the Bank), Harry P. “Chip” Umberger (Executive Vice President and Senior Credit Officer of the Bank), and Michael A. Syrek (Executive Vice President and Senior Loan Officer of the Bank). We are especially dependent on these executives as well as other key personnel because, as a community bank, we depend on our management team’s ties to the community to generate business for us, and our executives have key expertise needed to implement our business strategy. Our executive management and other key personnel have not signed non-competition covenants.

Competition for personnel is intense, and we may not be successful in attracting or retaining qualified personnel. Our failure to compete for these personnel, or the loss of the services of several of such key personnel, could adversely affect our growth strategy and seriously harm our business, results of operations and financial condition.

As a community bank, our ability to maintain our reputation is critical to the success of our business, and our failure to do so may materially adversely affect our performance.

As a community bank, our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. Negative publicity can result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance, acquisitions and actions taken or threatened by government regulators and community organizations in response to those activities. If our reputation is negatively affected by the actions of our employees or otherwise, there may be an adverse effect on our ability to keep and attract customers, and we might be exposed to litigation and regulatory action. Any of such events could harm our business, and, therefore, our operating results may be materially adversely affected. As a financial services company with a high profile in our market area, we are inherently exposed to this risk. While we take steps to minimize reputation risk in dealing with customers and other constituencies, we will continue to face additional challenges maintaining our reputation with respect to customers of the Bank in our current primary market area in Region 2000 and in establishing our reputation in new market areas.

Our decisions regarding how we manage our credit exposure may materially and adversely affect our business.

We manage our credit exposure through careful monitoring of lending relationships and loan concentrations in particular industries, and through loan approval and review procedures.

We have established an evaluation process designed to determine the adequacy of our allowance for loan losses. While this evaluation process uses historical and other objective information, the classification of loans and the establishment of loan losses is an estimate based on experience, judgment and expectations regarding our borrowers and the economies in which we and our borrowers operate, as well as the judgment of our regulators. While our board and senior management are continuing to improve the Bank’s risk management framework and align the Bank’s risk philosophy with its capital and strategic plans, failure to continue to improve such risk management framework could have a material adverse effect on our financial condition and results of operations. We can make no assurances that our loan loss reserves will be sufficient to absorb future loan losses or prevent a material adverse effect on our business, financial condition or results of operations.

Our profitability is vulnerable to interest rate fluctuations and changes in monetary policies.

Our profitability depends substantially upon our net interest income. Net interest income is the difference between the interest earned on interest-earning assets, such as loans and investment securities, and the interest expense paid on interest-bearing liabilities, such as NOW accounts, savings accounts, time deposits and other borrowings. Market interest rates for loans, investments and deposits are highly sensitive to many factors beyond our control. Interest rate spreads have seen a sustained period of narrowness due to many factors, such as market conditions, policies of various government and regulatory authorities and competitive pricing pressures, and we cannot predict whether these rate spreads will narrow further. This narrowing of interest rate spreads could adversely affect our financial condition and results of operations. In addition, we cannot predict whether interest rates will continue to remain at present levels. Changes in interest rates may cause significant changes, up or down, in our net interest income. Depending on our portfolio of loans and investments, our results of operations may be adversely affected by changes in interest rates.

Our financial condition and results of operations are affected by credit policies of monetary authorities, particularly the Federal Reserve Board. Actions by monetary and fiscal authorities, including the Federal Reserve Board, could have an adverse effect on our deposit levels, loan demand or business and earnings.

Our information systems may experience an interruption or breach in security.

We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer-relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur; or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny or expose us to civil litigation and possible financial liability; any of which could have a material adverse effect on our financial condition and results of operations.

We face the risk of cyber-attack to our computer systems.

Our computer systems, software and networks have been and will continue to be vulnerable to unauthorized access, loss or destruction of data (including confidential client information), account takeovers, unavailability of service, computer viruses or other malicious code, cyber-attacks and other events. These threats may derive from human error, fraud or malice on the part of employees or third parties, or may result from accidental technological failure. If one or more of these events occurs, it could result in the disclosure of confidential client information, damage to our reputation with our clients and the market, additional costs to us (such as repairing systems or adding new personnel or protection technologies), costs of breach response, regulatory penalties and financial losses, to both us and our clients and customers. Such events could also cause interruptions or malfunctions in our operations (such as the lack of availability of our online banking system), as well as the operations of our clients, customers or other third parties. Although we maintain safeguards to protect against these risks, there can be no assurance that we will not suffer losses in the future that may be material in amount or nature.

Changes in consumers’ use of banks and changes in consumers’ spending and saving habits could adversely affect our financial results.

Technology and other changes now allow many consumers to complete financial transactions without using banks. For example, consumers can pay bills and transfer funds directly without going through a bank. This disintermediation could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and saving habits could adversely affect our operations, and we may be unable to timely develop competitive new products and services in response to these changes that are accepted by new and existing customers.

Failure to implement new technologies in our operations may adversely affect our growth or profits.

The market for financial services, including banking services and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and telebanking. Our ability to compete successfully in our markets may depend on the extent to which we are able to exploit such technological changes. However, we can provide no assurance that we will be able to properly or timely anticipate or implement such technologies or properly train our staff to use such technologies. Any failure to adapt to new technologies could adversely affect our business, financial condition or operating results.

We are subject to operational risks.

The Company may also be subject to disruptions of its systems arising from events that are wholly or partially beyond its control (including, for example, computer viruses or electrical or telecommunications outages), which may give rise to losses in service to customers and to financial loss or liability. The Company is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as is the Company) and to the risk that the Company’s (or its vendors’) business continuity and data security systems prove to be inadequate.

We are subject to liquidity risk.

Liquidity risk is the potential that we will be unable to meet our obligations as they become due, capitalize on growth opportunities as they arise or pay regular cash dividends because of an inability to liquidate assets or obtain adequate funding in a timely basis, at a reasonable cost and within acceptable risk tolerances. A failure to adequately manage our liquidity risk could adversely affect our business, financial condition or operating results, especially in the event of another financial crisis. Further, the Federal Reserve could impose additional requirements on the Company if the agency determines that our enhanced liquidity risk management practices do not adequately manage our liquidity risk.

We may lose lower-cost funding sources.

Checking, savings and money market deposit account balances and other forms of customer deposits can decrease when customers perceive alternative investments, such as the stock market, as providing a better risk/return tradeoff. If customers move money out of bank deposits and into other investments, the Bank could lose a relatively low-cost source of funds, thereby increasing its funding costs and reducing the Bank’s net interest income and net income.

If we fail to maintain an effective system of internal and disclosure controls, we may not be able to accurately report our financial results or prevent or detect fraud.

Effective internal control over financial reporting and disclosure controls and procedures are necessary for us to provide reliable financial reports and effectively prevent or detect fraud and to operate successfully as a public company.

The Company faces the risk that the design of its controls and procedures, including those to mitigate the risk of fraud by employees or outsiders, may prove to be inadequate or are circumvented, thereby causing delays in detection of errors or inaccuracies in data and information. We regularly review and update the Company’s internal controls, disclosure controls and procedures and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations and financial condition.

Any failure to maintain effective controls or timely effect any necessary improvement of our internal and disclosure controls could hinder our ability to accurately report our operating results or cause us to fail to meet our reporting obligations, which could affect our ability to remain listed with The NASDAQ Capital Market. Ineffective internal and disclosure controls could also harm our reputation, negatively impact our operating results or cause investors to lose confidence in our reported financial information, which likely would have a negative effect on the trading price of our securities.

Changes in the financial markets could impair the value of our investment portfolio.

Our investment securities portfolio is a significant component of our total earning assets. Turmoil in the financial markets could impair the market value of our investment portfolio, which could adversely affect our net income and possibly our capital.

We hold as investments certain securities that have unrealized losses (representing a majority of our securities portfolio). While we currently maintain substantial liquidity which supports our intent and ability to hold these investments until they mature, or until there is a market price recovery, if we were to cease to have the ability and intent to hold these investments until maturity or if the market prices do not recover, and we were to sell these securities at a loss, it could adversely affect our net income and possibly our capital.

Our deposit insurance premiums could be substantially higher in the future, which could have a material adverse effect on our future earnings.

The FDIC insures deposits at FDIC-insured depository institutions, such as the Bank, up to applicable limits. The amount of a particular institution’s deposit insurance assessment is based on that institution’s risk classification under an FDIC risk-based assessment system. An institution’s risk

classification is assigned based on its capital levels and the level of supervisory concern the institution poses to its regulators. Bank failures significantly depleted the FDIC’s Deposit Insurance Fund and reduced the ratio of reserves to insured deposits. As a result of recent economic conditions and the enactment of the Dodd-Frank Reform Act, banks are now assessed deposit insurance premiums based on the bank’s average consolidated total assets, and the FDIC has modified certain risk-based adjustments, which increase or decrease a bank’s overall assessment rate. This has resulted in increases to the deposit insurance assessment rates, and thus raised deposit premiums for many insured depository institutions. If these increases are insufficient for the Deposit Insurance Fund to meet its funding requirements, further special assessments or increases in deposit insurance premiums may be required. We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, we may be required to pay even higher FDIC premiums than the recently increased levels. Any future additional assessments, increases or required prepayments in FDIC insurance premiums could reduce our profitability, may limit our ability to pursue certain business opportunities or otherwise negatively impact our operations.

We may be adversely affected by the soundness of other financial institutions.

Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by the Bank cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the Bank. Any such losses could have a material adverse effect on our financial condition and results of operations.

REGULATORY AND LEGAL RISKS

We are subject to extensive regulation that could limit or restrict our activities and impose financial requirements or limitations on the conduct of our business, which limitations or restrictions could adversely affect our profitability.

As a bank holding company, we are primarily regulated by the Federal Reserve. The Bank is primarily regulated by the BFI and the Federal Reserve. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of a financial institution, the classification of assets by a financial institution and the adequacy of a financial institution’s allowance for loan losses. The Company periodically reviews its policies, procedures and limits, and undertakes reporting, to ensure all guidance is appropriate for the Bank’s current and planned operations and aligns with regulatory expectations. In this regard, regulatory authorities may impose particular requirements on the Bank, which could have a material adverse effect on our results of operations. Any change in such regulation and regulatory oversight, whether in the form of regulatory policy, regulations or legislation, could have a material impact on us and our operations. Further, our compliance with Federal Reserve and the BFI regulations is costly. Because our business is highly regulated, the applicable laws, rules and regulations are subject to regular modification and change. Laws, rules and regulations may be adopted in the future that could make compliance more difficult or expensive or otherwise adversely affect our business, financial condition or prospects. For instance, such changes may limit our growth and restrict certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. We are also subject to capital requirements by our regulators.

The laws and regulations, including the Dodd-Frank Reform Act, applicable to the banking industry could change at any time, and these changes may adversely affect our business and profitability.

We are subject to extensive federal and state regulation. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, our cost of compliance could adversely affect our ability to operate profitably. The increased scope, complexity, and cost of corporate governance, reporting, and disclosure practices are proportionately higher for a company of our size and will affect our profitability more than that of some of our larger competitors. We expect to experience increasing compliance costs related to this supervision and regulation.

Also, the 2016 national election results and new administration have introduced additional uncertainty into future implementation and enforcement of the Dodd-Frank Reform Act and other financial sector regulatory requirements. Such additional regulation and supervision may increase our costs and limit our ability to pursue business opportunities. The effects of any such recently enacted, or proposed, legislation and regulatory programs on us cannot reliably be determined at this time.

The Consumer Financial Protection Bureau (the “CFPB”) recently issued “ability-to-repay” and “qualified mortgage” rules that may have a negative impact on our loan origination process and foreclosure proceedings, which could adversely affect our business, operating results and financial condition.

On January 10, 2013, the CFPB issued a final rule to implement the “qualified mortgage” provisions of the Dodd-Frank Reform Act requiring mortgage lenders to consider consumers’ ability to repay home loans before extending them credit. The CFPB’s “qualified mortgage” rule, which became effective on January 10, 2014, describes certain minimum requirements for lenders making ability-to-repay determinations, but does not dictate that they follow particular underwriting models. Lenders will be presumed to have complied with the ability-to-repay rule if they issue “qualified mortgages,” which are generally defined as mortgage loans prohibiting or limiting certain risky features. Loans that do not meet the ability-to-repay standard can be challenged in court by borrowers who default, and the absence of ability-to-repay status can be used against a lender in foreclosure proceedings. Any loans that we make outside of the “qualified mortgage” criteria could expose us to an increased risk of liability and reduce or delay our ability to foreclose upon the underlying property. Any decreases in loan origination volume or increases in compliance and foreclosure costs caused by the rule could negatively affect our business, operating results and financial condition. The CFPB also has adopted a number of additional requirements and issued additional guidance, including with respect to appraisals, escrow accounts and servicing, each of which entails increased compliance costs. In addition, the CFPB likely will continue to make rules relating to consumer protection, and it is difficult to predict which of our products and services will be subject to these rules or how these rules will be implemented.

Compliance with the Dodd-Frank Reform Act will increase our regulatory compliance burdens, and may increase our operating costs and may adversely impact our earnings or capital ratios, or both.

Signed into law on July 21, 2010, the Dodd-Frank Reform Act has represented a significant overhaul of many aspects of the regulation of the financial services industry. Among other things, the Dodd-Frank Reform Act created the CFPB, tightened capital standards, imposed clearing and margining requirements on many derivatives activities and generally increased oversight and regulation of financial institutions and financial activities.

In addition to the self-implementing provisions of the statute, the Dodd-Frank Reform Act calls for over 200 administrative rulemakings by numerous federal agencies to implement various parts of the legislation. While many rules have been finalized or issued in proposed form, additional rules have yet to be proposed. It is not possible at this time to predict when all such additional rules will be issued or

finalized, and what the content of such rules will be. We will have to apply resources to ensure that we are in compliance with all applicable provisions of the Dodd-Frank Reform Act and any implementing rules, which may increase our costs of operations and adversely impact our earnings or capital, or both.

The Dodd-Frank Reform Act and any implementing rules that are ultimately issued could have adverse implications on the financial industry, the competitive environment and our ability to conduct business.

The short-term and long-term impact of the changing regulatory capital requirements and new capital rules is uncertain.

On July 2, 2013, the Federal Reserve Board, and shortly thereafter, the other federal bank regulatory agencies, issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision and certain provisions of the Dodd-Frank Reform Act. The final rule applies to all depository institutions, top-tier bank holding companies and top-tier savings and loan holding companies with total consolidated assets of $1 billion or more. Among other things, the rule establishes a new common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets), increases the minimum Tier 1 capital to risk-based assets requirement (from 4.0% to 6.0% of risk-weighted assets) and assigns a higher risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and to certain commercial real estate facilities that finance the acquisition, development or construction of real property. The final rule also requires unrealized gains and losses on certain “available-for-sale” securities holdings to be included for purposes of calculating regulatory capital requirements unless a one-time opt-in or opt-out is exercised. The Bank exercised this one-time opt-out. The rule limits a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements. The final rule became effective for the Bank on January 1, 2015. The capital conservation buffer requirement began phasing in on January 1, 2016, at 0.625% of risk-weighted assets, and will increase each year until fully implemented at 2.5% on January 1, 2019, when the full capital conservation buffer requirement will be effective.

Under the new capital standards, in order to be well-capitalized, the Bank is required to have a common equity to Tier 1 capital ratio of 6.5% and a Tier 1 capital ratio of 8.0%. The application of more stringent capital requirements for the Bank could, among other things, result in lower returns on invested capital, require the raising of additional capital and result in regulatory actions if we were to be unable to comply with such requirements. Furthermore, the imposition of liquidity requirements in connection with the implementation of Basel III could result in our having to lengthen the term of our funding, restructure our business models or increase our holdings of liquid assets, or all or any combination of the foregoing. Implementation of changes to asset risk weightings for risk based capital calculations, items included or deducted in calculating regulatory capital or additional capital conservation buffers, or both, could result in management modifying its business strategy, and could limit our ability to make distributions, including paying out dividends or buying back shares.

RISKS RELATED TO OUR STOCK

Our ability to pay cash dividends is limited, and we may be unable to pay future dividends even if we desire to do so.

The Company is a legal entity, separate and distinct from the Bank. The Company currently does not have any significant sources of revenue other than cash dividends paid to it by the Bank. Both the Company and the Bank are subject to laws and regulations that limit the payment of cash dividends, including requirements to maintain capital at or above regulatory minimums. As a bank that is a member of the Federal Reserve System, the Bank must obtain prior written approval for any cash dividend if the total of all dividends declared in any calendar year would exceed the total of its net profits for that year combined with its retained net profits for the preceding two years.

Banking regulators have indicated that Virginia banking organizations should generally pay dividends only (1) from net undivided profits of the bank, after providing for all expenses, losses, interest and taxes accrued or due by the bank and (2) if the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition. In addition, the FDIA prohibits insured depository institutions such as the Bank from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become undercapitalized as defined in the statute. Moreover, the Federal Reserve is authorized to determine under certain circumstances relating to the financial condition of a bank that the payment of dividends would be an unsafe and unsound practice and to prohibit payment thereof. The payment of dividends that deplete a bank’s capital base could be deemed to constitute such an unsafe and unsound banking practice. The Federal Reserve has indicated that banking organizations generally pay dividends only out of current operating earnings. The Bank may be prohibited under Virginia law from the payment of dividends, including in the event the BFI determines that a limitation of dividends is in the public interest and is necessary to ensure the Bank’s financial soundness.

In addition, the Bank’s ability to pay dividends will be limited if the Bank does not have the capital conservation buffer required by the new capital rules, which may limit the Company’s ability to pay dividends to stockholders.

If the Bank is not permitted to pay cash dividends to the Company, it is unlikely that the Company would be able to pay cash dividends on our common stock. Moreover, holders of our common stock are entitled to receive dividends only when and if declared by our board of directors. Although we currently pay cash dividends on our common stock, we are not required to do so and our board of directors could reduce or eliminate the amount of our common stock dividends in the future.

A limited market exists for our common stock.

Our common stock commenced trading on The NASDAQ Capital Market on January 25, 2012, and trading volumes since that time have been relatively low as compared to other larger financial services companies. The limited trading market for our common stock may cause fluctuations in the market value of our common stock to be exaggerated, leading to price volatility in excess of that which would occur in a more active trading market. Accordingly, holders of our common stock may have difficulty selling our common stock at prices which holders find acceptable or which accurately reflect the value of the Company.

Future offerings of debt or other securities may adversely affect the market price of our stock.

In the future, we may attempt to increase our capital resources or, if our or the Bank’s capital ratios fall below the required minimums, we or the Bank could be forced to raise additional capital by making additional offerings of debt or preferred equity securities, including medium-term notes, trust preferred securities, senior or subordinated notes and preferred stock. Upon liquidation, holders of any debt securities and shares of preferred stock and lenders with respect to other borrowings will receive distributions of our available assets prior to the holders of our common stock.

Our stockholders may experience dilution due to our issuance(s) of additional securities in the future.

We may in the future issue additional shares of our common stock to raise cash for operations or to fund acquisitions, to provide equity based incentives to our management and employees, to permit our stockholders to invest cash dividends and optional cash payments in shares of our common stock or as consideration in acquisition transactions. Additional equity offerings and issuance(s) of additional shares

of our common stock may dilute the holdings of our existing stockholders or reduce the market price of our common stock, or both. No assurances can be given that the Company will not issue additional securities that will have the effect of diluting the equity interest of our stockholders. Holders of our common stock are not entitled to preemptive rights or other protections against dilution.

Virginia law and the provisions of our articles of incorporation and bylaws could deter or prevent takeover attempts by a potential purchaser of our common stock that would be willing to pay holders a premium for their shares of our common stock.

Our articles of incorporation and bylaws contain provisions that may be deemed to have the effect of discouraging or delaying uninvited attempts by third parties to gain control of us. These provisions include the division of our board of directors into classes with staggered terms, the ability of our board of directors to set the price, terms and rights of, and to issue, one or more series of our preferred stock and the ability of our board of directors, in evaluating a proposed business combination or other fundamental change transaction, to consider the effect of the business combination on us and our stockholders, employees, customers and the communities which we serve. Similarly, the Virginia Stock Corporation Act contains provisions designed to protect Virginia corporations and employees from the adverse effects of hostile corporate takeovers. These provisions reduce the possibility that a third party could effect a change in control without the support of our incumbent directors. These provisions may also strengthen the position of current management by restricting the ability of stockholders to change the composition of the board of directors, to affect its policies generally and to benefit from actions which are opposed by the current board of directors.

An investment in our common stock is not an insured deposit.

Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. An investment in our common stock is inherently risky for the reasons described in these “Risk Factors” and the Company’s filings with the SEC and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable

Item 3.

Defaults Upon Senior Securities

Not applicable

Item 4.

Mine Safety Disclosures

Not applicable

Item 5.

Other Information

Not applicable

Item 6.

Exhibits


Exhibit No.		Description of Exhibit

31.1		Certification of Robert R. Chapman III Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 8, 2017

31.2		Certification of J. Todd Scruggs Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 8, 2017

32.1		Certification Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 Of The Sarbanes-Oxley Act Of 2002, dated November 8, 2017

101		The following materials from Bank of the James Financial Group, Inc.’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2017, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets (unaudited) as of September 30, 2017 and December 31, 2016; (ii) Consolidated Statements of Income (unaudited) for the three and nine months ended September 30, 2017 and 2016; (iii) Consolidated Statements of Comprehensive Income (unaudited) for the three and nine months ended September 30, 2017 and 2016 (iv) Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2017 and 2016 (v) Consolidated Statements of Changes in Stockholders’ Equity (unaudited) for the nine months ended September 30, 2017 and 2016; (vi) Notes to Unaudited Consolidated Financial Statements.

Index of Exhibits


Exhibit No.		Description of Exhibit

31.1		Certification of Robert R. Chapman III Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 8, 2017

31.2		Certification of J. Todd Scruggs Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated November 8, 2017

32.1		Certification Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 Of The Sarbanes-Oxley Act Of 2002, dated November 8, 2017

101		The following materials from Bank of the James Financial Group, Inc.’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2017, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets (unaudited) as of September 30, 2017 and December 31, 2016; (ii) Consolidated Statements of Income (unaudited) for the three and nine months ended September 30, 2017 and 2016; (iii) Consolidated Statements of Comprehensive Income (unaudited) for the three and nine months ended September 30, 2017 and 2016 (iv) Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2017 and 2016 (v) Consolidated Statements of Changes in Stockholders’ Equity (unaudited) for the nine months ended September 30, 2017 and 2016; (vi) Notes to Unaudited Consolidated Financial Statements.

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


	BANK OF THE JAMES FINANCIAL GROUP, INC.

Date: November 8, 2017	By	/S/ Robert R. Chapman III
		Robert R. Chapman III, President (Principal Executive Officer)

Date: November 8, 2017	By	/S/ J. Todd Scruggs
		J. Todd Scruggs, Secretary and Treasurer (Principal Financial Officer and Principal Accounting Officer)