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COMMUNITY BANK SYSTEM, INC. - Quarter Report: 2019 March (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 March 31, 2019

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                       to                                          

Commission File Number: 001-13695


(Exact name of registrant as specified in its charter)

Delaware
 
16‑1213679
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)

5790 Widewaters Parkway, DeWitt, New York
 
13214-1883
(Address of principal executive offices)
 
(Zip Code)

(315) 445‑2282
(Registrant's telephone number, including area code)

NONE
(Former name, former address and former fiscal year, if changed since last report)

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 every Interactive Data File required to be submitted 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 such files).
Yes  ☒  No 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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.

Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
    Emerging growth company

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 in Rule 12b-2 of the Exchange Act).
Yes    No 

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Trading Symbol(s)

Name of each exchange on which registered

Common Stock, $1.00 par value per share

CBU

New York Stock Exchange


Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. 51,529,044 shares of Common Stock, $1.00 par value per share, were outstanding on April 30, 2019.



TABLE OF CONTENTS

Part I.
Financial Information
Page
     
Item 1.
Financial Statements (Unaudited)
 
     
 
3
     
 
4
     
 
5
     
 
6
     
 
7
     
 
8
     
Item 2.
27
     
Item 3.
42
     
Item 4.
43
     
Part II.
Other Information
 
     
Item 1.
44
     
Item 1A.
44
     
Item 2.
44
     
Item 3.
44
     
Item 4.
44
     
Item 5.
44
     
Item 6.
45

Part I.
Financial Information
Item 1.
Financial Statements

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CONDITION (Unaudited)
(In Thousands, Except Share Data)

   
March 31,
2019
   
December 31,
2018
 
Assets:
           
Cash and cash equivalents
 
$
508,364
   
$
211,834
 
Available-for-sale investment securities (cost of $2,915,267 and $2,952,278, respectively)
   
2,922,943
     
2,936,049
 
Equity and other securities (cost of $42,241 and $44,678, respectively)
   
43,204
     
45,609
 
Loans held for sale, at fair value
   
212
     
83
 
                 
Loans
   
6,266,086
     
6,281,121
 
Allowance for loan losses
   
(49,107
)
   
(49,284
)
Net loans
   
6,216,979
     
6,231,837
 
                 
Goodwill, net
   
733,503
     
733,503
 
Core deposit intangibles, net
   
17,113
     
18,596
 
Other intangibles, net
   
53,803
     
55,250
 
Intangible assets, net
   
804,419
     
807,349
 
                 
Premises and equipment, net
   
151,976
     
119,988
 
Accrued interest and fees receivable
   
35,573
     
31,048
 
Other assets
   
232,797
     
223,498
 
                 
Total assets
 
$
10,916,467
   
$
10,607,295
 
                 
Liabilities:
               
Noninterest-bearing deposits
 
$
2,346,635
   
$
2,312,816
 
Interest-bearing deposits
   
6,273,027
     
6,009,555
 
Total deposits
   
8,619,662
     
8,322,371
 
                 
Short-term borrowings
   
0
     
54,400
 
Securities sold under agreement to repurchase, short-term
   
249,880
     
259,367
 
Other long-term debt
   
1,953
     
1,976
 
Subordinated debt held by unconsolidated subsidiary trusts
   
97,939
     
97,939
 
Accrued interest and other liabilities
   
189,905
     
157,459
 
Total liabilities
   
9,159,339
     
8,893,512
 
                 
Commitments and contingencies (See Note K)
               
                 
Shareholders' equity:
               
Preferred stock, $1.00 par value, 500,000 shares authorized, 0 shares issued
   
0
     
0
 
Common stock, $1.00 par value, 75,000,000 shares authorized; 51,727,758 and 51,576,839 shares issued, respectively
   
51,728
     
51,577
 
Additional paid-in capital
   
913,917
     
911,748
 
Retained earnings
   
817,933
     
795,563
 
Accumulated other comprehensive (loss)
   
(26,762
)
   
(45,305
)
Treasury stock, at cost (256,387 shares, including 176,252 shares held by deferred compensation arrangements at March 31, 2019 and 319,015 shares including 207,403 shares held by deferred compensation arrangements at December 31, 2018, respectively)
   
(9,601
)
   
(11,528
)
Deferred compensation arrangements (176,252 and 207,403 shares, respectively)
   
9,913
     
11,728
 
Total shareholders' equity
   
1,757,128
     
1,713,783
 
                 
Total liabilities and shareholders' equity
 
$
10,916,467
   
$
10,607,295
 

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(In Thousands, Except Per-Share Data)

   
Three Months Ended
March 31,
 
   
2019
   
2018
 
Interest income:
           
Interest and fees on loans
 
$
73,703
   
$
69,441
 
Interest and dividends on taxable investments
   
16,087
     
15,525
 
Interest on nontaxable investments
   
2,891
     
3,438
 
Total interest income
   
92,681
     
88,404
 
                 
Interest expense:
               
Interest on deposits
   
4,107
     
2,132
 
Interest on borrowings
   
621
     
480
 
Interest on subordinated debt held by unconsolidated subsidiary trusts
   
1,094
     
1,168
 
Total interest expense
   
5,822
     
3,780
 
                 
Net interest income
   
86,859
     
84,624
 
Provision for loan losses
   
2,422
     
3,679
 
Net interest income after provision for loan losses
   
84,437
     
80,945
 
                 
Noninterest revenues:
               
Deposit service fees
   
15,864
     
19,177
 
Other banking revenues
   
1,536
     
1,243
 
Employee benefit services
   
24,054
     
23,006
 
Insurance services
   
7,862
     
7,359
 
Wealth management services
   
6,349
     
6,706
 
Unrealized gain on equity securities
   
31
     
0
 
Total noninterest revenues
   
55,696
     
57,491
 
                 
Noninterest expenses:
               
Salaries and employee benefits
   
53,379
     
51,859
 
Occupancy and equipment
   
10,288
     
10,531
 
Data processing and communications
   
9,399
     
8,742
 
Amortization of intangible assets
   
4,130
     
4,798
 
Legal and professional fees
   
2,720
     
2,781
 
Business development and marketing
   
2,788
     
2,059
 
Acquisition expenses
   
534
     
(8
)
Other expenses
   
5,414
     
5,569
 
Total noninterest expenses
   
88,652
     
86,331
 
                 
Income before income taxes
   
51,481
     
52,105
 
Income taxes
   
9,535
     
11,999
 
Net income
 
$
41,946
   
$
40,106
 
                 
Basic earnings per share
 
$
0.81
   
$
0.78
 
Diluted earnings per share
 
$
0.80
   
$
0.78
 

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(In Thousands)

   
Three Months Ended
March 31,
 
   
2019
   
2018
 
             
Pension and other post-retirement obligations:
           
Amortization of actuarial losses included in net periodic pension cost, gross
 
$
651
   
$
303
 
Tax effect
   
(159
)
   
(74
)
Amortization of actuarial losses included in net periodic pension cost, net
   
492
     
229
 
                 
Amortization of prior service cost included in net periodic pension cost, gross
   
(29
)
   
(127
)
Tax effect
   
7
     
31
 
Amortization of prior service cost included in net periodic pension cost, net
   
(22
)
   
(96
)
                 
Other comprehensive income related to pension and other post-retirement
   obligations, net of taxes
   
470
     
133
 
                 
Unrealized gains (losses) on available-for-sale securities:
               
Net unrealized holding gains (losses) arising during period, gross
   
23,905
     
(41,815
)
Tax effect
   
(5,832
)
   
10,155
 
Net unrealized holding gains (losses) arising during period, net
   
18,073
     
(31,660
)
                 
Other comprehensive income/(loss) related to unrealized gains (losses) on
   available-for-sale securities, net of taxes
   
18,073
     
(31,660
)
                 
Other comprehensive income (loss), net of tax
   
18,543
     
(31,527
)
Net income
   
41,946
     
40,106
 
Comprehensive income
 
$
60,489
   
$
8,579
 

   
As of
 
   
March 31,
2019
   
December 31,
2018
 
Accumulated Other Comprehensive Income By Component:
           
             
Unrealized (loss) for pension and other post-retirement obligations
 
(42,875
)
 
(43,497
)
Tax effect
   
10,508
     
10,660
 
Net unrealized (loss) for pension and other post-retirement obligations
   
(32,367
)
   
(32,837
)
                 
Unrealized gain (loss) on available-for-sale securities
   
7,676
     
(16,229
)
Tax effect
   
(2,071
)
   
3,969
 
Reclassification of other comprehensive income due to change in accounting principle – equity securities
   
0
     
(208
)
Net unrealized gain (loss) on available-for-sale securities
   
5,605
     
(12,468
)
                 
Accumulated other comprehensive (loss)
 
(26,762
)
 
(45,305
)

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)
Three months ended March 31, 2019 and 2018
(In Thousands, Except Share Data)


 
Common Stock
   
Additional
         
Accumulated
Other
         
Deferred
   
 
   
Shares
Outstanding
   
Amount
Issued
   
Paid-In
Capital
   
Retained
Earnings
   
Comprehensive
(Loss)
   
Treasury
Stock
   
Compensation
Arrangements
   
Total
 
                                                 
Balance at December 31, 2018
   
51,257,824
   
$
51,577
   
$
911,748
   
$
795,563
   
(45,305
)
 
(11,528
)
 
$
11,728
   
$
1,713,783
 
                                                                 
Net income
                           
41,946
                             
41,946
 
                                                                 
Other comprehensive income, net of tax
                                   
18,543
                     
18,543
 
                                                                 
Dividends declared:
                                                               
Common, $0.38 per share
                           
(19,576
)
                           
(19,576
)
                                                                 
Common stock activity under employee stock ownership plan
   
150,919
     
151
     
(995
)
                                   
(844
)
                                                                 
Stock-based compensation
                   
1,391
                                     
1,391
 
                                                                 
Distribution of stock under deferred compensation arrangements
   
32,431
             
1,064
                     
830
     
(1,894
)
   
0
 
                                                                 
Treasury stock issued to benefit plans, net
   
30,197
             
709
                     
1,097
     
79
     
1,885
 
                                                                 
Balance at March 31, 2019
   
51,471,371
   
$
51,728
   
$
913,917
   
$
817,933
   
(26,762
)
 
(9,601
)
 
$
9,913
   
$
1,757,128
 
                                                                 
Balance at December 31, 2017
   
50,696,077
   
$
51,264
   
$
894,879
   
$
700,557
   
(3,699
)
 
(21,014
)
 
$
13,328
   
$
1,635,315
 
                                                                 
Net income
                           
40,106
                             
40,106
 
                                                                 
Other comprehensive loss, net of tax
                                   
(31,527
)
                   
(31,527
)
                                                                 
Dividends declared:
                                                               
Common, $0.34 per share
                           
(17,259
)
                           
(17,259
)
                                                                 
Common stock activity under employee stock ownership plan
   
110,413
     
110
     
460
                                     
570
 
                                                                 
Stock-based compensation
                   
1,715
                                     
1,715
 
                                                                 
Distribution of stock under deferred compensation arrangements
   
35,233
                                     
1,898
     
(1,898
)
   
0
 
                                                                 
Treasury stock issued to benefit plans, net
   
41,880
             
982
                     
1,483
     
81
     
2,546
 
                                                                 
Balance at March 31, 2018
   
50,883,603
   
$
51,374
   
$
898,036
   
$
723,404
   
(35,226
)
 
(17,633
)
 
$
11,511
   
$
1,631,466
 

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In Thousands)

   
Three Months Ended
March 31,
 
   
2019
   
2018
 
Operating activities:
           
Net income
 
$
41,946
   
$
40,106
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation
   
3,830
     
4,001
 
Amortization of intangible assets
   
4,130
     
4,798
 
Net accretion on securities, loans and borrowings
   
(1,944
)
   
(2,214
)
Stock-based compensation
   
1,391
     
1,715
 
Provision for loan losses
   
2,422
     
3,679
 
Amortization of mortgage servicing rights
   
98
     
117
 
Unrealized gain on equity securities
   
(31
)
   
0
 
Income from bank-owned life insurance policies
   
(391
)
   
(388
)
Net loss (gain) on sale of loans and other assets
   
22
     
(80
)
Change in other assets and other liabilities
   
(16,864
)
   
9,253
 
Net cash provided by operating activities
   
34,609
     
60,987
 
Investing activities:
               
Proceeds from maturities, calls, and paydowns of available-for-sale investment securities
   
52,520
     
27,363
 
Proceeds from maturities and redemptions of equity and other investment securities
   
2,460
     
4,960
 
Purchases of available-for-sale investment securities
   
(13,388
)
   
(23,434
)
Purchases of equity and other securities
   
(24
)
   
(21
)
Net decrease in loans
   
11,847
     
25,900
 
Cash paid for acquisitions, net of cash acquired of $0 and $16, respectively
   
(1,200
)
   
(1,464
)
Purchases of premises and equipment, net
   
(1,227
)
   
(1,556
)
Real estate limited partnership investments
   
(564
)
   
(79
)
Net cash provided by investing activities
   
50,424
     
31,669
 
Financing activities:
               
Net increase in deposits
   
297,291
     
326,672
 
Net decrease in borrowings
   
(63,910
)
   
(81,338
)
Issuance of common stock
   
(844
)
   
570
 
Purchases of treasury stock
   
(79
)
   
(81
)
Sales of treasury stock
   
1,885
     
2,546
 
Increase in deferred compensation arrangements
   
79
     
81
 
Cash dividends paid
   
(19,806
)
   
(17,281
)
Withholding taxes paid on share-based compensation
   
(3,119
)
   
(964
)
Net cash provided by financing activities
   
211,497
     
230,205
 
Change in cash and cash equivalents
   
296,530
     
322,861
 
Cash and cash equivalents at beginning of period
   
211,834
     
221,038
 
Cash and cash equivalents at end of period
 
$
508,364
   
$
543,899
 
                 
Supplemental disclosures of cash flow information:
               
Cash paid for interest
 
$
5,684
   
$
3,757
 
Cash paid for income taxes
   
4,486
     
564
 
                 
Supplemental disclosures of noncash financing and investing activities:
               
Dividends declared and unpaid
   
19,578
     
17,438
 
Transfers from loans to other real estate
   
412
     
942
 
                 
Acquisitions:
               
Common stock issued
   
0
     
0
 
Fair value of assets acquired, excluding acquired cash and intangibles
   
0
     
27
 
Fair value of liabilities assumed
   
0
     
31
 

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2019

NOTE A:  BASIS OF PRESENTATION

The interim financial data as of and for the three months ended March 31, 2019 is unaudited; however, in the opinion of Community Bank System, Inc. (the “Company”), the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods in conformity with generally accepted accounting principles in the United States of America (“GAAP”).  The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.

NOTE B:  ACQUISITIONS

Pending Acquisition – Kinderhook Bank Corp.
On January 22, 2019, the Company announced that it had entered into a definitive agreement to acquire Kinderhook Bank Corp. (“Kinderhook”), parent company of The National Union Bank of Kinderhook headquartered in Kinderhook, New York, for approximately $93.4 million in cash. The acquisition will extend the Company’s footprint into the Capital District of Upstate New York. Upon completion of the merger, the Bank will add 11 branch locations across a five county area in the Capital District of Upstate New York. The parties have received the shareholder and regulatory approvals necessary to complete the merger, including approval from the Office of the Comptroller of the Currency and a waiver from filing an application with the Federal Reserve Bank of New York. The Company expects the merger to close on July 12, 2019, subject to customary closing conditions. The Company expects to incur certain one-time, transaction-related costs in 2019.

On January 2, 2019, the Company, through its subsidiary, Community Investment Services, Inc. (“CISI”), completed its acquisition of certain assets of Wealth Resources Network, Inc. (“Wealth Resources”), a financial services business headquartered in Liverpool, New York. The Company paid $1.2 million in cash to acquire a customer list from Wealth Resources, and recorded a $1.2 million customer list intangible asset in conjunction with the acquisition. The effects of the acquired assets have been included in the consolidated financial statements since that date.

On April 2, 2018, the Company, through its subsidiary, Benefit Plans Administrative Services, Inc. (“BPAS”), acquired certain assets of HR Consultants (SA), LLC (“HR Consultants”), a provider of actuarial and benefit consulting services headquartered in Puerto Rico. The Company paid $0.3 million in cash to acquire the assets of HR Consultants and recorded intangible assets of $0.3 million in conjunction with the acquisition. The effects of the acquired assets have been included in the consolidated financial statements since that date.

On January 2, 2018, the Company, through its subsidiary, OneGroup NY, Inc. (“OneGroup”), completed its acquisition of certain assets of Penna & Associates Agency, Inc. (“Penna”), an insurance agency headquartered in Johnson City, New York.  The Company paid $0.8 million in cash to acquire the assets of Penna, and recorded goodwill in the amount of $0.3 million and a customer list intangible asset of $0.3 million in conjunction with the acquisition.  The effects of the acquired assets and liabilities have been included in the consolidated financial statements since that date.

On January 2, 2018, the Company, through its subsidiary, CISI, completed its acquisition of certain assets of Styles Bridges Associates (“Styles Bridges”), a financial services business headquartered in Canton, New York.  The Company paid $0.7 million in cash to acquire a customer list from Styles Bridges, and recorded a $0.7 million customer list intangible asset in conjunction with the acquisition.  The effects of the acquired assets have been included in the consolidated financial statements since that date.

The assets and liabilities assumed in the acquisitions were recorded at their estimated fair values based on management's best estimates using information available at the dates of the acquisitions, and were subject to adjustment based on updated information not available at the time of the acquisitions.

The following table summarizes the estimated fair value of the assets acquired and liabilities assumed after considering the measurement period adjustments described above:

   
2019
   
2018
 
(000s omitted)
 
Wealth Resources
   
Other (1)
 
Consideration paid :
           
Cash
 
$
1,200
   
$
1,753
 
Total net consideration paid
 
$
1,200
   
$
1,753
 
Recognized amounts of identifiable assets acquired and liabilities assumed:
               
Cash and cash equivalents
   
0
     
16
 
Premises and equipment
   
0
     
10
 
Other assets
   
0
     
105
 
Other intangibles
   
1,200
     
1,343
 
Other liabilities
   
0
     
(31
)
Total identifiable assets, net
   
1,200
     
1,443
 
Goodwill
 
$
0
   
$
310
 

 (1) Includes amounts related to the Styles Bridges, Penna, and HR Consultants acquisitions.

The other intangibles related to the Wealth Resources, Styles Bridges, Penna, and HR Consultants acquisitions are being amortized using an accelerated method over their estimated useful life of eight years.  The goodwill, which is not amortized for book purposes, was assigned to the All Other segment for the Penna acquisition.  Goodwill arising from the Penna acquisition is deductible for tax purposes.

Direct costs related to the acquisitions were expensed as incurred.  Merger and acquisition integration-related expenses amount to $0.5 million during the three months ended March 31, 2019 and have been separately stated in the consolidated statements of income.  Merger and acquisition integration-related expenses for the three months ended March 31, 2018 were immaterial.

NOTE C:  ACCOUNTING POLICIES

The accounting policies of the Company, as applied in the consolidated interim financial statements presented herein, are substantially the same as those followed on an annual basis as presented on pages 65 through 75 of the Annual Report on Form 10-K for the year ended December 31, 2018 filed with the Securities and Exchange Commission (“SEC”) on March 1, 2019 except as noted below.

Contract Balances
A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity’s obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. The Company’s noninterest revenue streams are largely based on transactional activity, or standard month-end revenue accruals such as asset management fees based on month-end market values. Consideration is often received immediately or shortly after the Company satisfies its performance obligation and revenue is recognized. The Company does not typically enter into long-term revenue contracts with customers, and therefore, does not experience significant contract balances. As of March 31, 2019, $29.4 million of accounts receivable, including $9.5 million of unbilled fee revenue, and $3.5 million of unearned revenue was recorded in the consolidated statements of condition. As of December 31, 2018, $26.4 million of accounts receivable, including $7.8 million of unbilled fee revenue, and $2.2 million of unearned revenue was recorded in the consolidated statements of condition.

Leases
The Company occupies certain offices and uses certain equipment under non-cancelable operating lease agreements. The Company determines if an arrangement is a lease at inception. The right-of-use assets associated with operating leases are recorded in premises and equipment in the Company’s consolidated statements of condition. The lease liabilities associated with operating leases are included in accrued interest and other liabilities in the Company’s consolidated statements of condition.

Right-of-use assets represent the Company’s right to use the underlying assets for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the associated leases. Operating lease right-of-use assets and liabilities are recognized at the commencement date of the lease based on the present value of lease payments over the lease term. The Company uses interest rates on advances from the Federal Home Loan Bank of New York available at the time of commencement to determine the present value of lease payments. The operating lease right-of-use assets include any lease payments made at the time of commencement and exclude lease incentives. The Company’s lease terms may include options to extend or terminate the lease when it is reasonably certain that the option will be exercised. Lease expense is recognized on a straight-line basis over the lease term and is included in occupancy and equipment expense in the Company’s consolidated statements of income.

The Company elected to account for lease and non-lease components separately, applies a portfolio approach to account for the lease right-of-use assets and liabilities for certain equipment leases and elected to exclude leases with a term of 12 months or less from the recognition and measurement policies described above.

Derivative Financial Instruments and Hedging Activities
The Company accounts for derivative financial instruments at fair value.  If certain conditions are met, a derivative may be specifically designated as (1) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment (“fair value hedge”), (2) a hedge of the exposure to variable cash flows of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow hedge”), or (3) an instrument with no hedging designation (“stand-alone derivative”).  For a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item, are recognized in current earnings as fair values change.  For a cash flow hedge, the gain or loss on the derivative is reported in other comprehensive income and is reclassified into earnings in the same periods during which the hedged transaction affects earnings.  Changes in the fair value of derivatives that do not qualify for hedge accounting are reported currently in earnings, as noninterest revenues.

Net cash settlements on derivatives that qualify for hedge accounting are recorded in interest income or interest expense, based on the item being hedged.  Net cash settlements on derivatives that do not qualify for hedge accounting are reported in noninterest revenues.  Cash flows on hedges are classified in the consolidated statement of cash flow statement the same as the cash flows of the items being hedged.

The Company formally documents the relationship between derivatives and hedged items, as well as the risk-management objective and strategy for undertaking hedge transactions at the inception of the hedging relationship.  This documentation includes linking the fair value or cash flow hedges to specific assets and liabilities on the statement of condition or to specific commitments or forecasted transactions.  The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivative instruments that are used are highly effective in offsetting changes in fair values or cash flows of the hedged items.

When hedge accounting is discontinued, subsequent changes in fair value of the derivative are recorded in noninterest revenues.  When a fair value hedge is discontinued, the hedged asset or liability is no longer adjusted for changes in fair value and the existing basis adjustment is amortized or accreted over the remaining life of the asset or liability.  When a cash flow hedge is discontinued, but the hedged cash flows or forecasted transactions are still expected to occur, gains or losses that were accumulated in other comprehensive income are amortized into earnings over the same periods which the hedged transactions will affect earnings.

Recently Adopted Accounting Pronouncements
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This new guidance supersedes the lease requirements in Topic 840, Leases and is based on the principle that a lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term.  The accounting applied by a lessor is largely unchanged from that applied under the previous guidance.  In addition, the guidance requires an entity to separate the lease components from the nonlease components in a contract.  The ASU requires disclosures about the amount, timing, and judgments related to a reporting entity’s accounting for leases and related cash flows.  The standard is required to be applied to all leases in existence as of the date of adoption using a modified retrospective transition approach, with certain practical expedients available. The Company adopted this guidance on January 1, 2019 using the cumulative-effect adjustment method. The cumulative-effect adjustment was not material. The Company elected several practical expedients available under the standard. The Company elected to not reassess whether any expired or existing contracts are or contain leases, to not reassess the classification (operating or capital) of any expired or existing contracts, to not reassess initial direct costs for existing leases, and to use hindsight in determining the lease term. The Company has implemented processes and a lease accounting system to ensure adequate internal controls were in place to assess our contracts and enable proper accounting and reporting of financial information upon adoption. The increase in total assets and total liabilities was $34.2 million. The impact on the Company’s results of operations and cash flows was not material.

In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.  This new guidance amends current guidance to better align hedge accounting with risk management activities and reduce the complexity involved in applying hedge accounting.  Under this new guidance, the concept of hedge ineffectiveness will be eliminated.  Ineffective income generated by cash flow and net investment hedges will be recognized in the same financial reporting period and income statement line item as effective income, so as to reflect the full cost of hedging at one time and in one place. Ineffective income generated by fair value hedges will continue to be reflected in current period earnings; however, it will be recognized in the same income statement line item as effective income. The guidance will also allow any contractually specified variable rate to be designated as the hedged risk in a cash flow hedge.  With respect to fair value hedges of interest rate risk, the guidance will allow changes in the fair value of the hedged item to be calculated solely using changes in the benchmark interest rate component of the instrument’s total contractual coupon cash flows. The Company adopted this guidance on January 1, 2019 on a modified retrospective basis. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

New Accounting Pronouncements
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326).  This new guidance significantly changes how entities will measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income.  This ASU will replace the “incurred loss” model under existing guidance with an “expected loss” model for instruments measured at amortized cost, and require entities to record allowances for available-for-sale debt securities rather than reduce the carrying amount, as they do today under the other-than-temporary impairment model.  This ASU also simplifies the accounting model for purchased credit-impaired debt securities and loans.  This guidance requires adoption through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted.  This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.  Early adoption is permitted for all companies as of fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  The Company is currently evaluating the impact the guidance will have on the Company’s consolidated financial statements, and expects a change in the allowance for loan losses resulting from the change to expected losses for the estimated life of the financial asset. The amount of the change in the allowance for loan losses resulting from the new guidance will be impacted by the portfolio composition and asset quality at the adoption date, as well as economic conditions and forecasts at the time of adoption.  Implementation efforts include evaluation of data requirements, segmentation of the Company’s loan portfolio, guidance interpretation and consideration of relevant internal processes and controls.

In January 2017, the FASB issued ASU No. 2017-04, Intangibles-Goodwill and Other (Topic 350). The amendments simplify how an entity is required to test goodwill for impairment by eliminating the requirement to measure a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill.  Instead, an entity will perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount, and recognize an impairment charge for the amount by which the carrying amount of the reporting unit exceeds its fair value.  Impairment loss recognized under this new guidance will be limited to the goodwill allocated to the reporting unit.  This ASU is effective prospectively for the Company for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019.  Early adoption was permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017.  This ASU is not expected to have a material impact on the Company’s consolidated financial statements.

NOTE D:  INVESTMENT SECURITIES

The amortized cost and estimated fair value of investment securities as of March 31, 2019 and December 31, 2018 are as follows:


 
March 31, 2019
   
December 31, 2018
 
(000's omitted)
 
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
Available-for-Sale Portfolio:
                                               
U.S. Treasury and agency securities
 
$
2,033,399
   
$
6,841
   
$
5,268
   
$
2,034,972
   
$
2,036,474
   
$
2,190
   
$
14,911
   
$
2,023,753
 
Obligations of state and political subdivisions
   
423,916
     
9,319
     
76
     
433,159
     
453,640
     
6,563
     
1,049
     
459,154
 
Government agency mortgage-backed securities
   
389,154
     
2,587
     
5,198
     
386,543
     
390,234
     
1,526
     
9,283
     
382,477
 
Corporate debt securities
   
2,572
     
0
     
19
     
2,553
     
2,588
     
0
     
42
     
2,546
 
Government agency collateralized mortgage obligations
   
66,226
     
88
     
598
     
65,716
     
69,342
     
60
     
1,283
     
68,119
 
Total available-for-sale portfolio
 
$
2,915,267
   
$
18,835
   
$
11,159
   
$
2,922,943
   
$
2,952,278
   
$
10,339
   
$
26,568
   
$
2,936,049
 
                                                                 
Equity and other Securities:
                                                               
Equity securities, at fair value
 
$
251
   
$
215
   
$
2
   
$
464
   
$
251
   
$
200
   
$
19
   
$
432
 
Federal Home Loan Bank common stock
   
6,308
     
0
     
0
     
6,308
     
8,768
     
0
     
0
     
8,768
 
Federal Reserve Bank common stock
   
30,690
     
0
     
0
     
30,690
     
30,690
     
0
     
0
     
30,690
 
Other equity securities, at adjusted cost
   
4,992
     
750
     
0
     
5,742
     
4,969
     
750
     
0
     
5,719
 
Total equity and other securities
 
$
42,241
   
$
965
   
$
2
   
$
43,204
   
$
44,678
   
$
950
   
$
19
   
$
45,609
 

A summary of investment securities that have been in a continuous unrealized loss position is as follows:

As of March 31, 2019


 
Less than 12 Months
   
12 Months or Longer
   
Total
 
(000's omitted)
   
#
   
Fair
Value
   
Gross
Unrealized
Losses
     
#
   
Fair
Value
   
Gross
Unrealized
Losses
     
#
   
Fair
Value
   
Gross
Unrealized
Losses
 
                                                             
Available-for-Sale Portfolio:
                                                           
U.S. Treasury and agency securities
   
0
   
$
0
   
$
0
     
48
   
$
862,482
   
$
5,268
     
48
   
$
862,482
   
$
5,268
 
Obligations of state and political subdivisions
   
3
     
869
     
2
     
20
     
11,854
     
74
     
23
     
12,723
     
76
 
Government agency mortgage-backed securities
   
9
     
5,241
     
6
     
181
     
242,566
     
5,192
     
190
     
247,807
     
5,198
 
Corporate debt securities
   
0
     
0
     
0
     
1
     
2,553
     
19
     
1
     
2,553
     
19
 
Government agency collateralized mortgage obligations
   
1
     
1
     
0
     
39
     
56,690
     
598
     
40
     
56,691
     
598
 
Total available-for-sale investment portfolio
   
13
   
$
6,111
   
$
8
     
289
   
$
1,176,145
   
$
11,151
     
302
   
$
1,182,256
   
$
11,159
 
                                                                         
Equity and other Securities:
                                                                       
Equity securities, at fair value
   
1
   
$
98
   
$
2
     
0
   
$
0
   
$
0
     
1
   
$
98
   
$
2
 
Total equity and other securities
   
1
   
$
98
   
$
2
     
0
   
$
0
   
$
0
     
1
   
$
98
   
$
2
 

As of December 31, 2018


 
Less than 12 Months
   
12 Months or Longer
   
Total
 
(000's omitted)
   
#
   
Fair
Value
   
Gross
Unrealized
Losses
     
#
   
Fair
Value
   
Gross
Unrealized
Losses
     
#
   
Fair
Value
   
Gross
Unrealized
Losses
 
                                                             
Available-for-Sale Portfolio:
                                                           
U.S. Treasury and agency securities
   
7
   
$
473,082
   
$
682
     
64
   
$
1,213,276
   
$
14,229
     
71
   
$
1,686,358
   
$
14,911
 
Obligations of state and political subdivisions
   
118
     
55,671
     
216
     
97
     
51,753
     
833
     
215
     
107,424
     
1,049
 
Government agency mortgage-backed securities
   
43
     
47,708
     
258
     
181
     
253,931
     
9,025
     
224
     
301,639
     
9,283
 
Corporate debt securities
   
0
     
0
     
0
     
1
     
2,546
     
42
     
1
     
2,546
     
42
 
Government agency collateralized mortgage obligations
   
1
     
66
     
0
     
41
     
63,112
     
1,283
     
42
     
63,178
     
1,283
 
Total available-for-sale investment portfolio
   
169
   
$
576,527
   
$
1,156
     
384
   
$
1,584,618
   
$
25,412
     
553
   
$
2,161,145
   
$
26,568
 
                                                                         
Equity and other Securities:
                                                                       
Equity securities, at fair value
   
1
   
$
82
   
$
19
     
0
   
$
0
   
$
0
     
1
   
$
82
   
$
19
 
Total equity and other securities
   
1
   
$
82
   
$
19
     
0
   
$
0
   
$
0
     
1
   
$
82
   
$
19
 

The unrealized losses reported pertaining to securities issued by the U.S. government and its sponsored entities, include treasuries, agencies, and mortgage-backed securities issued by Ginnie Mae, Fannie Mae, and Freddie Mac, which are currently rated AAA by Moody’s Investor Services, AA+ by Standard & Poor’s and are guaranteed by the U.S. government. The majority of the obligations of state and political subdivisions and corporations carry a credit rating of A or better.  Additionally, a majority of the obligations of state and political subdivisions carry a secondary level of credit enhancement. The Company does not intend to sell these securities, nor is it more likely than not that the Company will be required to sell these securities prior to recovery of the amortized cost. The unrealized losses in the portfolios are primarily attributable to changes in interest rates.  As such, management does not believe any individual unrealized loss as of March 31, 2019 represents other-than-temporary impairment.

The amortized cost and estimated fair value of debt securities at March 31, 2019, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Securities not due at a single maturity date are shown separately.


 
Available-for-Sale
 
(000's omitted)
 
Amortized
Cost
   
Fair
Value
 
Due in one year or less
 
$
76,873
   
$
76,767
 
Due after one through five years
   
2,093,361
     
2,096,910
 
Due after five years through ten years
   
152,168
     
156,042
 
Due after ten years
   
137,485
     
140,965
 
Subtotal
   
2,459,887
     
2,470,684
 
Government agency mortgage-backed securities
   
389,154
     
386,543
 
Government agency collateralized mortgage obligations
   
66,226
     
65,716
 
Total
 
$
2,915,267
   
$
2,922,943
 

As of March 31, 2019, $263.0 million of U.S. Treasury securities were pledged as collateral for securities sold under agreement to repurchase.  All securities sold under agreement to repurchase as of March 31, 2019 have an overnight and continuous maturity.

NOTE E:  LOANS

The segments of the Company’s loan portfolio are disaggregated into the following classes that allow management to monitor risk and performance:


Consumer mortgages consist primarily of fixed rate residential instruments, typically 10 – 30 years in contractual term, secured by first liens on real property.

Business lending is comprised of general purpose commercial and industrial loans including, but not limited to, municipal lending, agricultural-related and dealer floor plans, as well as mortgages on commercial properties.

Consumer indirect consists primarily of installment loans originated through selected dealerships and are secured by automobiles, marine and other recreational vehicles.

Consumer direct consists of all other loans to consumers such as personal installment loans and lines of credit.

Home equity products are consumer purpose installment loans or lines of credit most often secured by a first or second lien position on residential real estate with terms up to 30 years.

The balances of these classes are summarized as follows:

(000's omitted)
 
March 31,
2019
   
December 31,
2018
 
Business lending
 
$
2,410,477
   
$
2,396,977
 
Consumer mortgage
   
2,237,430
     
2,235,408
 
Consumer indirect
   
1,070,840
     
1,083,207
 
Consumer direct
   
173,042
     
178,820
 
Home equity
   
374,297
     
386,709
 
Gross loans, including deferred origination costs
   
6,266,086
     
6,281,121
 
Allowance for loan losses
   
(49,107
)
   
(49,284
)
Loans, net of allowance for loan losses
 
$
6,216,979
   
$
6,231,837
 

The outstanding balance related to credit impaired acquired loans was $7.3 million and $7.4 million at March 31, 2019 and December 31, 2018, respectively.  The changes in the accretable discount related to the credit impaired acquired loans are as follows:

(000’s omitted)
     
Balance at December 31, 2018
 
$
437
 
Accretion recognized, year-to-date
   
(74
)
Balance at March 31, 2019
 
$
363
 

Credit Quality
Management monitors the credit quality of its loan portfolio on an ongoing basis.  Measurement of delinquency and past due status are based on the contractual terms of each loan.  Past due loans are reviewed on a monthly basis to identify loans for non-accrual status.  The following is an aged analysis of the Company’s past due loans, by class as of March 31, 2019:

Legacy Loans (excludes loans acquired after January 1, 2009)

(000’s omitted)
 
Past Due
30 – 89
Days
   
90+ Days Past
Due and
Still Accruing
   
Nonaccrual
   
Total
Past Due
   
Current
   
Total Loans
 
Business lending
 
$
6,042
   
$
68
   
$
4,147
   
$
10,257
   
$
1,652,950
   
$
1,663,207
 
Consumer mortgage
   
8,937
     
1,960
     
9,794
     
20,691
     
1,843,754
     
1,864,445
 
Consumer indirect
   
9,824
     
201
     
0
     
10,025
     
1,051,493
     
1,061,518
 
Consumer direct
   
985
     
41
     
0
     
1,026
     
169,334
     
170,360
 
Home equity
   
1,005
     
323
     
1,583
     
2,911
     
301,113
     
304,024
 
Total
 
$
26,793
   
$
2,593
   
$
15,524
   
$
44,910
   
$
5,018,644
   
$
5,063,554
 

Acquired Loans (includes loans acquired after January 1, 2009)

(000’s omitted)
 
Past Due
30 – 89
Days
   
90+ Days Past
Due and
Still Accruing
   
Nonaccrual
   
Total
Past Due
   
Acquired
Impaired(1)
   
Current
   
Total Loans
 
Business lending
 
$
2,526
   
$
66
   
$
3,254
   
$
5,846
   
$
5,342
   
$
736,082
   
$
747,270
 
Consumer mortgage
   
883
     
287
     
1,954
     
3,124
     
0
     
369,861
     
372,985
 
Consumer indirect
   
32
     
33
     
0
     
65
     
0
     
9,257
     
9,322
 
Consumer direct
   
33
     
25
     
0
     
58
     
0
     
2,624
     
2,682
 
Home equity
   
558
     
15
     
520
     
1,093
     
0
     
69,180
     
70,273
 
Total
 
$
4,032
   
$
426
   
$
5,728
   
$
10,186
   
$
5,342
   
$
1,187,004
   
$
1,202,532
 

(1)
Acquired impaired loans were not classified as nonperforming assets as the loans are considered to be performing under ASC 310-30.  As a result interest income, through the accretion of the difference between the carrying amount of the loans and the expected cashflows, is being recognized on all acquired impaired loans.

The following is an aged analysis of the Company’s past due loans by class as of December 31, 2018:

Legacy Loans (excludes loans acquired after January 1, 2009)

(000’s omitted)
 
Past Due
30 – 89
Days
   
90+ Days Past
Due and
Still Accruing
   
Nonaccrual
   
Total
Past Due
   
Current
   
Total Loans
 
Business lending
 
$
5,261
   
$
179
   
$
4,872
   
$
10,312
   
$
1,608,515
   
$
1,618,827
 
Consumer mortgage
   
12,468
     
1,393
     
9,872
     
23,733
     
1,824,717
     
1,848,450
 
Consumer indirect
   
14,609
     
258
     
0
     
14,867
     
1,057,525
     
1,072,392
 
Consumer direct
   
1,778
     
48
     
0
     
1,826
     
173,948
     
175,774
 
Home equity
   
983
     
228
     
1,438
     
2,649
     
309,892
     
312,541
 
Total
 
$
35,099
   
$
2,106
   
$
16,182
   
$
53,387
   
$
4,974,597
   
$
5,027,984
 

Acquired Loans (includes loans acquired after January 1, 2009)

(000’s omitted)
 
Past Due
30 – 89
Days
   
90+ Days Past
Due and
Still Accruing
   
Nonaccrual
   
Total
Past Due
   
Acquired
Impaired(1)
   
Current
   
Total Loans
 
Business lending
 
$
974
   
$
0
   
$
3,498
   
$
4,472
   
$
5,446
   
$
768,232
   
$
778,150
 
Consumer mortgage
   
841
     
232
     
2,390
     
3,463
     
0
     
383,495
     
386,958
 
Consumer indirect
   
78
     
34
     
0
     
112
     
0
     
10,703
     
10,815
 
Consumer direct
   
115
     
4
     
0
     
119
     
0
     
2,927
     
3,046
 
Home equity
   
613
     
79
     
474
     
1,166
     
0
     
73,002
     
74,168
 
Total
 
$
2,621
   
$
349
   
$
6,362
   
$
9,332
   
$
5,446
   
$
1,238,359
   
$
1,253,137
 

(1)
Acquired impaired loans were not classified as nonperforming assets as the loans are considered to be performing under ASC 310-30.  As a result interest income, through the accretion of the difference between the carrying amount of the loans and the expected cashflows, is being recognized on all acquired impaired loans.

The Company uses several credit quality indicators to assess credit risk in an ongoing manner.  The Company’s primary credit quality indicator for its business lending portfolio is an internal credit risk rating system that categorizes loans as “pass”, “special mention”,  “classified”, or “doubtful”.  Credit risk ratings are applied individually to those classes of loans that have significant or unique credit characteristics that benefit from a case-by-case evaluation.  In general, the following are the definitions of the Company’s credit quality indicators:

Pass
The condition of the borrower and the performance of the loans are satisfactory or better.
Special Mention
The condition of the borrower has deteriorated although the loan performs as agreed.
Classified
The condition of the borrower has significantly deteriorated and the performance of the loan could further deteriorate, if deficiencies are not corrected.
Doubtful
The condition of the borrower has deteriorated to the point that collection of the balance is improbable based on current facts and conditions.

The following table shows the amount of business lending loans by credit quality category:

   
March 31, 2019
   
December 31, 2018
 
(000’s omitted)
 
Legacy
   
Acquired
   
Total
   
Legacy
   
Acquired
   
Total
 
Pass
 
$
1,475,145
   
$
659,645
   
$
2,134,790
   
$
1,439,337
   
$
702,493
   
$
2,141,830
 
Special mention
   
108,129
     
53,562
     
161,691
     
105,065
     
40,107
     
145,172
 
Classified
   
79,933
     
28,721
     
108,654
     
74,425
     
28,525
     
102,950
 
Doubtful
   
0
     
0
     
0
     
0
     
1,579
     
1,579
 
Acquired impaired
   
0
     
5,342
     
5,342
     
0
     
5,446
     
5,446
 
Total
 
$
1,663,207
   
$
747,270
   
$
2,410,477
   
$
1,618,827
   
$
778,150
   
$
2,396,977
 

All other loans are underwritten and structured using standardized criteria and characteristics, primarily payment performance, and are normally risk rated and monitored collectively on a monthly basis.  These are typically loans to individuals in the consumer categories and are delineated as either performing or nonperforming.   Performing loans include loans classified as current as well as those classified as 30 - 89 days past due.  Nonperforming loans include 90+ days past due and still accruing and nonaccrual loans. The following table details the balances in all other loan categories at March 31, 2019:

Legacy Loans (excludes loans acquired after January 1, 2009)

(000’s omitted)
 
Consumer
Mortgage
   
Consumer
Indirect
   
Consumer
Direct
   
Home
Equity
   
Total
 
Performing
 
$
1,852,691
   
$
1,061,317
   
$
170,319
   
$
302,118
   
$
3,386,445
 
Nonperforming
   
11,754
     
201
     
41
     
1,906
     
13,902
 
Total
 
$
1,864,445
   
$
1,061,518
   
$
170,360
   
$
304,024
   
$
3,400,347
 

Acquired Loans (includes loans acquired after January 1, 2009)

(000’s omitted)
 
Consumer
Mortgage
   
Consumer
Indirect
   
Consumer
Direct
   
Home
Equity
   
Total
 
Performing
 
$
370,744
   
$
9,289
   
$
2,657
   
$
69,738
   
$
452,428
 
Nonperforming
   
2,241
     
33
     
25
     
535
     
2,834
 
Total
 
$
372,985
   
$
9,322
   
$
2,682
   
$
70,273
   
$
455,262
 

The following table details the balances in all other loan categories at December 31, 2018:

Legacy Loans (excludes loans acquired after January 1, 2009)

(000’s omitted)
 
Consumer
Mortgage
   
Consumer
Indirect
   
Consumer
Direct
   
Home
Equity
   
Total
 
Performing
 
$
1,837,185
   
$
1,072,134
   
$
175,726
   
$
310,875
   
$
3,395,920
 
Nonperforming
   
11,265
     
258
     
48
     
1,666
     
13,237
 
Total
 
$
1,848,450
   
$
1,072,392
   
$
175,774
   
$
312,541
   
$
3,409,157
 

Acquired Loans (includes loans acquired after January 1, 2009)

(000’s omitted)
 
Consumer
Mortgage
   
Consumer
Indirect
   
Consumer
Direct
   
Home
Equity
   
Total
 
Performing
 
$
384,336
   
$
10,781
   
$
3,042
   
$
73,615
   
$
471,774
 
Nonperforming
   
2,622
     
34
     
4
     
553
     
3,213
 
Total
 
$
386,958
   
$
10,815
   
$
3,046
   
$
74,168
   
$
474,987
 

All loan classes are collectively evaluated for impairment except business lending.  A summary of individually evaluated impaired loans as of March 31, 2019 and December 31, 2018 follows:

(000’s omitted)
 
March 31,
2019
   
December 31,
2018
 
Loans with allowance allocation
 
$
0
   
$
3,956
 
Loans without allowance allocation
   
5,118
     
2,230
 
Carrying balance
   
5,118
     
6,186
 
Contractual balance
   
12,052
     
12,078
 
Specifically allocated allowance
   
0
     
956
 

In the course of working with borrowers, the Company may choose to restructure the contractual terms of certain loans.  In this scenario, the Company attempts to work-out an alternative payment schedule with the borrower in order to optimize collectability of the loan.  Any loans that are modified are reviewed by the Company to identify if a troubled debt restructuring (“TDR”) has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider.  Terms may be modified to fit the ability of the borrower to repay in line with its current financial standing and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms, or a combination of the two.

In accordance with the clarified guidance issued by the Office of the Comptroller of the Currency (“OCC”), loans that have been discharged in Chapter 7 bankruptcy but not reaffirmed by the borrower, are classified as TDRs, irrespective of payment history or delinquency status, even if the repayment terms for the loan have not been otherwise modified.  The Company’s lien position against the underlying collateral remains unchanged.  Pursuant to that guidance, the Company records a charge-off equal to any portion of the carrying value that exceeds the net realizable value of the collateral.  The amount of loss incurred in the three months ended March 31, 2019 and 2018 was immaterial.

TDRs that are less than $0.5 million are collectively included in the general loan loss allocation and the qualitative review.  TDRs that are commercial loans and greater than $0.5 million are individually evaluated for impairment, and if necessary, a specific allocation of the allowance for loan losses is provided.  As a result, the determination of the amount of allowance for loan losses related to TDRs is the same as detailed in the critical accounting policies.

Information regarding TDRs as of March 31, 2019 and December 31, 2018 is as follows:

   
March 31, 2019
   
December 31, 2018
 
(000’s omitted)
 
Nonaccrual
   
Accruing
   
Total
   
Nonaccrual
   
Accruing
   
Total
 
     
#
   
Amount
     
#
   
Amount
     
#
   
Amount
     
#
   
Amount
     
#
   
Amount
     
#
   
Amount
 
Business lending
   
3
   
$
87
     
2
   
$
161
     
5
   
$
248
     
4
   
$
162
     
2
   
$
165
     
6
   
$
327
 
Consumer mortgage
   
50
     
2,214
     
50
     
2,027
     
100
     
4,241
     
46
     
1,986
     
46
     
1,769
     
92
     
3,755
 
Consumer indirect
   
0
     
0
     
85
     
916
     
85
     
916
     
0
     
0
     
77
     
857
     
77
     
857
 
Consumer direct
   
0
     
0
     
15
     
1
     
15
     
1
     
0
     
0
     
22
     
71
     
22
     
71
 
Home equity
   
13
     
233
     
9
     
270
     
22
     
503
     
12
     
240
     
9
     
275
     
21
     
515
 
Total
   
66
   
$
2,534
     
161
   
$
3,375
     
227
   
$
5,909
     
62
   
$
2,388
     
156
   
$
3,137
     
218
   
$
5,525
 

The following table presents information related to loans modified in a TDR during the three months ended March 31, 2019 and 2018.  Of the loans noted in the table below, all loans for the three months ended March 31, 2019 and 2018 were modified due to a Chapter 7 bankruptcy as described previously.  The financial effects of these restructurings were immaterial

   
Three Months Ended
March 31, 2019
   
Three Months Ended
March 31, 2018
 
(000’s omitted)
 
Number of
loans modified
   
Outstanding
Balance
   
Number of
loans modified
   
Outstanding
Balance
 
Business lending
   
0
   
$
0
     
1
   
$
93
 
Consumer mortgage
   
8
     
665
     
0
     
0
 
Consumer indirect
   
11
     
98
     
4
     
41
 
Consumer direct
   
0
     
0
     
2
     
2
 
Home equity
   
1
     
4
     
0
     
0
 
Total
   
20
   
$
767
     
7
   
$
136
 

Allowance for Loan Losses

The allowance for loan losses is general in nature and is available to absorb losses from any loan type despite the analysis below.  The following presents by class the activity in the allowance for loan losses:

   
Three Months Ended March 31, 2019
 
(000’s omitted)
 
Business
Lending
   
Consumer
Mortgage
   
Consumer
Indirect
   
Consumer
Direct
   
Home
Equity
   
Unallocated
   
Acquired
Impaired
   
Total
 
Beginning balance
 
$
18,522
   
$
10,124
   
$
14,366
   
$
3,095
   
$
2,144
   
$
1,000
   
$
33
   
$
49,284
 
Charge-offs
   
(1,216
)
   
(253
)
   
(1,823
)
   
(535
)
   
(74
)
   
0
     
0
     
(3,901
)
Recoveries
   
134
     
22
     
962
     
179
     
5
     
0
     
0
     
1,302
 
Provision
   
831
     
424
     
746
     
317
     
(8
)
   
(10
)
   
122
     
2,422
 
Ending balance
 
$
18,271
   
$
10,317
   
$
14,251
   
$
3,056
   
$
2,067
   
$
990
   
$
155
   
$
49,107
 

   
Three Months Ended March 31, 2018
 
(000’s omitted)
 
Business
Lending
   
Consumer
Mortgage
   
Consumer
Indirect
   
Consumer
Direct
   
Home
Equity
   
Unallocated
   
Acquired
Impaired
   
Total
 
Beginning balance
 
$
17,257
   
$
10,465
   
$
13,468
   
$
3,039
   
$
2,107
   
$
1,100
   
$
147
   
$
47,583
 
Charge-offs
   
(1,669
)
   
(199
)
   
(2,284
)
   
(496
)
   
(56
)
   
0
     
(43
)
   
(4,747
)
Recoveries
   
198
     
8
     
1,151
     
222
     
9
     
0
     
0
     
1,588
 
Provision
   
1,821
     
108
     
1,363
     
219
     
(20
)
   
(16
)
   
204
     
3,679
 
Ending balance
 
$
17,607
   
$
10,382
   
$
13,698
   
$
2,984
   
$
2,040
   
$
1,084
   
$
308
   
$
48,103
 

NOTE F:  GOODWILL AND IDENTIFIABLE INTANGIBLE ASSETS

The gross carrying amount and accumulated amortization for each type of identifiable intangible asset are as follows:

   
March 31, 2019
   
December 31, 2018
 
(000's omitted)
 
Gross
Carrying
Amount
   
Accumulated
Amortization
   
Net
Carrying
Amount
   
Gross
Carrying
Amount
   
Accumulated
Amortization
   
Net
Carrying
Amount
 
Amortizing intangible assets:
                                   
Core deposit intangibles
 
$
62,902
   
(45,789
)
 
$
17,113
   
$
62,902
   
(44,306
)
 
$
18,596
 
Other intangibles
   
88,816
   
 
(35,013
)
   
53,803
     
87,616
     
(32,366
)
   
55,250
 
Total amortizing intangibles
 
$
151,718
   
(80,802
)
 
$
70,916
   
$
150,518
   
(76,672
)
 
$
73,846
 

The estimated aggregate amortization expense for each of the five succeeding fiscal years ended December 31 is as follows:

(000's omitted)
 
Apr - Dec 2019
 
$
11,433
 
2020
   
12,956
 
2021
   
11,053
 
2022
   
9,483
 
2023
   
7,947
 
Thereafter
   
18,044
 
Total
 
$
70,916
 

Shown below are the components of the Company’s goodwill at December 31, 2018 and March 31, 2019:

(000’s omitted)
 
December 31, 2018
   
Activity
   
March 31, 2019
 
Goodwill
 
$
738,327
   
$
0
   
$
738,327
 
Accumulated impairment
   
(4,824
)
   
0
     
(4,824
)
Goodwill, net
 
$
733,503
   
$
0
   
$
733,503
 

NOTE G: LEASES

The Company has operating leases for certain offices and certain equipment. These leases have remaining terms that range from less than one year to 16 years. Options to extend the leases range from a single extension option of one year to multiple extension options for up to 40 years. Certain agreements include an option to terminate the lease within one year.

The components of lease expense are as follows:

(000’s omitted)
 
Three Months Ended
March 31, 2019
 
Operating lease cost
 
$
2,117
 
Short-term lease cost (1)
   
54
 
Total lease cost
 
$
2,171
 

(1)
Short-term lease cost includes the cost of leases with terms of twelve months or less, excluding leases with terms of one month or less.

Supplemental cash flow information related to leases is as follows:

(000’s omitted)
 
Three Months Ended
March 31, 2019
 
Cash paid for amounts included in the measurement of lease liabilities:
     
Operating cash outflows for operating leases
 
$
2,030
 
         
Right-of-use assets obtained in exchange for lease obligations:
       
Operating leases
   
2,969
 

Supplemental balance sheet information related to leases is as follows:

(000’s omitted, except lease term and discount rate)
 
Three Months Ended
March 31, 2019
 
Operating leases
     
Operating lease right-of-use assets
 
$
34,956
 
         
Operating lease liabilities
   
35,630
 
         
Weighted average remaining lease term      
Operating leases
 
6.7 years
 
         
Weighted average discount rate
       
Operating leases
   
3.26
%

Maturities of lease liabilities as of March 31, 2019 are as follows:

(000’s omitted)
 
Operating Leases
 
Apr - Dec 2019
 
$
6,534
 
2020
   
7,967
 
2021
   
6,396
 
2022
   
5,143
 
2023
   
3,393
 
Thereafter
   
10,653
 
Total lease payments
   
40,086
 
Less imputed interest
   
(4,456
)
Total
 
$
35,630
 

Included in the Company’s operating leases are related party leases where BPAS Actuarial & Pension Services, LLC and OneGroup NY, Inc., subsidiaries of the Company, lease office space from 706 North Clinton, LLC., an entity the Company holds a 50% membership interest in through its subsidiary Oneida Preferred Funding II, LLC.  The operating lease right-of-use assets and operating lease liabilities associated with these related party leases total $5.2 million and $5.2 million, respectively.  The weighted average remaining lease term and weighted average discount rate for these leases are 10.7 years and 3.67%, respectively.  The maturities of the Company’s related party lease liabilities as of March 31, 2019 are as follows:

(000’s omitted)
 
706 North Clinton, LLC
 
Apr - Dec 2019
 
$
443
 
2020
   
591
 
2021
   
591
 
2022
   
591
 
2023
   
591
 
Thereafter
   
3,538
 
Total lease payments
   
6,345
 
Less imputed interest
   
(1,105
)
Total
 
$
5,240
 

As of March 31, 2019, the Company has an immaterial amount of additional operating leases for offices and equipment that have not yet commenced.

NOTE H:  MANDATORILY REDEEMABLE PREFERRED SECURITIES

The Company sponsors two business trusts, Community Capital Trust IV (“CCT IV”) and MBVT Statutory Trust I (“MBVT I”), of which 100% of the common stock is owned by the Company.  The common stock of MBVT Statutory Trust I was acquired in the Merchants Bancshares, Inc. (“Merchants”) acquisition.  The trusts were formed for the purpose of issuing company-obligated mandatorily redeemable preferred securities to third-party investors and investing the proceeds from the sale of such preferred securities solely in junior subordinated debt securities of the Company.  The debentures held by each trust are the sole assets of such trust.  Distributions on the preferred securities issued by each trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust and are recorded as interest expense in the consolidated financial statements.  The preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures.  The Company has entered into agreements which, taken collectively, fully and unconditionally guarantee the preferred securities subject to the terms of each of the guarantees.  The terms of the preferred securities of each trust are as follows:

Trust
Issuance
Date
Par
Amount
Interest Rate
Maturity
Date
Call Price
CCT IV
12/8/2006
$75.0 million
3 month LIBOR plus 1.65% (4.26%)
12/15/2036
Par
MBVT I
12/15/2004
$20.6 million
3 month LIBOR plus 1.95% (4.56%)
12/31/2034
Par

NOTE I:  BENEFIT PLANS

The Company provides a qualified defined benefit pension to eligible employees and retirees, other post-retirement health and life insurance benefits to certain retirees, an unfunded supplemental pension plan for certain key executives, and an unfunded stock balance plan for certain of its nonemployee directors.  The Company accrues for the estimated cost of these benefits through charges to expense during the years that employees earn these benefits.  The service cost component of net periodic benefit income is included in the salaries and employee benefits line of the Consolidated Statements of Income, while the other components of net periodic benefit income are included in other expenses. The Company made a $7.3 million contribution to its defined benefit pension plan in the first quarter of 2019.

Effective June 1, 2018, the Company adopted the Community Bank System, Inc. Restoration Plan (“Restoration Plan”).  The Restoration Plan is a non-qualified deferred compensation plan for certain employees whose benefits under tax-qualified retirement plans are restricted by the Internal Revenue Code Section 401(a)(17) limitation on compensation.  Adoption of the plan resulted in an unfunded initial projected benefit obligation of approximately $0.8 million that will be amortized over the average expected future years of service of active plan participants.

The net periodic benefit cost for the three months ended March 31, 2019 and 2018 is as follows:


 
Pension Benefits
   
Post-retirement Benefits
 
   
Three Months Ended
March 31,
   
Three Months Ended
March 31,
 
(000's omitted)
 
2019
   
2018
   
2019
   
2018
 
Service cost
 
$
1,270
   
$
1,121
   
$
0
   
$
0
 
Interest cost
   
1,566
     
1,415
     
18
     
17
 
Expected return on plan assets
   
(3,577
)
   
(3,705
)
   
0
     
0
 
Amortization of unrecognized net loss
   
642
     
298
     
9
     
5
 
Amortization of prior service cost
   
16
     
(83
)
   
(45
)
   
(44
)
Net periodic benefit
 
(83
)
 
(954
)
 
(18
)
 
(22
)

NOTE J:  EARNINGS PER SHARE

The two class method is used in the calculations of basic and diluted earnings per share.  Under the two class method, earnings available to common shareholders for the period are allocated between common shareholders and participating securities according to dividends declared and participation rights in undistributed earnings.  The Company has determined that all of its outstanding non-vested stock awards are participating securities as of March 31, 2019.

Basic earnings per share are computed based on the weighted-average of the common shares outstanding for the period.  Diluted earnings per share are based on the weighted-average of the shares outstanding and the assumed exercise of stock options during the year.  The dilutive effect of options is calculated using the treasury stock method of accounting.  The treasury stock method determines the number of common shares that would be outstanding if all the dilutive options (those where the average market price is greater than the exercise price) were exercised and the proceeds were used to repurchase common shares in the open market at the average market price for the applicable time period.  There were approximately 0.5 million weighted-average anti-dilutive stock options outstanding for the three months ended March 31, 2019, compared to approximately 0.4 million weighted-average anti-dilutive stock options outstanding for the three months ended March 31, 2018 that were not included in the computation below.

The following is a reconciliation of basic to diluted earnings per share for the three months ended March 31, 2019 and 2018:

   
Three Months Ended
March 31,
 
(000's omitted, except per share data)
 
2019
   
2018
 
Net income
 
$
41,946
   
$
40,106
 
Income attributable to unvested stock-based compensation awards
   
(109
)
   
(141
)
Income available to common shareholders
 
$
41,837
   
$
39,965
 
                 
Weighted-average common shares outstanding – basic
   
51,520
     
50,934
 
Basic earnings per share
 
$
0.81
   
$
0.78
 
                 
Net income
 
$
41,946
   
$
40,106
 
Income attributable to unvested stock-based compensation awards
   
(109
)
   
(141
)
Income available to common shareholders
 
$
41,837
   
$
39,965
 
                 
Weighted-average common shares outstanding
   
51,520
     
50,934
 
Assumed exercise of stock options
   
541
     
563
 
Weighted-average common shares outstanding – diluted
   
52,061
     
51,497
 
Diluted earnings per share
 
$
0.80
   
$
0.78
 

Stock Repurchase Program
At its December 2017 meeting, the Company’s Board of Directors (the “Board”) approved a stock repurchase program authorizing the repurchase of up to 2.5 million shares of the Company’s common stock in accordance with securities laws and regulations, through December 31, 2018.  At its December 2018 meeting, the Board approved a similar program for 2019, authorizing the repurchase of up to 2.5 million shares of the Company’s common stock through December 31, 2019. Any repurchased shares will be used for general corporate purposes, including those related to stock plan activities.  The timing and extent of repurchases will depend on market conditions and other corporate considerations as determined at the Company’s discretion.  The Company did not repurchase any shares under the authorized plan during the first three months of 2019 or 2018.

NOTE K:  COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments consist primarily of commitments to extend credit and standby letters of credit.  Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee.  These commitments consist principally of unused commercial and consumer credit lines.  Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of an underlying contract with a third party.  The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to the Company’s normal credit policies.  Collateral may be obtained based on management’s assessment of the customer’s creditworthiness.  The fair value of the standby letters of credit is immaterial for disclosure.

The contract amounts of commitments and contingencies are as follows:

(000's omitted)
 
March 31,
2019
   
December 31,
2018
 
Commitments to extend credit
 
$
1,047,047
   
$
1,134,576
 
Standby letters of credit
   
36,485
     
33,169
 
Total
 
$
1,083,532
   
$
1,167,745
 

The Company and its subsidiaries are subject in the normal course of business to various pending and threatened legal proceedings in which claims for monetary damages are asserted. As of March 31, 2019, management, after consultation with legal counsel, does not anticipate that the aggregate ultimate liability arising out of litigation pending or threatened against the Company or its subsidiaries will be material to the Company’s consolidated financial position. On at least a quarterly basis, the Company assesses its liabilities and contingencies in connection with such legal proceedings. For those matters where it is probable that the Company will incur losses and the amounts of the losses can be reasonably estimated, the Company records an expense and corresponding liability in its consolidated financial statements. To the extent the pending or threatened litigation could result in exposure in excess of that liability, the amount of such excess is not currently estimable. The range of reasonably possible losses for matters where an exposure is not currently estimable or considered probable, beyond the existing recorded liabilities, is between $0 and $1 million in the aggregate. Although the Company does not believe that the outcome of pending litigation will be material to the Company’s consolidated financial position, it cannot rule out the possibility that such outcomes will be material to the consolidated results of operations for a particular reporting period in the future.

NOTE L:  FAIR VALUE

Accounting standards establish a framework for measuring fair value and require certain disclosures about such fair value instruments.  It defines fair value as 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 (i.e. exit price).  Inputs used to measure fair value are classified into the following hierarchy:

Level 1 -
Quoted prices in active markets for identical assets or liabilities.
Level 2 -
Quoted prices in active markets for similar assets or liabilities, or quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
Level 3 -
Significant valuation assumptions not readily observable in a market.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.  The following tables set forth the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis.  There were no transfers between any of the levels for the periods presented.

   
March 31, 2019
 
(000's omitted)
 
Level 1
   
Level 2
   
Level 3
   
Total Fair
Value
 
Available-for-sale investment securities:
                       
U.S. Treasury and agency securities
 
$
1,913,361
   
$
121,611
   
$
0
   
$
2,034,972
 
Obligations of state and political subdivisions
   
0
     
433,159
     
0
     
433,159
 
Government agency mortgage-backed securities
   
0
     
386,543
     
0
     
386,543
 
Corporate debt securities
   
0
     
2,553
     
0
     
2,553
 
Government agency collateralized mortgage obligations
   
0
     
65,716
     
0
     
65,716
 
Total available-for-sale investment securities
   
1,913,361
     
1,009,582
     
0
     
2,922,943
 
Equity securities
   
464
     
0
     
0
     
464
 
Mortgage loans held for sale
   
0
     
212
     
0
     
212
 
Commitments to originate real estate loans for sale
   
0
     
0
     
20
     
20
 
Forward sales commitments
   
0
     
(6
)
   
0
     
(6
)
Interest rate swap agreements asset
   
0
     
835
     
0
     
835
 
Interest rate swap agreements liability
   
0
     
(705
)
   
0
     
(705
)
Total
 
$
1,913,825
   
$
1,009,918
   
$
20
   
$
2,923,763
 

   
December 31, 2018
 
(000's omitted)
 
Level 1
   
Level 2
   
Level 3
   
Total Fair
Value
 
Available-for-sale investment securities:
                       
U.S. Treasury and agency securities
 
$
1,896,931
   
$
126,822
   
$
0
   
$
2,023,753
 
Obligations of state and political subdivisions
   
0
     
459,154
     
0
     
459,154
 
Government agency mortgage-backed securities
   
0
     
382,477
     
0
     
382,477
 
Corporate debt securities
   
0
     
2,546
     
0
     
2,546
 
Government agency collateralized mortgage obligations
   
0
     
68,119
     
0
     
68,119
 
Total available-for-sale investment securities
   
1,896,931
     
1,039,118
     
0
     
2,936,049
 
Equity securities
   
432
     
0
     
0
     
432
 
Mortgage loans held for sale
   
0
     
83
     
0
     
83
 
Interest rate swap agreements asset
   
0
     
793
     
0
     
793
 
Interest rate swap agreements liability
   
0
     
(742
)
   
0
     
(742
)
Total
 
$
1,897,363
   
$
1,039,252
   
$
0
   
$
2,936,615
 

The valuation techniques used to measure fair value for the items in the table above are as follows:

Available-for-sale investment securities and equity securities – The fair values of available-for-sale investment securities are based upon quoted prices, if available.  If quoted prices are not available, fair values are measured using quoted market prices for similar securities or model-based valuation techniques.  Level 1 securities include U.S. Treasury obligations and marketable equity securities that are traded by dealers or brokers in active over-the-counter markets.  Level 2 securities include U.S. agency securities, mortgage-backed securities issued by government-sponsored entities, municipal securities and corporate debt securities that are valued by reference to prices for similar securities or through model-based techniques in which all significant inputs, such as reported trades, trade execution data, LIBOR swap yield curve, market prepayment speeds, credit information, market spreads, and security’s terms and conditions, are observable.  See Note D for further disclosure of the fair value of investment securities.

Mortgage loans held for sale – The Company has elected to value loans held for sale at fair value in order to more closely match the gains and losses associated with loans held for sale with the gains and losses on forward sales contracts.  Accordingly, the impact on the valuation will be recognized in the Company’s consolidated statement of income.  All mortgage loans held for sale are current and in performing status.  The fair value of mortgage loans held for sale is determined using quoted secondary-market prices of loans with similar characteristics and, as such, has been classified as a Level 2 valuation.  The unpaid principal value of mortgage loans held for sale was approximately $0.2 million and $0.1 million at March 31, 2019 and December 31, 2018, respectively.  The unrealized gain on mortgage loans held for sale was recognized in other banking revenues in the consolidated statements of income and is immaterial.

Forward sales commitments – The Company enters into forward sales commitments to sell certain residential real estate loans.  Such commitments are considered to be derivative financial instruments and, therefore, are carried at estimated fair value in the other asset or other liability section of the consolidated statement of condition.  The fair value of these forward sales commitments is primarily measured by obtaining pricing from certain government-sponsored entities and reflects the underlying price the entity would pay the Company for an immediate sale on these mortgages.  As such, these instruments are classified as Level 2 in the fair value hierarchy.

Commitments to originate real estate loans for sale – The Company enters into various commitments to originate residential real estate loans for sale.  Such commitments are considered to be derivative financial instruments and, therefore, are carried at estimated fair value in the other asset or other liability section of the consolidated statement of condition.  The estimated fair value of these commitments is determined using quoted secondary market prices obtained from certain government-sponsored entities.  Additionally, accounting guidance requires the expected net future cash flows related to the associated servicing of the loan to be included in the fair value measurement of the derivative.  The expected net future cash flows are based on a valuation model that calculates the present value of estimated net servicing income.  The valuation model incorporates assumptions that market participants would use in estimating future net servicing income.  Such assumptions include estimates of the cost of servicing loans, appropriate discount rate and prepayment speeds.  The determination of expected net cash flows is considered a significant unobservable input contributing to the Level 3 classification of commitments to originate real estate loans for sale.

Interest rate swaps – The interest rate swaps are reported at their fair value utilizing Level 2 inputs from third parties. The fair value of the interest rate swaps are determined using prices obtained from a third party advisor.  The fair value measurement of the interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts.  The variable cash receipts are based on the expectation of future interest rates derived from observed market interest rate curves.

The changes in Level 3 assets measured at fair value on a recurring basis are immaterial.

The fair value information of assets and liabilities measured on a non-recurring basis presented below is not as of the period-end, but rather as of the date the fair value adjustment was recorded closest to the date presented.

   
March 31, 2019
   
December 31, 2018
 
(000's omitted)
 
Level 1
   
Level 2
   
Level 3
   
Total Fair
Value
   
Level 1
   
Level 2
   
Level 3
   
Total Fair
Value
 
Impaired loans
 
$
0
   
$
0
   
$
2,831
   
$
2,831
   
$
0
   
$
0
   
$
1,102
   
$
1,102
 
Other real estate owned
   
0
     
0
     
1,524
     
1,524
     
0
     
0
     
1,320
     
1,320
 
Total
 
$
0
   
$
0
   
$
4,355
   
$
4,355
   
$
0
   
$
0
   
$
2,422
   
$
2,422
 

Loans are generally not recorded at fair value on a recurring basis.  Periodically, the Company records nonrecurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans.  Nonrecurring adjustments also include certain impairment amounts for collateral-dependent loans calculated when establishing the allowance for loan losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan and, as a result, the carrying value of the loan less the calculated valuation amount does not necessarily represent the fair value of the loan. Real estate collateral is typically valued using independent appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable in the marketplace, adjusted for non-observable inputs.  Thus, the resulting nonrecurring fair value measurements are generally classified as Level 3. Estimates of fair value used for other collateral supporting commercial loans generally are based on assumptions not observable in the marketplace and, therefore, such valuations classify as Level 3.

Other real estate owned (“OREO”) is valued at the time the loan is foreclosed upon and the asset is transferred to OREO. The value is based primarily on third party appraisals, less costs to sell. The appraisals are sometimes further discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the customer and customer’s business. Such discounts are significant, ranging from 9.0% to 75.8% at March 31, 2019 and result in a Level 3 classification of the inputs for determining fair value. OREO is reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above. The Company recovers the carrying value of OREO through the sale of the property. The ability to affect future sales prices is subject to market conditions and factors beyond the Company’s control and may impact the estimated fair value of a property.

Originated mortgage servicing rights are recorded at their fair value at the time of sale of the underlying loan, and are amortized in proportion to and over the estimated period of net servicing income.  The fair value of mortgage servicing rights is based on a valuation model incorporating inputs that market participants would use in estimating future net servicing income.  Such inputs include estimates of the cost of servicing loans, appropriate discount rate and prepayment speeds and are considered to be unobservable and contribute to the Level 3 classification of mortgage servicing rights.  In accordance with GAAP, the Company must record impairment charges, on a nonrecurring basis, when the carrying value of a stratum exceeds its estimated fair value.  Impairment is recognized through a valuation allowance.  There is no valuation allowance at March 31, 2019.

The Company determines fair values based on quoted market values, where available, estimates of present values, or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including, but not limited to, the discount rate and estimates of future cash flows.  In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, may not be realized in immediate settlement of the instrument.  The significant unobservable inputs used in the determination of fair value of assets classified as Level 3 on a recurring or non-recurring basis are as follows:

(000's omitted)
 
Fair Value at
March 31, 2019
 
Valuation Technique
Significant Unobservable Inputs
 
Significant
Unobservable Input
Range
(Weighted Average)
 
Impaired loans
 
$
2,831
 
Fair value of collateral
Estimated cost of disposal/market adjustment
   
9.0% - 40.4% (35.0
%)
Other real estate owned
   
1,524
 
Fair value of collateral
Estimated cost of disposal/market adjustment
   
9.0% - 75.8% (23.8
%)
Commitments to originate real estate loans for sale
   
20
 
Discounted cash flow
Embedded servicing value
   
1
%

(000's omitted)
 
Fair Value at
December 31, 2018
 
Valuation Technique
Significant Unobservable Inputs
 
Significant
Unobservable Input
Range
(Weighted Average)
 
Impaired loans
 
$
1,102
 
Fair value of collateral
Estimated cost of disposal/market adjustment
   
9.0% - 35.4% (28.8
%)
Other real estate owned
   
1,320
 
Fair value of collateral
Estimated cost of disposal/market adjustment
   
9.0% - 69.3% (23.8
%)

Certain financial instruments and all nonfinancial instruments are excluded from fair value disclosure requirements.  Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.  The carrying amounts and estimated fair values of the Company’s other financial instruments that are not accounted for at fair value at March 31, 2019 and December 31, 2018 are as follows:

   
March 31, 2019
   
December 31, 2018
 
(000's omitted)
 
Carrying
Value
   
Fair
Value
   
Carrying
Value
   
Fair
Value
 
Financial assets:
                       
Net loans
 
$
6,216,979
   
$
6,266,587
   
$
6,231,837
   
$
6,247,939
 
Financial liabilities:
                               
Deposits
   
8,619,662
     
8,607,827
     
8,322,371
     
8,308,765
 
Short-term borrowings
   
0
     
0
     
54,400
     
54,400
 
Securities sold under agreement to repurchase, short-term
   
249,880
     
249,880
     
259,367
     
259,367
 
Other long-term debt
   
1,953
     
1,914
     
1,976
     
1,921
 
Subordinated debt held by unconsolidated subsidiary trusts
   
97,939
     
97,939
     
97,939
     
97,939
 

The following is a further description of the principal valuation methods used by the Company to estimate the fair values of its financial instruments.

Loans have been classified as a Level 3 valuation.  Fair values for variable rate loans that reprice frequently are based on carrying values.  Fair values for fixed rate loans are estimated using discounted cash flows and interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

Deposits have been classified as a Level 2 valuation.  The fair value of demand deposits, interest-bearing checking deposits, savings accounts, and money market deposits is the amount payable on demand at the reporting date.  The fair value of time deposit obligations are based on current market rates for similar products.

Borrowings and subordinated debt held by unconsolidated subsidiary trusts have been classified as a Level 2 valuation.  The fair value of short-term borrowings and securities sold under agreement to repurchase, short-term, is the amount payable on demand at the reporting date.  Fair values for long-term debt and subordinated debt held by unconsolidated subsidiary trusts are estimated using discounted cash flows and interest rates currently being offered on similar securities.  The difference between the carrying values of long-term borrowings and subordinated debt held by unconsolidated subsidiary trusts, and their fair values, are not material as of the reporting dates.

Other financial assets and liabilities – Cash and cash equivalents have been classified as a Level 1 valuation, while accrued interest receivable and accrued interest payable have been classified as a Level 2 valuation.  The fair values of each approximate the respective carrying values because the instruments are payable on demand or have short-term maturities and present relatively low credit risk and interest rate risk.

NOTE M:  DERIVATIVE INSTRUMENTS

The Company is party to derivative financial instruments in the normal course of its business to meet the financing needs of its customers and to manage its own exposure to fluctuations in interest rates.  These financial instruments have been limited to interest rate swap agreements, commitments to originate real estate loans held for sale and forward sales commitments.  The Company does not hold or issue derivative financial instruments for trading or other speculative purposes.

The Company enters into forward sales commitments for the future delivery of residential mortgage loans, and interest rate lock commitments to fund loans at a specified interest rate.  The forward sales commitments are utilized to reduce interest rate risk associated with interest rate lock commitments and loans held for sale.  Changes in the estimated fair value of the forward sales commitments and interest rate lock commitments subsequent to inception are based on changes in the fair value of the underlying loan resulting from the fulfillment of the commitment and changes in the probability that the loan will fund within the terms of the commitment, which is affected primarily by changes in interest rates and the passage of time.  At inception and during the life of the interest rate lock commitment, the Company includes the expected net future cash flows related to the associated servicing of the loan as part of the fair value measurement of the interest rate lock commitments.  These derivatives are recorded at fair value, which were immaterial at March 31, 2019 and December 31, 2018.  The effect of the changes to these derivatives for the three months then ended was also immaterial.

The Company acquired interest rate swaps from the Merchants acquisition with notional amounts with certain commercial customers which totaled $36.6 million at March 31, 2019 and $37.0 million at December 31, 2018.  In order to minimize the Company’s risk, these customer derivatives (pay floating/receive fixed swaps) have been offset with essentially matching interest rate swaps (pay fixed/receive floating swaps) with the Company’s counterparty totaling $36.6 million at March 31, 2019 and $37.0 million at December 31, 2018. At March 31, 2019, the weighted average receive rate of these interest rate swaps was 4.37%, the weighted average pay rate was 3.83% and the weighted average maturity was 5.2 years.  At December 31, 2018, the weighted average receive rate of these interest rate swaps was 4.34%, the weighted average pay rate was 3.84% and the weighted average maturity was 5.5 years.  Hedge accounting has not been applied for these derivatives.  Since the terms of the swaps with the Company’s customer and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact the Company’s results of operations.

The Company also acquired interest rate swaps from the Merchants acquisition with notional amounts totaling $6.6 million at March 31, 2019, and $6.6 million at December 31, 2018, that were designated as fair value hedges of certain fixed rate loans with municipalities which are recorded in loans in the consolidated statements of financial condition. At March 31, 2019, the weighted average receive rate of these interest rate swaps was 2.94%, the weighted average pay rate was 3.11% and the weighted average maturity was 14.3 years. At December 31, 2018, the weighted average receive rate of these interest rate swaps was 2.92%, the weighted average pay rate was 3.11% and the weighted average maturity was 14.5 years.  The Company includes the gain or loss on the hedged items in interest and fees on loans, the same line item as the offsetting gain or loss on the related interest rate swaps. The effects of fair value accounting in the consolidated statement of income for the three months ended March 31, 2019 are immaterial.

As of March 31, 2019, the following amounts were recorded in the consolidated statement of condition related to cumulative basis adjustments for fair value hedges:

(000’s omitted)
Line Item in the Consolidated
Statement of Condition in Which
the Hedged Item Is Included
 
Carrying
Amount of the
Hedged Assets
   
Cumulative Amount of Fair Value
Hedging Adjustment Included in the
Carrying Amount of the Hedged Assets
 
 
March 31, 2019
   
March 31, 2019
 
Loans
 
$
7,006
   
$
(130
)

Fair values of derivative instruments as of March 31, 2019 are as follows:

(000’s omitted)
March 31, 2019
 
 
Derivative Assets
 
Derivative Liabilities
 

Consolidated Statement of
Condition Location
 
Fair
Value
 
Consolidated Statement of
Condition Location
 
Fair
Value
 
Derivatives designated as hedging instruments under Subtopic 815-20
               
Interest rate swaps
Other assets
 
$
130
         
                   
Derivatives not designated as hedging instruments under Subtopic 815-20
                 
Interest rate swaps
Other assets
   
705
 
Accrued interest and other liabilities
 
$
705
 
Commitments to originate real estate  loans for sale
Other assets
   
20
           
Forward sales commitments
         
Accrued interest and other liabilities
   
6
 
Total derivatives
   
$
855
     
$
711
 

The Company assessed its counterparty risk at March 31, 2019 and determined any credit risk inherent in our derivative contracts was not material. Further information about the fair value of derivative financial instruments can be found in Note L to these consolidated financial statements.

NOTE N:  SEGMENT INFORMATION

Operating segments are components of an enterprise, which are evaluated regularly by the “chief operating decision maker” in deciding how to allocate resources and assess performance.  The Company’s chief operating decision maker is the President and Chief Executive Officer of the Company. The Company has identified Banking, Employee Benefit Services and All Other as its reportable operating business segments.  Community Bank, N.A. (the “Bank” or “CBNA”) operates the Banking segment that provides full-service banking to consumers, businesses, and governmental units in Upstate New York as well as Northeastern Pennsylvania, Vermont and Western Massachusetts.  Employee Benefit Services, which includes the operating subsidiaries Benefit Plans Administrative Services, LLC, BPAS Actuarial and Pension Services, LLC, BPAS Trust Company of Puerto Rico, Northeast Retirement Services, LLC (“NRS”), Global Trust Company, Inc. (“GTC”), and Hand Benefits & Trust Company, provides employee benefit trust, collective investment fund, retirement plan administration, fund administration, transfer agency, actuarial, VEBA/HRA, and health and welfare consulting services.  The All Other segment is comprised of: (a) wealth management services including trust services provided by the personal trust unit within the Bank, broker-dealer and investment advisory services provided by CISI and The Carta Group, Inc., as well as asset management provided by Nottingham Advisors, Inc., and (b) full-service insurance, risk management and employee benefit services provided by OneGroup.  The accounting policies used in the disclosure of business segments are the same as those described in the summary of significant accounting policies (See Note A, Summary of Significant Accounting Policies of the most recent Form 10-K for the year ended December 31, 2018 filed with the SEC on March 1, 2019).

Information about reportable segments and reconciliation of the information to the consolidated financial statements follows:

(000's omitted)
 
Banking
   
Employee
Benefit Services
   
All Other
   
Eliminations
   
Consolidated
Total
 
Three Months Ended March 31, 2019
                             
Net interest income
 
$
86,715
   
$
108
   
$
36
   
$
0
   
$
86,859
 
Provision for loan losses
   
2,422
     
0
     
0
     
0
     
2,422
 
Noninterest revenues
   
17,348
     
24,670
     
14,447
     
(769
)
   
55,696
 
Amortization of intangible assets
   
1,483
     
1,769
     
878
     
0
     
4,130
 
Acquisition expenses
   
534
     
0
     
0
     
0
     
534
 
Other operating expenses
   
59,769
     
14,279
     
10,709
     
(769
)
   
83,988
 
Income before income taxes
 
$
39,855
   
$
8,730
   
$
2,896
   
$
0
   
$
51,481
 
Assets
 
$
10,699,384
   
$
199,345
   
$
71,047
   
$
(53,309
)
 
$
10,916,467
 
Goodwill
 
$
629,916
   
$
83,275
   
$
20,312
   
$
0
   
$
733,503
 
Core deposit intangibles & Other intangibles
 
$
17,113
   
$
42,777
   
$
11,026
   
$
0
   
$
70,916
 
                                         
Three Months Ended March 31, 2018
                                       
Net interest income
 
$
84,530
   
$
70
   
$
24
   
$
0
   
$
84,624
 
Provision for loan losses
   
3,679
     
0
     
0
     
0
     
3,679
 
Noninterest revenues
   
20,357
     
23,449
     
14,380
     
(695
)
   
57,491
 
Amortization of intangible assets
   
1,744
     
2,088
     
966
     
0
     
4,798
 
Acquisition expenses
   
(15
)
   
7
     
0
     
0
     
(8
)
Other operating expenses
   
56,955
     
13,709
     
11,572
     
(695
)
   
81,541
 
Income before income taxes
 
$
42,524
   
$
7,715
   
$
1,866
   
$
0
   
$
52,105
 
Assets
 
$
10,736,383
   
$
205,544
   
$
68,167
   
$
(43,539
)
 
$
10,966,555
 
Goodwill
 
$
629,916
   
$
83,275
   
$
20,434
   
$
0
   
$
733,625
 
Core deposit intangibles & Other intangibles
 
$
23,281
   
$
50,200
   
$
13,478
   
$
0
   
$
86,959
 

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) primarily reviews the financial condition and results of operations of Community Bank System, Inc. (the “Company” or “CBSI”) as of and for the three months ended March 31, 2019 and 2018, although in some circumstances the fourth quarter of 2018 is also discussed in order to more fully explain recent trends.  The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 26.  All references in the discussion of the financial condition and results of operations refer to the consolidated position and results of the Company and its subsidiaries taken as a whole.  Unless otherwise noted, the term “this year” and equivalent terms refers to results in calendar year 2019, “last year” and equivalent terms refer to calendar year 2018, “first quarter” refers to the three months ended March 31, and earnings per share (“EPS”) figures refer to diluted EPS.

This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations, and business of the Company.  These forward-looking statements involve certain risks and uncertainties.  Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set herein under the caption, “Forward-Looking Statements,” on page 40.

Critical Accounting Policies

As a result of the complex and dynamic nature of the Company’s business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations.  The policy decision process not only ensures compliance with the current accounting principles generally accepted in the United States of America (“GAAP”), but also reflects management’s discretion with regard to choosing the most suitable methodology for reporting the Company’s financial performance.  It is management’s opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process.  These estimates affect the reported amounts of assets and liabilities as well as disclosures of revenues and expenses during the reporting period.  Actual results could differ from these estimates.  Management believes that the critical accounting estimates include the allowance for loan losses, actuarial assumptions associated with the pension, post-retirement and other employee benefit plans, the provision for income taxes, investment valuation and other-than-temporary impairment, the carrying value of goodwill and other intangible assets, and acquired loan valuations.  A summary of the accounting policies used by management is disclosed in Note A, “Summary of Significant Accounting Policies” on pages 65-75 of the most recent Form 10-K (fiscal year ended December 31, 2018) filed with the Securities and Exchange Commission (“SEC”) on March 1, 2019.

Supplemental Reporting of Non-GAAP Results of Operations

The Company also provides supplemental reporting of its results on an “operating,” “adjusted” or “tangible” basis, from which it excludes the after-tax effect of amortization of core deposit and other intangible assets (and the related goodwill, core deposit intangible and other intangible asset balances, net of applicable deferred tax amounts), accretion on non-impaired purchased loans, acquisition expenses, the unrealized gain (loss) on equity securities, and loss on debt extinguishment.  Although “adjusted net income” as defined by the Company is a non-GAAP measure, the Company’s management believes this information helps investors understand the effect of acquisition and other non-recurring activity in its reported results.  Diluted adjusted net earnings per share were $0.85 in the first quarter of 2019, compared to $0.82 in the first quarter of 2018, a 3.7% increase.     Reconciliations of GAAP amounts with corresponding non-GAAP amounts are presented in Table 11.

Executive Summary

The Company’s business philosophy is to operate as a diversified financial services enterprise providing a broad array of banking and other financial services to retail, commercial and municipal customers.  The Company’s banking subsidiary is Community Bank, N.A. (the “Bank” or “CBNA”).  The Company also provides employee benefit and trust related services via its Benefit Plans Administrative Services, Inc. (“BPAS”) subsidiary, and wealth management and insurance-related services.

The Company’s core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build profitable loan and deposit volume using both organic and acquisition strategies, (iii) manage an investment securities portfolio to complement the Company’s loan and deposit strategies and optimize interest rate risk, yield and liquidity, (iv) increase the noninterest component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services and banking businesses, and (v) utilize technology to deliver customer-responsive products and services and improve efficiencies.

Significant factors reviewed by management to evaluate achievement of the Company’s operating objectives and its operating results and financial condition include, but are not limited to:  net income and earnings per share; return on assets and equity; net interest margins; noninterest revenues; noninterest expenses; asset quality; loan and deposit growth; capital management; performance of individual banking and financial services units; performance of specific product lines and customers; liquidity and interest rate sensitivity; enhancements to customer products and services and their underlying performance characteristics; technology advancements; market share; peer comparisons; and the performance of recently acquired businesses.

On January 22, 2019, the Company announced that it had entered into a definitive agreement to acquire Kinderhook Bank Corp. (“Kinderhook”), parent company of The National Union Bank of Kinderhook headquartered in Kinderhook, New York, for approximately $93.4 million in cash. The acquisition will extend the Company’s footprint into the Capital District of Upstate New York. Upon completion of the merger, the Bank will add 11 branch locations across a five county area in the Capital District of Upstate New York. The parties have received the shareholder and regulatory approvals necessary to complete the merger, including approval from the Office of the Comptroller of the Currency and a waiver from filing an application with the Federal Reserve Bank of New York. The Company expects the merger to close on July 12, 2019, subject to customary closing conditions. The Company expects to incur certain one-time, transaction-related costs in 2019.

On January 2, 2019, the Company, through its subsidiary, Community Investment Services, Inc. (“CISI”), completed its acquisition of certain assets of Wealth Resources Network, Inc. (“Wealth Resources”), a financial services business headquartered in Liverpool, New York. The Company paid $1.2 million in cash to acquire a customer list from Wealth Resources, and recorded a $1.2 million customer list intangible asset in conjunction with the acquisition.

First quarter net income increased $1.8 million as compared to the first quarter of 2018.  Earnings per share of $0.80 for the first quarter of 2019 increased $0.02 from the first quarter of 2018.  The increase in net income and earnings per share for the quarter are primarily the result of higher net interest income, a lower provision for loan losses and a lower effective tax rate, partially offset by lower noninterest revenues, higher noninterest expenses and an increase in diluted shares outstanding.  First quarter net income adjusted to exclude acquisition expenses and unrealized gain on equity securities (“operating net income”), increased $2.3 million as compared to the first quarter of 2018.  Earnings per share adjusted to exclude acquisition expenses and unrealized gain on equity securities (“operating earnings per share”) of $0.81 for the first quarter increased $0.03 compared to the first quarter of 2018.

Loans increased on both an average and ending basis as compared to the prior year first quarter, while deposits decreased on both an average and ending basis as compared to the prior year first quarter.  Market interest rates for deposits have increased over the past year.  In connection with these rising deposit interest rates, the Company’s total cost of funds increased 10 basis points from the year earlier period, as the rate paid on interest-bearing deposits and the rate on borrowings both increased from the prior year first quarter.  Due to the Merchants Bancshares, Inc. (“Merchants”) acquisition, the majority of borrowings are now customer repurchase agreements, rather than wholesale borrowings obtained through capital markets and correspondent banks.  Customer repurchase agreements have deposit-like features and typically bear lower rates of interest than other types of wholesale borrowings.

The first quarter 2019 provision for loan losses of $2.4 million was $1.3 million lower than the first quarter of 2018, reflective of moderate improvements in the Company’s credit quality metrics.  Net charge-offs were $2.6 million for the first quarter of 2019, compared to $3.2 million of net charge-offs for the first quarter of 2018.  First quarter 2019 nonperforming loan ratios generally improved in comparison to the first quarter of 2018.

Net Income and Profitability

As shown in Table 1, net income for the first quarter of $41.9 million increased $1.8 million, or 4.6%, as compared to the first quarter of 2018.  Earnings per share of $0.80 for the first quarter increased $0.02 compared to the first quarter of 2018.  The increase in net income and earnings per share for the quarter are primarily the result of higher net interest income, a lower provision for loan losses and a lower effective tax rate, partially offset by lower noninterest revenues, higher noninterest expenses and an increase in diluted shares outstanding.  Operating net income of $42.4 million for the first quarter increased $2.3 million, or 5.6%, as compared to the first quarter of 2018.  Operating earnings per share of $0.81 for the first quarter was up $0.03 compared to the first quarter of 2018.  See Table 11 for Reconciliation of GAAP to Non-GAAP Measures.

As reflected in Table 1, first quarter net interest income of $86.9 million was up $2.2 million, or 2.6%, from the comparable prior year period.  The improvement resulted from an increase in the yield on interest-earning assets and a decrease in interest-bearing liabilities, partially offset by an increase in the rate paid on interest-bearing liabilities and a decrease in interest-earning assets.

The provision for loan losses for the first quarter decreased $1.3 million as compared to the first quarter of 2018, reflective of moderate improvements in the Company’s credit quality metrics.

First quarter noninterest revenues were $55.7 million, down $1.8 million, or 3.1%, from the first quarter of 2018.  The decrease was primarily a result of the $3.2 million impact of the debit interchange fee limitations established by the Durbin amendment of the Dodd-Frank Act (“Durbin amendment”) that were effective for the Company beginning in the third quarter of 2018, partially offset by increases in employee benefits services revenue and wealth management and insurance services revenue.

Noninterest expenses of $88.7 million for the first quarter reflected an increase of $2.3 million, or 2.7%, from the first quarter of 2018.  Excluding acquisition-related expenses, 2019 operating expenses were $1.8 million, or 2.1%, higher as compared to the prior year first quarter.  The increase in noninterest expenses for the quarter was due to an increase in salaries and benefits related to annual merit-based personnel cost increases, an increase in data processing and communications and business development and marketing expenses, partially offset by a decrease in amortization of intangibles and other expenses.

Income tax expense decreased $2.5 million between comparable quarters due to the impact of windfall tax benefits associated with accounting for share-based transactions combined with adjustments to state tax rates used in the development of the Company’s provision for income taxes.

A condensed income statement is as follows:

Table 1: Condensed Income Statements

   
Three Months Ended
March 31,
 
(000's omitted, except per share data)
 
2019
   
2018
 
Net interest income
 
$
86,859
   
$
84,624
 
Provision for loan losses
   
2,422
     
3,679
 
Noninterest revenues
   
55,696
     
57,491
 
Noninterest expenses
   
88,652
     
86,331
 
Income before income taxes
   
51,481
     
52,105
 
Income taxes
   
9,535
     
11,999
 
Net income
 
$
41,946
   
$
40,106
 
                 
Diluted weighted average common shares outstanding
   
52,195
     
51,677
 
Diluted earnings per share
 
$
0.80
   
$
0.78
 

Net Interest Income

Net interest income is the amount by which interest and fees on earning assets (loans, investments, and cash equivalents) exceeds the cost of funds, which consists primarily of interest paid to the Company's depositors and on borrowings.  Net interest margin is the difference between the yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets.

As shown in Table 2, net interest income (with nontaxable income converted to a fully tax-equivalent basis) for the first quarter was $87.9 million, a $2.1 million, or 2.5%, increase from the same period last year.  The increase resulted from an 18 basis point increase in the average yield on earning assets and a $190.8 million decrease in average interest-bearing liabilities from the first quarter of 2018, partially offset by a decrease in interest-earning assets of $7.1 million and a 13 basis point increase in the average rate paid on interest-bearing liabilities.  As reflected in Table 3, the first quarter volume decrease in interest-bearing liabilities and the increase in the average yield on earning assets had a $4.3 million favorable impact on net interest income, while the volume decrease in interest-earning assets and rate increase on interest-bearing liabilities had a $2.2 million unfavorable impact on net interest income.  The net interest margin of 3.80% for the first quarter of 2019 was nine basis points higher than the comparable period of 2018.

The higher average yield on interest earning assets for the quarter was the result of an increase in the average yield on loans and investments.  The average yield on loans for the first quarter increased by 25 basis points compared to the first quarter of 2018 and the average yield on investments, including cash equivalents, increased two basis points compared to the prior year.  The increase in the loan yield included the impact of $1.0 million in loan pre-payment fees in the first quarter of 2019, partially offset by a $0.7 million decrease in acquired non-impaired loan accretion.

The average rate on interest-bearing liabilities increased 13 basis points compared to the prior year quarter due to a 13 basis point increase in the average rate paid on interest-bearing deposits and a 38 basis point increase in the average rate paid on borrowings.  The increase in the average cost of borrowings was primarily the result of an increase in the variable rates paid on overnight borrowings and subordinated debt due to increases in market interest rates.

The first quarter average balance of investments, including cash equivalents, decreased $43.1 million as compared to the corresponding prior year period as maturities, calls and principal payments outpaced investment purchases.  Average loan balances increased $36.0 million for the quarter as compared to the prior year with growth in the consumer mortgage and consumer indirect loan portfolios partially offset by decreases in the business lending, home equity and consumer direct portfolios.

Average interest-bearing deposits decreased $111.3 million between the first quarter of 2018 and the first quarter of 2019 due to decreases in money market and time deposits that were partially offset by increases in interest checking and savings deposits.  The average borrowing balance, including borrowings at the Federal Home Loan Bank of New York and the Federal Home Loan Bank of Boston (collectively referred to as “FHLB”), subordinated debt held by unconsolidated subsidiary trusts and securities sold under agreement to repurchase (customer repurchase agreements), decreased $79.5 million for the quarter primarily due to a decrease in customer repurchase agreements and a decrease in subordinated debt held by unconsolidated subsidiary trusts associated with the redemption of the trust preferred subordinated debt held by Community Statutory Trust III during the third quarter of 2018.

Table 2 below sets forth information related to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated.  Interest income and yields are on a fully tax-equivalent basis (“FTE”) using marginal income tax rates of 24.4% and 24.3% in 2019 and 2018, respectively.  Average balances are computed by totaling the daily ending balances in a period and dividing by the number of days in that period.  Loan interest income and yields include amortization of deferred loan income and costs, loan prepayment fees and the accretion of acquired loan marks.  Average loan balances include nonaccrual loans and loans held for sale.

Table 2: Quarterly Average Balance Sheet

   
Three Months Ended
March 31, 2019
   
Three Months Ended
March 31, 2018
 
(000's omitted except yields and rates)
 
Average
Balance
   
Interest
   
Avg.
Yield/Rate
Paid
   
Average
Balance
   
Interest
   
Avg.
Yield/Rate
Paid
 
Interest-earning assets:
                                   
Cash equivalents
 
$
121,304
   
$
695
     
2.33
%
 
$
90,406
   
$
344
     
1.54
%
Taxable investment securities (1)
   
2,574,902
     
15,392
     
2.42
%
   
2,583,446
     
15,181
     
2.38
%
Nontaxable investment securities (1)
   
403,359
     
3,656
     
3.68
%
   
468,773
     
4,349
     
3.76
%
Loans (net of unearned discount)(2)
   
6,273,798
     
73,946
     
4.78
%
   
6,237,824
     
69,648
     
4.53
%
Total interest-earning assets
   
9,373,363
     
93,689
     
4.05
%
   
9,380,449
     
89,522
     
3.87
%
Noninterest-earning assets
   
1,314,345
                     
1,335,080
                 
Total assets
 
$
10,687,708
                   
$
10,715,529
                 
                                                 
Interest-bearing liabilities:
                                               
Interest checking, savings, and money market deposits
 
$
5,359,692
     
2,433
     
0.18
%
 
$
5,453,004
     
1,322
     
0.10
%
Time deposits
   
748,040
     
1,674
     
0.91
%
   
766,048
     
810
     
0.43
%
Customer repurchase agreements
   
248,449
     
441
     
0.72
%
   
306,144
     
389
     
0.52
%
FHLB borrowings
   
27,268
     
180
     
2.67
%
   
24,154
     
91
     
1.53
%
Subordinated debt held by unconsolidated subsidiary trusts
   
97,939
     
1,094
     
4.53
%
   
122,816
     
1,168
     
3.86
%
Total interest-bearing liabilities
   
6,481,388
     
5,822
     
0.36
%
   
6,672,166
     
3,780
     
0.23
%
Noninterest-bearing liabilities:
                                               
Noninterest checking deposits
   
2,297,472
                     
2,268,778
                 
Other liabilities
   
182,535
                     
148,634
                 
Shareholders' equity
   
1,726,313
                     
1,625,951
                 
Total liabilities and shareholders' equity
 
$
10,687,708
                   
$
10,715,529
                 
                                                 
Net interest earnings
         
$
87,867
                   
$
85,742
         
                                                 
Net interest spread
                   
3.69
%
                   
3.64
%
Net interest margin on interest-earning assets
                   
3.80
%
                   
3.71
%
                                                 
Fully tax-equivalent adjustment
         
$
1,008
                   
$
1,118
         


(1)
Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of noninterest-earning assets, shareholders’ equity, and deferred taxes.

(2)
Includes nonaccrual loans.  The impact of interest and fees not recognized on nonaccrual loans was immaterial.

As discussed above and disclosed in Table 3 below, the change in net interest income (fully tax-equivalent basis) may be analyzed by segregating the volume and rate components of the changes in interest income and interest expense for each underlying category.

Table 3: Rate/Volume

   
 Three months ended March 31, 2019
versus March 31, 2018
Increase (Decrease) Due to Change in (1)
 
(000's omitted)
 
Volume
   
Rate
   
Net
Change
 
Interest earned on:
                 
Cash equivalents
 
$
142
   
$
209
   
$
351
 
Taxable investment securities
   
(50
)
   
261
     
211
 
Nontaxable investment securities
   
(593
)
   
(100
)
   
(693
)
Loans
   
404
     
3,894
     
4,298
 
Total interest-earning assets (2)
   
(68
)
   
4,235
     
4,167
 
                         
Interest paid on:
                       
Interest checking, savings and money   market deposits
   
(23
)
   
1,134
     
1,111
 
Time deposits
   
(19
)
   
883
     
864
 
Customer repurchase agreements
   
43
     
9
     
52
 
FHLB borrowings
   
13
     
76
     
89
 
Subordinated debt held by unconsolidated subsidiary trusts
   
(259
)
   
185
     
(74
)
Total interest-bearing liabilities (2)
   
(111
)
   
2,153
     
2,042
 
                         
Net interest earnings (2)
   
(65
)
   
2,190
     
2,125
 

 (1)
The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of such change in each component.
 (2)
Changes due to volume and rate are computed from the respective changes in average balances and rates of the totals; they are not a summation of the changes of the components.

Noninterest Revenues

The Company’s sources of noninterest revenues are of four primary types: 1) general banking services related to loans, deposits, and other core customer activities typically provided through the branch network and electronic banking channels (performed by CBNA); 2) employee benefit services (performed by BPAS and its subsidiaries); 3) wealth management services, comprised of trust services (performed by the trust unit within CBNA), investment products and services (performed by CISI) and asset management services (performed by Nottingham Advisors, Inc.); and 4) insurance products and services (performed by OneGroup).  Additionally, the Company has periodic transactions, most often net gains or losses from the sale of investment securities and prepayment of debt instruments.

Table 4: Noninterest Revenues

   
Three Months Ended
March 31,
 
(000's omitted)
 
2019
   
2018
 
Employee benefit services
 
$
24,054
   
$
23,006
 
Deposit service charges and fees
   
10,435
     
10,654
 
Electronic banking
   
5,429
     
8,523
 
Insurance services
   
7,862
     
7,359
 
Wealth management services
   
6,349
     
6,706
 
Other banking revenues
   
1,536
     
1,243
 
Subtotal
   
55,665
     
57,491
 
Unrealized gain on equity securities
   
31
     
0
 
Total noninterest revenues
 
$
55,696
   
$
57,491
 
                 
Noninterest revenues/operating revenues (FTE basis) (1)
   
39.1
%
   
40.7
%

(1) For purposes of this ratio noninterest revenues excludes unrealized gain on equity securities. Operating revenues, a non-GAAP measure, is defined as net interest income on a fully-tax equivalent basis plus noninterest revenues, excluding unrealized gain on equity securities and acquired non-impaired loan accretion.  See Table 11 for Reconciliation of GAAP to Non-GAAP Measures.

As displayed in Table 4, noninterest revenues were $55.7 million for the first quarter of 2019.  This represents a decrease of $1.8 million, or 3.1%, for the quarter in comparison to the same 2018 timeframe.  The decrease was driven by a decrease in debit card-related revenue related to the Durbin amendment mandated debit interchange price restrictions, a decrease in deposit-related fees and a decrease in wealth management revenue, partially offset by higher employee benefit services revenue, higher insurance services revenue and higher other banking revenue.

General recurring banking noninterest revenue of $17.4 million for the first quarter of 2018 decreased $3.0 million, or 14.8% as compared to the corresponding prior year period.  This year-over-year decrease was primarily driven by a $3.2 million, or $0.05 per share, decrease in debit card-related revenue due to the impact of the Durbin amendment mandated debit interchange price restrictions that were effective at the beginning of the third quarter of 2018.

Employee benefit services revenue increased $1.0 million, or 4.6%, as compared to the prior year first quarter primarily related to growth in the collective investment fund administration and trust business, as well as growth in actuarial services revenues.  Wealth management and insurance services revenue was up $0.1 million, or 1.0%, for the first quarter of 2019 as compared to the first quarter of 2018, as an increase of $0.5 million in insurance services revenue was offset by a $0.4 million decrease in wealth management revenue.

The ratio of noninterest revenues to operating revenues (FTE basis) was 39.1% for the quarter ended March 31, 2019 versus 40.7% for the equivalent period of 2018.  The decrease is due to a 3.4% increase in adjusted net interest income (FTE basis) while non-interest revenues decreased 3.2%.

Noninterest Expenses

Table 5 below sets forth the quarterly results of the major noninterest expense categories for the current and prior year, as well as efficiency ratios (defined below), a standard measure of expense utilization effectiveness commonly used in the banking industry.

Table 5: Noninterest Expenses

   
Three Months Ended
March 31,
 
(000's omitted)
 
2019
   
2018
 
Salaries and employee benefits
 
$
53,379
   
$
51,859
 
Occupancy and equipment
   
10,288
     
10,531
 
Data processing and communications
   
9,399
     
8,742
 
Amortization of intangible assets
   
4,130
     
4,798
 
Legal and professional fees
   
2,720
     
2,781
 
Business development and marketing
   
2,788
     
2,059
 
Acquisition expenses
   
534
     
(8
)
Other
   
5,414
     
5,569
 
Total noninterest expenses
 
$
88,652
   
$
86,331
 
                 
Operating expenses(1)/average assets
   
3.19
%
   
3.09
%
Efficiency ratio(2)
   
59.1
%
   
57.8
%

 (1)
Operating expenses, a non-GAAP measure, is calculated as total noninterest expenses less acquisition expenses and amortization of intangibles.  See Table 11 for Reconciliation of GAAP to Non-GAAP Measures.
 (2)
Efficiency ratio, a non-GAAP measure, is calculated as operating expenses as defined in (1) above divided by net interest income on a fully tax-equivalent basis excluding acquired non-impaired loan accretion plus noninterest revenues excluding unrealized gain on equity securities.  See Table 11 for Reconciliation of GAAP to Non-GAAP Measures.

As shown in Table 5, the Company recorded noninterest expenses of $88.7 million for the first quarter of 2019, representing an increase of $2.3 million, or 2.7%, from the prior year first quarter.  Included in the first quarter 2019 noninterest expenses are $0.5 million acquisition-related expenses associated with the Kinderhook acquisition.  Salaries and employee benefits increased $1.5 million, or 2.9%, for the first quarter of 2019 as compared to the corresponding period of 2018 primarily due to annual merit-based personnel cost increases.  The remaining increase in operating expenses can be attributed to higher data processing and communications (up $0.7 million) and business development and marketing (up $0.7 million), partially offset by lower occupancy and equipment (down $0.2 million), amortization of intangible assets (down $0.7 million), legal and professional fees (down $0.1 million) and other expenses (down $0.1 million).

The Company’s efficiency ratio (as defined in the table above) was 59.1% for the first quarter of 2019, 1.3% unfavorable to the comparable quarter of 2018.  This resulted from operating expenses (as described above) increasing 3.0%, while operating revenue (as described above) increased by a lesser 0.7% including the impact of the Durbin amendment.  Current year operating expenses, excluding intangible amortization and acquisition expenses, as a percentage of average assets increased 10 basis points versus the prior year quarter.  First quarter operating expenses (as defined above) increased 3.0% year-over-year, while average assets decreased 0.3%.

Income Taxes

The first quarter 2019 effective income tax rate was 18.5%, compared to 23.0% for the first quarter of 2018.  The decline in the rate is attributable to the impact of the windfall tax benefit associated with the accounting for share-based transactions combined with adjustments to state tax rates used in the development of the Company’s provision for income taxes.  The Company recorded a $1.7 million and $0.7 million reduction in income tax expense associated with the windfall tax benefit from share-based transactions for the first quarter of 2019 and 2018, respectively. The effective tax rates adjusted for windfall tax benefit were 21.8% for the first quarter of 2019 and 24.4% for the first quarter of 2018.

Investments

The carrying value of investments (including unrealized gains and losses on available-for-sale securities) was $2.97 billion at the end of the first quarter, a decrease of $15.5 million from December 31, 2018 and $66.5 million lower than March 31, 2018.  The book value (excluding unrealized gains and losses) of investments decreased $39.4 million from December 31, 2018 and decreased $93.0 million from March 31, 2018.  During the first quarter of 2019, the Company purchased $13.4 million of government agency mortgage-backed securities with an average yield of 3.82%.  The Company also received proceeds of $52.5 million from investment maturities, calls, and principal payments during the first three months of 2019.

The change in the carrying value of investments is also impacted by the amount of net unrealized gains or losses.  At March 31, 2019, the portfolio had an $8.6 million net unrealized gain, an increase of $23.9 million from the unrealized loss at December 31, 2018 and a $26.5 million increase from the unrealized loss at March 31, 2018.  These changes in the net unrealized position of the portfolio were principally driven by the movements in medium to long-term interest rates.

Table 6: Investment Securities

   
March 31, 2019
   
December 31, 2018
   
March 31, 2018
 
(000's omitted)
 
Amortized
Cost
   
Fair
Value
   
Amortized
Cost
   
Fair
Value
   
Amortized
Cost
   
Fair
Value
 
                                     
Available-for-Sale Portfolio:
                                   
U.S. Treasury and agency securities
 
$
2,033,399
   
$
2,034,972
   
$
2,036,474
   
$
2,023,753
   
$
2,044,795
   
$
2,027,914
 
Obligations of state and political subdivisions
   
423,916
     
433,159
     
453,640
     
459,154
     
502,517
     
510,308
 
Government agency mortgage-backed securities
   
389,154
     
386,543
     
390,234
     
382,477
     
371,857
     
364,539
 
Corporate debt securities
   
2,572
     
2,553
     
2,588
     
2,546
     
2,633
     
2,579
 
Government agency collateralized mortgage obligations
   
66,226
     
65,716
     
69,342
     
68,119
     
83,113
     
81,429
 
Marketable equity securities
   
0
     
0
     
0
     
0
     
250
     
521
 
Total available-for-sale portfolio
   
2,915,267
     
2,922,943
     
2,952,278
     
2,936,049
     
3,005,165
     
2,987,290
 
                                                 
Equity and other Securities:
                                               
Equity securities, at fair value
   
251
     
464
     
251
     
432
     
0
     
0
 
Federal Home Loan Bank common stock
   
6,308
     
6,308
     
8,768
     
8,768
     
8,801
     
8,801
 
Federal Reserve Bank common stock
   
30,690
     
30,690
     
30,690
     
30,690
     
30,690
     
30,690
 
Other equity securities, at adjusted cost
   
4,992
     
5,742
     
4,969
     
5,719
     
5,861
     
5,861
 
Total equity and other securities
   
42,241
     
43,204
     
44,678
     
45,609
     
45,352
     
45,352
 
                                                 
Total investments
 
$
2,957,508
   
$
2,966,147
   
$
2,996,956
   
$
2,981,658
   
$
3,050,517
   
$
3,032,642
 

Loans

As shown in Table 7, loans ended the first quarter at $6.27 billion, up $39.1 million, or 0.6%, from one year earlier and down $15.0 million, or 0.2%, from the end of 2018.  The growth during the last twelve months was primarily attributable to organic growth in the consumer mortgage, consumer indirect and consumer direct portfolios, partially offset by decreases in the business lending and home equity portfolios.  The decrease during the first three months of 2019 occurred primarily in the consumer indirect, consumer direct and home equity portfolios, while the business lending and consumer mortgage portfolios increased.

Table 7: Loans

(000's omitted)
 
March 31, 2019
   
December 31, 2018
   
March 31, 2018
 
Business lending
 
$
2,410,477
     
38.5
%
 
$
2,396,977
     
38.2
%
 
$
2,426,086
     
39.0
%
Consumer mortgage
   
2,237,430
     
35.7
%
   
2,235,408
     
35.6
%
   
2,211,882
     
35.5
%
Consumer indirect
   
1,070,840
     
17.1
%
   
1,083,207
     
17.2
%
   
1,008,198
     
16.2
%
Consumer direct
   
173,042
     
2.7
%
   
178,820
     
2.8
%
   
173,032
     
2.8
%
Home equity
   
374,297
     
6.0
%
   
386,709
     
6.2
%
   
407,832
     
6.5
%
Total loans
 
$
6,266,086
     
100.0
%
 
$
6,281,121
     
100.0
%
 
$
6,227,030
     
100.0
%

The business lending portfolio consists of general-purpose business lending to commercial and industrial customers, municipal lending, mortgages on commercial property, and dealer floor plan financing.  The business lending portfolio decreased $15.6 million, or 0.6%, from March 31, 2018 and increased $13.5 million, or 0.6%, from December 31, 2018, as contractual and unscheduled principal reductions impacted growth in this portfolio.  Highly competitive conditions continue to prevail in the markets in which the Company operates.  The Company strives to generate growth in its business portfolio in a manner that adheres to its goals of maintaining strong asset quality and producing profitable margins.  The Company continues to invest in additional personnel, technology and business development resources to further strengthen its capabilities in this important product category.

Consumer mortgages increased $25.5 million, or 1.2%, from one year ago and increased $2.0 million from December 31, 2018.  Consumer mortgage volume has been relatively strong over the last several years due to historically low long-term rates and comparatively stable real estate valuations in the Company’s primary markets.  However, recent changes in consumer preference has altered the primary loan purpose to predominately new home purchases, while negatively impacting refinance origination volumes.  Interest rate levels and expected duration continue to be the most significant factors in determining whether the Company chooses to retain, versus sell and service, portions of its new mortgage production.  Home equity loans decreased $33.5 million, or 8.2%, from one year ago and decreased $12.4 million, or 3.2%, from December 31, 2018.  Similar to refinance origination volumes in the Company’s consumer mortgage portfolio, interest rates have impacted the level of utilization of the Company’s home equity loan products.

Consumer installment loans, both those originated directly in the branches (referred to as “consumer direct”) and indirectly in automobile, marine, and recreational vehicle dealerships (referred to as “consumer indirect”), increased $62.7 million, or 5.3%, from one year ago and decreased $18.1 million, or 1.4%, from December 31, 2018.  Although the consumer indirect loan market is highly competitive, the Company is focused on maintaining a profitable, in-market and contiguous market indirect portfolio, while continuing to pursue the expansion of its dealer network.

Asset Quality

Table 8 below exhibits the major components of nonperforming loans and assets and key asset quality metrics for the periods ending March 31, 2019 and 2018 and December 31, 2018.

Table 8: Nonperforming Assets

(000's omitted)
 
March 31,
2019
   
December 31,
2018
   
March 31,
2018
 
Nonaccrual loans
                 
Business lending
 
$
7,401
   
$
8,370
   
$
7,798
 
Consumer mortgage
   
11,748
     
12,262
     
12,941
 
Consumer indirect
   
0
     
0
     
5
 
Consumer direct
   
0
     
0
     
0
 
Home equity
   
2,103
     
1,912
     
2,495
 
Total nonaccrual loans
   
21,252
     
22,544
     
23,239
 
Accruing loans 90+ days delinquent
                       
Business lending
   
134
     
179
     
4,069
 
Consumer mortgage
   
2,247
     
1,625
     
1,719
 
Consumer indirect
   
234
     
292
     
217
 
Consumer direct
   
66
     
52
     
30
 
Home equity
   
338
     
307
     
390
 
Total accruing loans 90+ days delinquent
   
3,019
     
2,455
     
6,425
 
Nonperforming loans
                       
Business lending
   
7,535
     
8,549
     
11,867
 
Consumer mortgage
   
13,995
     
13,887
     
14,660
 
Consumer indirect
   
234
     
292
     
222
 
Consumer direct
   
66
     
52
     
30
 
Home equity
   
2,441
     
2,219
     
2,885
 
Total nonperforming loans
   
24,271
     
24,999
     
29,664
 
Other real estate owned (OREO)
   
1,524
     
1,320
     
1,865
 
Total nonperforming assets
 
$
25,795
   
$
26,319
   
$
31,529
 
                         
Nonperforming loans / total loans
   
0.39
%
   
0.40
%
   
0.48
%
Nonperforming assets / total loans and other real estate
   
0.41
%
   
0.42
%
   
0.51
%
Delinquent loans (30 days old to nonaccruing) to total loans
   
0.88
%
   
1.00
%
   
1.01
%
Net charge-offs to average loans outstanding (quarterly)
   
0.17
%
   
0.21
%
   
0.21
%
Legacy net charge-offs to average legacy loans outstanding (quarterly)
   
0.12
%
   
0.24
%
   
0.16
%
Provision for loan losses to net charge-offs (quarterly)
   
93
%
   
75
%
   
116
%
Legacy provision for loan losses to net charge-offs (quarterly) (1)
   
142
%
   
76
%
   
122
%

(1)Legacy loans exclude loans acquired after January 1, 2009.  These ratios are included for comparative purposes to prior periods.

The Company’s asset quality profile remained strong in the first quarter of 2019 and continued to illustrate the long-term effectiveness of the Company’s disciplined risk management and underwriting standards.  As displayed in Table 8, nonperforming assets at March 31, 2019 were $25.8 million.  This represents a $0.5 million decrease as compared to the level at the end of 2018 and a $5.7 million decrease as compared to one year earlier.  Nonperforming loans decreased $0.7 million from year-end 2018 and decreased $5.4 million from March 31, 2018.  Other real estate owned (“OREO”) at March 31, 2019 was $1.5 million.  This compares to $1.3 million at December 31, 2018 and $1.9 million as of March 31, 2018.  At March 31, 2019, OREO consisted of 21 residential properties with a total value of $1.4 million and one commercial property with a value of $0.1 million.  This compares to 18 residential properties with a total value of $1.3 million at December 31, 2018, and 31 residential properties with a total value of $1.8 million and one commercial property with a value of $0.1 million at March 31, 2018.  Nonperforming loans were 0.39% of total loans outstanding at the end of the first quarter, one basis point lower than the level at December 31, 2018 and nine basis points lower than the level at March 31, 2018.

Approximately 58% of nonperforming loans at March 31, 2019 were comprised of consumer mortgages.  Collateral values of residential properties within the Company’s market area have generally remained stable over the past several years.  Additionally, economic conditions, including lower unemployment levels, have positively impacted consumers and resulted in more favorable nonperforming mortgage ratios.  Approximately 31% of the nonperforming loans at March 31, 2019 were related to the business lending portfolio, which is comprised of business loans broadly diversified by industry type.  The remaining 11% of nonperforming loans relate to consumer installment and home equity loans, with home equity non-performing loan levels being driven by the same factors that were identified for consumer mortgages.  The allowance for loan losses to nonperforming loans ratio, a general measure of coverage adequacy, was 202% at the end of the first quarter, as compared to 197% at year-end 2018 and 162% at March 31, 2018.

The Company’s senior management, special asset officers and lenders review all delinquent and nonaccrual loans and OREO regularly in order to identify deteriorating situations, monitor known problem credits and discuss any needed changes to collection efforts, if warranted.  Based on the group’s consensus, a relationship may be assigned a special assets officer or other senior lending officer to review the loan, meet with the borrowers, assess the collateral and recommend an action plan.  This plan could include foreclosure, restructuring loans, issuing demand letters or other actions.  The Company’s larger criticized credits are also reviewed on a quarterly basis by senior credit administration management, special assets officers and commercial lending management to monitor their status and discuss credit management plans.  Commercial lending management reviews the criticized loan portfolio on a monthly basis.

Delinquent loans (30 days past due through nonaccruing) as a percent of total loans was 0.88% at the end of the first quarter, 12 basis points below the 1.00% at year-end 2018 and 13 basis points below the 1.01% at March 31, 2018.  The business lending delinquency ratio at the end of the first quarter was five basis points above the level at December 31, 2018 and 20 basis points below the level at March 31, 2018.  The delinquency rates for consumer mortgage and consumer direct loans decreased as compared to the level at December 31, 2018 and the level one year ago.  The delinquency ratio for the consumer indirect portfolio decreased as compared to December 31, 2018, but increased in comparison to the level at March 31, 2018.  The delinquency ratio for the home equity portfolio increased in comparison to December 31, 2018, but decreased in comparison to the level one year ago.  The Company’s success at keeping the nonperforming and delinquency ratios at favorable levels has been the result of its continued focus on maintaining strict underwriting standards, as well as the effective utilization of its collection and recovery capabilities.

Table 9: Allowance for Loan Losses Activity

   
Three Months Ended
March 31,
 
(000's omitted)
 
2019
   
2018
 
Allowance for loan losses at beginning of period
 
$
49,284
   
$
47,583
 
Charge-offs:
               
Business lending
   
1,216
     
1,712
 
Consumer mortgage
   
253
     
199
 
Consumer indirect
   
1,823
     
2,284
 
Consumer direct
   
535
     
496
 
Home equity
   
74
     
56
 
Total charge-offs
   
3,901
     
4,747
 
Recoveries:
               
Business lending
   
134
     
198
 
Consumer mortgage
   
22
     
8
 
Consumer indirect
   
962
     
1,151
 
Consumer direct
   
179
     
222
 
Home equity
   
5
     
9
 
Total recoveries
   
1,302
     
1,588
 
                 
Net charge-offs
   
2,599
     
3,159
 
Provision for loans losses
   
2,422
     
3,679
 
                 
Allowance for loan losses at end of period
 
$
49,107
   
$
48,103
 
Allowance for loan losses / total loans
   
0.78
%
   
0.77
%
Allowance for legacy loan losses / total legacy loans (1)
   
0.94
%
   
0.97
%
Allowance for loan losses / nonperforming loans
   
202
%
   
162
%
Allowance for legacy loan losses  / legacy nonperforming loans (1)
   
262
%
   
216
%
Net charge-offs (annualized) to average loans outstanding:
               
Business lending
   
0.18
%
   
0.25
%
Consumer mortgage
   
0.04
%
   
0.03
%
Consumer indirect
   
0.33
%
   
0.46
%
Consumer direct
   
0.81
%
   
0.62
%
Home equity
   
0.07
%
   
0.05
%
Total loans
   
0.17
%
   
0.21
%

 (1)
Legacy loans exclude loans acquired after January 1, 2009.  These ratios are included for comparative purposes to prior periods.

As displayed in Table 9, net charge-offs during the first quarter of 2019 were $2.6 million, $0.6 million lower than the first quarter of 2018.  The business lending and consumer indirect portfolios experienced lower net charge-offs during the first quarter of 2019, as compared to the first quarter of 2018, while the consumer mortgage, home equity and consumer direct portfolios experienced higher net charge-offs than the prior period.  The net charge-off ratio (net charge-offs as a percentage of average loans outstanding) for the first quarter of 2019 was 0.17%, four basis points lower than the first quarter of 2018.  Net charge-off ratios for the first quarter of 2019 for the business lending, consumer mortgage and consumer direct portfolios were above the Company’s average for the trailing eight quarters, while the net charge-off ratios for the consumer indirect and home equity portfolios were below the Company’s average for the trailing eight quarters.

The Company recorded a $2.4 million provision for loan losses in the first quarter, with $2.1 million related to legacy loans and $0.3 million related to acquired loans.  The first quarter provision was $1.3 million lower than the equivalent prior year period.  The first quarter 2019 loan loss provision was $0.2 million less than the level of net charge-offs for the quarter.  The allowance for loan losses of $49.1 million as of March 31, 2019 increased of $1.0 million from the level one year ago.  Stable asset quality metrics have resulted in an allowance for loan loss to total loans ratio of 0.78% at March 31, 2019, one basis point higher than the level at March 31, 2018 and consistent with the level at December 31, 2018.

As of March 31, 2019, the purchase discount related to the $1.22 billion of remaining non-impaired loan balances acquired from Merchants Bank, Oneida Savings Bank, HSBC Bank USA, N.A., First Niagara Bank, N.A., and Wilber National Bank was approximately $22.6 million, or 1.9% of that portfolio, with $1.5 million included in the allowance for loan losses for acquired loans where the carrying value exceeded the estimated net recoverable value.

Deposits

As shown in Table 10, average deposits of $8.41 billion in the first quarter were $82.6 million, or 1.0%, lower than the first quarter of 2018.  This compares to an increase of $48.8 million, or 0.6%, from the fourth quarter of last year.  The mix of average deposit balances changed as the weighting of core deposits (noninterest checking, interest checking, savings and money markets) has increased slightly from the prior year levels.  Conversely, the proportion of time deposits decreased over the past 12 months, consistent with the last several years.  The quarterly average cost of deposits was 0.20% for the first quarter of 2019, compared to 0.10% in the first quarter of 2018, reflective of increases in market deposit interest rates between the periods.  The Company continues to focus heavily on growing its core deposit relationships through its proactive marketing efforts, competitive product offerings and high quality customer service.

Average nonpublic fund deposits for the first quarter of 2019 decreased $1.5 million versus the fourth quarter of 2018 and increased $19.2 million, or 0.3%, versus the year-earlier period.  Average public fund deposits for the first quarter increased $50.3 million, or 5.2%, from the fourth quarter of 2018 and decreased $101.8 million, or 9.1%, from the first quarter of 2018.  Public fund deposits as a percentage of total deposits decreased from 13.2% in the first quarter of 2018 to 12.1% in the first quarter of 2019.

Table 10: Quarterly Average Deposits

(000's omitted)
 
March 31,
2019
   
December 31,
2018
   
March 31,
2018
 
Noninterest checking deposits
 
$
2,297,472
   
$
2,317,042
   
$
2,268,778
 
Interest checking deposits
   
1,975,091
     
1,880,610
     
1,870,277
 
Savings deposits
   
1,461,847
     
1,450,707
     
1,444,871
 
Money market deposits
   
1,922,754
     
1,966,279
     
2,137,856
 
Time deposits
   
748,040
     
741,794
     
766,048
 
Total deposits
 
$
8,405,204
   
$
8,356,432
   
$
8,487,830
 
                         
Nonpublic fund deposits
 
$
7,385,439
   
$
7,386,943
   
$
7,366,222
 
Public fund deposits
   
1,019,765
     
969,489
     
1,121,608
 
Total deposits
 
$
8,405,204
   
$
8,356,432
   
$
8,487,830
 

Borrowings

Borrowings, excluding securities sold under agreement to repurchase, at the end of the first quarter of 2019 totaled $99.9 million. This was $54.4 million, or 35.3%, lower than borrowings at December 31, 2018 and $25.0 million, or 20.0%, below the end of the first quarter of 2018.  The decrease from the prior year first quarter was primarily due to the redemption of the trust preferred subordinated debt held by Community Statutory Trust III, an unconsolidated subsidiary trust, during the third quarter of 2018, while the decrease from the fourth quarter of 2018 was related to a $54.4 million decrease in overnight FHLB borrowings.

Securities sold under agreement to repurchase, also referred to as customer repurchase agreements, represent collateralized municipal and commercial customer accounts that price and operate similar to a deposit instrument.  Customer repurchase agreements were $249.9 million at the end of the first quarter of 2019, a decrease of $9.5 million from December 31, 2018 and $29.8 million below March 31, 2018.

Shareholders’ Equity

Total shareholders’ equity of $1.76 billion at the end of the first quarter of 2019 represents an increase of $43.3 million from the balance at December 31, 2018.  During the first quarter of 2019, the Company recorded net income of $41.9 million, issued $1.9 million of treasury stock to the Company’s benefit plans, recorded $1.4 million from employee stock options earned and other comprehensive income increased $18.5 million.  These amounts were partially offset by dividends declared of $19.6 million and a $0.8 million decrease in shareholders’ equity associated with the net activity under the Company’s employee stock plan.  In the first quarter of 2019, the issuance of shares under the employee stock plan was more than offset by the impact of the net settlement of tax withholding obligations associated with the vesting of stock-based compensation instruments.  The change in other comprehensive income was comprised of an $18.1 million increase in the after-tax market value adjustment on the available-for-sale investment portfolio and a positive $0.4 million adjustment to the funded status of the Company’s retirement plans.  Over the past 12 months, total shareholders’ equity increased by $125.7 million, as net income, the issuance of common stock in association with the employee stock plan and the Company’s benefit plans and an increase in the market value adjustment on investments, more than offset dividends declared and the change in the funded status of the Company’s defined benefit pension and other postretirement plans.

The Company’s Tier 1 leverage ratio, a primary measure of regulatory capital for which 5% is the requirement to be “well-capitalized”, was 11.27% at the end of the first quarter, up 19 basis points from year-end 2018 and 1.08% above its level one year earlier.  The increase in the Tier 1 leverage ratio in comparison to December 31, 2018 was the result of ending shareholders’ equity, excluding intangibles and other comprehensive income items, increasing 2.5%, primarily from net earnings retention, while average assets, excluding intangibles and the market value adjustment on investments, increased 0.8%.  The Tier 1 leverage ratio increased compared to the prior year’s first quarter as shareholders’ equity, excluding intangibles and other comprehensive income, increased 10.6% primarily due to earnings retention, while average assets excluding intangibles and the market value adjustment, decreased 0.1%.  The net tangible equity-to-assets ratio (a non-GAAP measure) of 9.83% increased 0.15% from December 31, 2018 and increased 1.41% versus March 31, 2018 (See Table 11 for Reconciliation of Quarterly GAAP to Non-GAAP Measures).  The increase in the tangible equity ratio over the past 12 months was due to a proportionally larger increase in tangible equity levels than the increase in tangible assets.

The dividend payout ratio (dividends declared divided by net income) for the first quarter of 2019 was 46.7%, compared to 43.0% for the first quarter of 2018.  First quarter dividends declared increased 13.4% versus one year earlier, as the Company’s quarterly dividend per share was raised from $0.34 to $0.38 in August 2018, while net income increased 4.6% over the prior year period.  The 2018 dividend increase marked the Company’s 26th consecutive year of increased dividend payouts to common shareholders.  Additionally, the number of common shares outstanding increased 1.2% over the last twelve months.

Liquidity

Liquidity risk is a measure of the Company’s ability to raise cash when needed at a reasonable cost and minimize any loss.  The Bank maintains appropriate liquidity levels in both normal operating environments as well as stressed environments.  The Company must be capable of meeting all obligations to its customers at any time and, therefore, the active management of its liquidity position remains an important management objective.  The Bank has appointed the Asset Liability Committee (“ALCO”) to manage liquidity risk using policy guidelines and limits on indicators of potential liquidity risk.  The indicators are monitored using a scorecard with three risk level limits.  These risk indicators measure core liquidity and funding needs, capital at risk and change in available funding sources.  The risk indicators are monitored using such statistics as the core basic surplus ratio, unencumbered securities to average assets, free loan collateral to average assets, loans to deposits, deposits to total funding and borrowings to total funding ratios.

Given the uncertain nature of the Company’s customers' demands, as well as the Company's desire to take advantage of earnings enhancement opportunities, the Company must have adequate sources of on and off-balance sheet funds available that can be utilized in time of need.  Accordingly, in addition to the liquidity provided by balance sheet cash flows, liquidity must be supplemented with additional sources such as credit lines from correspondent banks and borrowings from the FHLB and the Federal Reserve Bank of New York (“Federal Reserve”).  Other funding alternatives may also be appropriate from time to time, including wholesale and retail repurchase agreements, large certificates of deposit and the brokered CD market.  The primary source of non-deposit funds is FHLB overnight advances, of which there were no outstanding borrowings at March 31, 2019.

The Bank’s primary sources of liquidity are its liquid assets, as well as unencumbered loans and securities that can be used to collateralize additional funding.  At March 31, 2019, the Bank had $508.4 million of cash and cash equivalents of which $343.4 million are interest-earning deposits held at the Federal Reserve, FHLB and other correspondent banks.  The Bank also had $1.7 billion in unused FHLB borrowing capacity based on the Company’s quarter-end collateral levels.  Additionally, the Company has $1.4 billion of unencumbered securities that could be pledged at the FHLB or Federal Reserve to obtain additional funding.  There is $25.0 million available in unsecured lines of credit with other correspondent banks at year end.

The Company’s primary approach to measuring short-term liquidity is known as the Basic Surplus/Deficit model.  It is used to calculate liquidity over two time periods: first, the amount of cash that could be made available within 30 days (calculated as liquid assets less short-term liabilities as a percentage of average assets); and second, a projection of subsequent cash availability over an additional 60 days.  As of March 31, 2019, this ratio was 15.1% for 30-days and 14.9% for 90-days, excluding the Company's capacity to borrow additional funds from the FHLB and other sources.  This is considered to be a sufficient amount of liquidity based on the Company’s internal policy requirement of 7.5%.

A sources and uses statement is used by the Company to measure intermediate liquidity risk over the next twelve months.  As of March 31, 2019, there is more than enough liquidity available during the next year to cover projected cash outflows.  In addition, stress tests on the cash flows are performed in various scenarios ranging from high probability events with a low impact on the liquidity position to low probability events with a high impact on the liquidity position.  The results of the stress tests as of March 31, 2019 indicate the Bank has sufficient sources of funds for the next year in all simulated stressed scenarios.

To measure longer-term liquidity, a baseline projection of loan and deposit growth for five years is made to reflect how liquidity levels could change over time.  This five-year measure reflects ample liquidity for loan and other asset growth over the next five years.

Though remote, the possibility of a funding crisis exists at all financial institutions.  Accordingly, management has addressed this issue by formulating a Liquidity Contingency Plan, which has been reviewed and approved by both the Company’s Board of Directors (the “Board”) and the Company’s ALCO.  The plan addresses the actions that the Company would take in response to both a short-term and long-term funding crisis.

A short-term funding crisis would most likely result from a shock to the financial system, either internal or external, which disrupts orderly short-term funding operations.  Such a crisis would likely be temporary in nature and would not involve a change in credit ratings.  A long-term funding crisis would most likely be the result of drastic credit deterioration at the Company.  Management believes that both potential circumstances have been fully addressed through detailed action plans and the establishment of trigger points for monitoring such events.

Forward-Looking Statements

This document contains comments or information that constitute forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995), which involve significant risks and uncertainties.  Forward-looking statements often use words such as “anticipate,” “target,” “expect,” “estimate,” “intend,” “plan,” “goal,” “forecast, ” “believe,” or other words of similar meaning.  Actual results may differ materially from the results discussed in the forward-looking statements.  Moreover, the Company’s plans, objectives and intentions are subject to change based on various factors (some of which are beyond the Company’s control).  Factors that could cause actual results to differ from those discussed in the forward-looking statements include:  (1) risks related to credit quality, interest rate sensitivity and liquidity;  (2) the strength of the U.S. economy in general and the strength of the local economies where the Company conducts its business;  (3) the effect of, and changes in, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System;  (4) inflation, interest rate, market and monetary fluctuations;  (5) the timely development of new products and services and customer perception of the overall value thereof (including features, pricing and quality) compared to competing products and services;  (6) changes in consumer spending, borrowing and savings habits;  (7) technological changes and implementation and financial risks associated with transitioning to new technology-based systems involving large multi-year contracts;  (8) the ability of the Company to maintain the security of its financial, accounting, technology, data processing and other operating systems and facilities;  (9) effectiveness of the Company’s risk management processes and procedures, reliance on models which may be inaccurate or misinterpreted, the Company’s ability to manage its credit risk, the sufficiency of its allowance for loan losses and the accuracy of the assumptions or estimates used in preparing the Company’s financial statements; (10) failure of third parties to provide various services that are important to the Company’s operations;  (11) any acquisitions or mergers that might be considered or consummated by the Company and the costs and factors associated therewith, including differences in the actual financial results of the acquisition or merger compared to expectations and the realization of anticipated cost savings and revenue enhancements;  (12) the ability to maintain and increase market share and control expenses;  (13) the nature, timing and effect of changes in banking regulations or other regulatory or legislative requirements affecting the respective businesses of the Company and its subsidiaries, including changes in laws and regulations concerning taxes, accounting, banking, risk management, securities and other aspects of the financial services industry, specifically the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010;  (14) changes in the Company’s organization, compensation and benefit plans and in the availability of, and compensation levels for, employees in its geographic markets;  (15) the outcome of pending or future litigation and government proceedings; (16) other risk factors outlined in the Company’s filings with the SEC from time to time; and (17) the success of the Company at managing the risks of the foregoing.

The foregoing list of important factors is not all-inclusive.  Such forward-looking statements speak only as of the date on which they are made and the Company does not undertake any obligation to update any forward-looking statement, whether written or oral, to reflect events or circumstances after the date on which such statement is made.  If the Company does update or correct one or more forward-looking statements, investors and others should not conclude that the Company will make additional updates or corrections with respect thereto or with respect to other forward-looking statements.

Reconciliation of GAAP to Non-GAAP Measures

Table 11: GAAP to Non-GAAP Reconciliations

   
Three Months Ended
March 31,
 
(000's omitted)
 
2019
   
2018
 
Income statement data
           
Net income
           
Net income (GAAP)
 
$
41,946
   
$
40,106
 
Acquisition expenses
   
534
     
(8
)
Tax effect of acquisition expenses
   
(99
)
   
2
 
Subtotal (non-GAAP)
   
42,381
     
40,100
 
Unrealized gain on equity securities
   
(31
)
   
0
 
Tax effect of unrealized gain on equity securities
   
6
     
0
 
Operating net income (non-GAAP)
   
42,356
     
40,100
 
Amortization of intangibles
   
4,130
     
4,798
 
Tax effect of amortization of intangibles
   
(765
)
   
(1,105
)
Subtotal (non-GAAP)
   
45,721
     
43,793
 
Acquired non-impaired loan accretion
   
(1,330
)
   
(2,063
)
Tax effect of acquired non-impaired loan accretion
   
246
     
475
 
Adjusted net income (non-GAAP)
 
$
44,637
   
$
42,205
 
                 
Return on average assets
               
Adjusted net income (non-GAAP)
 
$
44,637
   
$
42,205
 
Average total assets
   
10,687,708
     
10,715,529
 
Adjusted return on average assets (non-GAAP)
   
1.69
%
   
1.60
%
                 
Return on average equity
               
Adjusted net income (non-GAAP)
 
$
44,637
   
$
42,205
 
Average total equity
   
1,726,313
     
1,625,951
 
Adjusted return on average equity (non-GAAP)
   
10.49
%
   
10.53
%
                 
Earnings per common share
               
Diluted earnings per share (GAAP)
 
$
0.80
   
$
0.78
 
Acquisition expenses
   
0.01
     
0.00
 
Tax effect of acquisition expenses
   
0.00
     
0.00
 
Subtotal (non-GAAP)
   
0.81
     
0.78
 
Unrealized gain on equity securities
   
0.00
     
0.00
 
Tax effect of unrealized gain on equity securities
   
0.00
     
0.00
 
Operating net income (non-GAAP)
   
0.81
     
0.78
 
Amortization of intangibles
   
0.08
     
0.09
 
Tax effect of amortization of intangibles
   
(0.01
)
   
(0.02
)
Subtotal (non-GAAP)
   
0.88
     
0.85
 
Acquired non-impaired loan accretion
   
(0.03
)
   
(0.04
)
Tax effect of acquired non-impaired loan accretion
   
0.00
     
0.01
 
Diluted adjusted net earnings per share (non-GAAP)
 
$
0.85
   
$
0.82
 

   
Three Months Ended
March 31,
 
(000's omitted)
 
2019
   
2018
 
Noninterest operating expenses
           
Noninterest expenses (GAAP)
 
$
88,652
   
$
86,331
 
Amortization of intangibles
   
(4,130
)
   
(4,798
)
Acquisition expenses
   
(534
)
   
8
 
Total adjusted noninterest expenses (non-GAAP)
 
$
83,988
   
$
81,541
 
                 
Efficiency ratio
               
Adjusted noninterest expenses (non-GAAP) - numerator
 
$
83,988
   
$
81,541
 
Fully tax-equivalent net interest income
   
87,867
     
85,742
 
Noninterest revenues
   
55,696
     
57,491
 
Acquired non-impaired loan accretion
   
(1,330
)
   
(2,063
)
Unrealized gain on equity securities
   
(31
)
   
0
 
Operating revenues (non-GAAP) - denominator
 
$
142,202
   
$
141,170
 
Efficiency ratio (non-GAAP)
   
59.1
%
   
57.8
%

(000's omitted)
 
March 31,
2019
   
December 31,
2018
   
March 31,
2018
 
Balance sheet data – at end of quarter
                 
Total assets
                 
Total assets (GAAP)
 
$
10,916,467
   
$
10,607,295
   
$
10,966,555
 
Intangible assets
   
(804,419
)
   
(807,349
)
   
(820,584
)
Deferred taxes on intangible assets
   
45,994
     
46,370
     
47,904
 
Total tangible assets (non-GAAP)
 
$
10,158,042
   
$
9,846,316
   
$
10,193,875
 
                         
Total common equity
                       
Shareholders' Equity (GAAP)
   
1,757,128
     
1,713,783
     
1,631,466
 
Intangible assets
   
(804,419
)
   
(807,349
)
   
(820,584
)
Deferred taxes on intangible assets
   
45,994
     
46,370
     
47,904
 
Total tangible common equity (non-GAAP)
 
$
998,703
   
$
952,804
   
$
858,786
 
                         
Net tangible equity-to-assets ratio at quarter end
                       
Total tangible common equity (non-GAAP) - numerator
 
$
998,703
   
$
952,804
   
$
858,786
 
Total tangible assets (non-GAAP) - denominator
 
$
10,158,042
   
$
9,846,316
   
$
10,193,875
 
Net tangible equity-to-assets ratio at quarter end (non-GAAP)
   
9.83
%
   
9.68
%
   
8.42
%

Item 3.
Quantitative and Qualitative Disclosures about Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates, prices or credit risk.  Credit risk associated with the Company’s loan portfolio has been previously discussed in the asset quality section of the MD&A.  Management believes that the tax risk of the Company’s municipal investments associated with potential future changes in statutory, judicial and regulatory actions is minimal.  Treasury, agency, mortgage-backed and CMO securities issued by government agencies comprise 84% of the total portfolio and are currently rated AAA by Moody’s Investor Services and AA+ by Standard & Poor’s.  Municipal and corporate bonds account for 15% of the total portfolio, of which, 99% carry a minimum rating of A-.  The remaining 1% of the portfolio is comprised of other investment grade securities.  The Company does not have material foreign currency exchange rate risk exposure.  Therefore, almost all the market risk in the investment portfolio is related to interest rates.

The ongoing monitoring and management of both interest rate risk and liquidity, in the short and long term time horizons is an important component of the Company's asset/liability management process, which is governed by limits established in the policies reviewed and approved annually by the Company’s Board.  The Board delegates responsibility for carrying out the policies to the ALCO, which meets each month.  The committee is made up of the Company's senior management as well as regional and line-of-business managers who oversee specific earning asset classes and various funding sources.  As the Company does not believe it is possible to reliably predict future interest rate movements, it has maintained an appropriate process and set of measurement tools, which enables it to identify and quantify sources of interest rate risk in varying rate environments.  The primary tool used by the Company in managing interest rate risk is income simulation.

While a wide variety of strategic balance sheet and treasury yield curve scenarios are tested on an ongoing basis, the following reflects the Company's projected net interest income sensitivity over the subsequent twelve months based on:

Asset and liability levels using March 31, 2019 as a starting point.

There are assumed to be conservative levels of balance sheet growth, low-to-mid single digit growth in loans and deposits, while using the cash flows from investment contractual maturities and prepayments to repay short-term capital market borrowings or reinvest into securities or cash equivalents.

The prime rate and federal funds rates are assumed to move over a 12-month period while moving the long end of the treasury curve to spreads over the three month treasury that are more consistent with historical norms (normalized yield curve).  Deposit rates are assumed to move in a manner that reflects the historical relationship between deposit rate movement and changes in the federal funds rate.

Cash flows are based on contractual maturity, optionality, and amortization schedules along with applicable prepayments derived from internal historical data and external sources.

Net Interest Income Sensitivity Model

 
 
 
Change in interest rates
 
Calculated annualized increase
(decrease) in projected net interest
income at March 31, 2019
(000’s omitted)
 
+200 basis points
 
(1,345
)
+100 basis points
 
$
729
 
-100 basis points
 
(1,496
)
-200 basis points
 
(7,665
)

The short term modeled net interest income (NII) increases modestly in the +100 bp rising rate environment largely due to the historical normalization of the yield curve.  New loan pricing primarily benefits from this assumption.  The short term modeled NII, however, decreases in the +200 bp rising rate environment due to assumed deposit and funding costs increasing faster than the repricing of corresponding assets.  Over the longer time period, (years 2 and beyond), the growth in NII improves in both rising rate environments as lower yielding assets mature and are replaced at higher rates.

In the falling rate environments, the Bank shows interest rate risk exposure to lower short term rates.  During the first twelve months, net interest income declines largely due to lower assumed rates on new loans, including adjustable and variable rate assets.  Modestly lower funding costs associated with deposits and borrowings only partially offset the decrease in interest income.

The analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results.  These hypothetical estimates are based upon numerous assumptions: the nature and timing of interest rate levels (including yield curve shape), prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and other factors.  While the assumptions are developed based upon reasonable economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.  Furthermore, the sensitivity analysis does not reflect actions that the ALCO might take in responding to or anticipating changes in interest rates.

Item 4.
Controls and Procedures

Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures, as defined in Rule 13a -15(e) and 15d – 15(e) under the Securities Exchange Act of 1934 as amended (the “Exchange Act”), designed to ensure information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is: (i) recorded, processed, summarized, and reported within the time periods specified in the SEC rules and forms, and (ii) accumulated and communicated to management, including the principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure.  Based on management’s evaluation of the effectiveness of the Company’s disclosure controls and procedures, with the participation of the Chief Executive Officer and the Chief Financial Officer, it has concluded that, as of the end of the period covered by this Quarterly Report on Form 10-Q, these disclosure controls and procedures were effective as of March 31, 2019.

Changes in Internal Control over Financial Reporting
The Company regularly assesses the adequacy of its internal controls over financial reporting.  There have been no changes in the Company’s internal controls over financial reporting in connection with the evaluation referenced in the paragraph above that occurred during the Company’s quarter ended March 31, 2019 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II.
Other Information

Item 1.
Legal Proceedings

The Company and its subsidiaries are subject in the normal course of business to various pending and threatened legal proceedings in which claims for monetary damages are asserted. As of March 31, 2019, management, after consultation with legal counsel, does not anticipate that the aggregate ultimate liability arising out of litigation pending or threatened against the Company or its subsidiaries will be material to the Company’s consolidated financial position. On at least a quarterly basis, the Company assesses its liabilities and contingencies in connection with such legal proceedings. For those matters where it is probable that the Company will incur losses and the amounts of the losses can be reasonably estimated, the Company records an expense and corresponding liability in its consolidated financial statements. To the extent the pending or threatened litigation could result in exposure in excess of that liability, the amount of such excess is not currently estimable. The range of reasonably possible losses for matters where an exposure is not currently estimable or considered probable, beyond the existing recorded liabilities, is between $0 and $1 million in the aggregate. Although the Company does not believe that the outcome of pending litigation will be material to the Company’s consolidated financial position, it cannot rule out the possibility that such outcomes will be material to the consolidated results of operations for a particular reporting period in the future.

Item 1A.
Risk Factors

There has not been any material change in the risk factors disclosure from that contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018 filed with the SEC on March 1, 2019.

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

a)  Not applicable.

b)  Not applicable.

c)  At its December 2018 meeting, the Board approved a new stock repurchase program authorizing the repurchase, at the discretion of senior management, of up to 2,500,000 shares of the Company’s common stock, in accordance with securities laws and regulations, during a twelve-month period beginning January 1, 2019.  Any repurchased shares will be used for general corporate purposes, including those related to stock plan activities.  The timing and extent of repurchases will depend on market conditions and other corporate considerations as determined at the Company’s discretion.

The following table presents stock purchases made during the first quarter of 2019:

Issuer Purchases of Equity Securities

Period
 
Total
Number of
Shares
Purchased
   
Average
Price Paid
Per Share
   
Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs
   
Maximum Number of
Shares That May Yet Be
Purchased Under the Plans
or Programs
 
January 1-31, 2019
   
35,753
   
$
60.26
     
0
     
2,500,000
 
February 1-28, 2019
   
324
     
60.22
     
0
     
2,500,000
 
March 1-31, 2019
   
15,809
     
64.79
     
0
     
2,500,000
 
Total (1)
   
51,886
   
$
61.64
                 

(1) Included in the common shares repurchased were 50,606 shares acquired by the Company in connection with satisfaction of tax withholding obligations on vested restricted stock issued pursuant to the employee benefit plan and 1,280 shares acquired by the Company in connection with the administration of a deferred compensation plan.  These shares were not repurchased as part of the publicly announced repurchase plan described above.

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

Agreement and Plan of Merger, dated as of January 21, 2019, by and among Community Bank System, Inc., VB Merger Sub Inc., and Kinderhook Bank Corp.  Incorporated by reference to Exhibit No. 2.1 to the Current Report on Form 8-K filed on January 25, 2019 (Registration No. 001-13695).
   
Employment Agreement, dated January 4, 2019, by and among Community Bank System, Inc., Community Bank, N.A. and Joseph F. Serbun.  Incorporated by reference to Exhibit No. 10.1 to the Current Report on Form 8-K filed on January 8, 2019 (Registration No. 001-13695). (1)
   
Certification of Mark E. Tryniski, President and Chief Executive Officer of the Registrant, pursuant to Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (2)
   
Certification of Joseph E. Sutaris, Treasurer and Chief Financial Officer of the Registrant, pursuant to Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (2)
   
Certification of Mark E. Tryniski, President and Chief Executive Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (3)
   
Certification of Joseph E. Sutaris, Treasurer and Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (3)
   
101
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Statements of Condition, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) the Consolidated Statements of Changes in Shareholders’ Equity, (v) the Consolidated Statements of Cash Flows, and (vi) the Notes to Consolidated Financial Statements tagged as blocks of text and in detail.(4)

(1)
Denotes management contract or compensatory plan or arrangement.
(2)
Filed herewith.
(3)
Furnished herewith.
(4)
XBRL (Extensible Business Reporting Language) information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections.

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Community Bank System, Inc.

Date: May 10, 2019
/s/ Mark E. Tryniski
 
Mark E. Tryniski, President and Chief Executive Officer
   
Date: May 10, 2019
/s/ Joseph E. Sutaris
 
Joseph E. Sutaris, Treasurer and Chief  Financial Officer


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