FARMERS & MERCHANTS BANCORP INC - Annual Report: 2018 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10‑K

For the fiscal year ended December 31, 2018

or

For the transition period from          to         

Commission File Number 001-38084

FARMERS & MERCHANTS BANCORP, INC.

Registrant’s telephone number, including area code (419) 446-2501

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

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

Common shares without par value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ☐    No  ☒

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ☐    No  ☒

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or Section 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    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.  

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.  ☐

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

As of June 30, 2018, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $373,858,083.

As of February 22, 2019, the Registrant had 12,230,000 shares of common stock issued of which 11,107,063 shares are outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III of Form 10-K – Portions of the definitive Proxy Statement for the 2019 Annual Meeting of Shareholders of Farmers & Merchants Bancorp, Inc.

FARMERS & MERCHANTS BANCORP, INC.

TABLE OF CONTENTS

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Forward Looking Statements

Statements contained in the Company's Annual Report on Form 10-K may be forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995.  Forward-looking statements may be identified by the use of such words as "intend," "believe," "expect," "anticipate," "should," "planned," "estimated," and "potential."  Such forward-looking statements are based on current expectations but may differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission from time to time.  Other factors which could have a material adverse effect on the operations of the Company and its subsidiaries which include, but are not limited to, changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Bank's market area, changes in relevant accounting principles and guidelines and other factors over which management has no control.  The forward-looking statements are made as of the date of this report, and the Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results could differ from those projected in the forward-looking statements.

PART I

ITEM 1. BUSINESS

General

Farmers & Merchants Bancorp, Inc. (Company) is a bank holding company incorporated under the laws of Ohio in 1985 and elected to become a financial holding company under the Federal Reserve in 2014.  Our primary subsidiary, The Farmers & Merchants State Bank (Bank) is a community bank operating in Northwest Ohio and Northeast Indiana since 1897.  Our other subsidiary, Farmers & Merchants Risk Management (Captive) is a captive insurance company formed in December 2014 and located in Nevada. We report our financial condition and net income on a consolidated basis and we report only one segment.

Our executive offices are located at 307 North Defiance Street, Archbold, Ohio 43502, and our telephone number is                  (419) 446-2501.

For a discussion of the general development of the Company’s business throughout 2018, please see the portion of Management’s Discussion and Analysis of Financial Condition and Results of Operations captioned “2018 in Review.”

Nature of Activities

The Farmers & Merchants State Bank engages in general commercial banking business. Its activities include commercial, agricultural and residential mortgage as well as consumer and credit card lending activities.  Because the Bank's offices are located in Northwest Ohio and Northeast Indiana, a substantial amount of the loan portfolio is comprised of loans made to customers in the farming industry for such things as farm land, farm equipment, livestock and operating loans for seed, fertilizer, and feed. Other types of lending activities include loans for home improvements and loans for such items as autos, trucks, recreational vehicles and motorcycles.  With the expansion into newer market areas, the most recent increases in loan activity have been in commercial real estate, providing operation lines of credit and machinery purchases.

The Bank also provides checking account services, as well as savings and time deposit services such as certificates of deposits. In addition, Automated Teller Machines (ATMs) or Interactive Teller Machines (ITMs) are provided at most branch locations along with other independent locations in the market area. The Bank has custodial services for Individual Retirement Accounts (IRAs) and Health Savings Accounts (HSAs).  The Bank provides on-line banking access for consumer and business customers. For consumers, this includes bill-pay, on-line statement opportunities and mobile banking. For business customers, it provides the option of electronic transaction origination such as wire and Automated Clearing House (ACH) file transmittal.  In addition, the Bank offers remote deposit capture or electronic deposit processing and merchant credit card services.  Upgrades to our digital products and services continue to occur in both retail and business lines.

The Bank has established underwriting policies and procedures which facilitate operating in a safe and sound manner in accordance with supervisory and regulatory guidance.  Within this sphere of safety and soundness, the Bank's practice has been to not promote innovative, unproven credit products which may not be in the best interest of the Bank or its customers.  The Bank does offer a hybrid mortgage loan.  Hybrid loans are loans that start out as a fixed rate mortgage but after a set number of years automatically adjust to an adjustable rate mortgage.  The Bank offers a three year fixed rate mortgage after which the interest rate will adjust annually.  The majority of the Bank's adjustable rate mortgages are of this type. In order to offer longer term fixed rate mortgages, the Bank does participate in the Freddie Mac, Farmer Mac and Small Business Lending programs.

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The Bank also normally retains the servicing rights on these partially or 100% sold loans.  In order for the customer to participate in these programs, they must meet the requirements established by those agencies. In addition, the Bank does sell some of its longer term fixed rate agricultural mortgages into the secondary market with the aid of a broker.

The Bank does not have a program to fund sub-prime loans.  Sub-prime loans are characterized as a lending program or strategy that targets borrowers who pose a significantly higher risk of default than traditional retail banking customers.

All loan requests are reviewed as to credit worthiness and are subject to the Bank's underwriting guidelines as to secured versus unsecured credit. Secured loans are in turn subject to loan to value (LTV) requirements based on collateral types as set forth in the Bank's Loan Policy. In addition, credit scores of those seeking consumer credit are reviewed and if they do not meet the Bank's Loan Policy guidelines an additional officer approval is required.

Consumer Loans:

Commercial/Agriculture/Real Estate:

Inventory:

Livestock and grain up to 80% LTV, crops (insured) up to 75% and Warehouse Receipts up to 87%.

Maximum LTV of 50% on raw and finished goods.

Equipment:

F&M Investment Services, the brokerage department of the Bank, opened for business in April 1999.  Securities are offered through Raymond James Financial Services, Inc.

In December of 2014, the Company became a financial holding company within the meaning of the Bank Holding Company Act of 1956 as amended, in order to provide the flexibility to take advantage of the expanded powers available to a financial holding company under the Act.  Our subsidiary bank is in turn regulated and examined by the Ohio Division of Financial Institutions and the Federal Deposit Insurance Corporation. The activities of our bank subsidiary are also subject to other federal and state laws and regulations. The Company also formed a Captive insurance company in December 2014. The Captive is located in Nevada and regulated by the State of Nevada Division of Insurance.

The Bank’s primary market includes communities located in the Ohio counties of Defiance, Fulton, Hancock, Henry, Lucas, Williams, Wood and in the Indiana counties of Adams, Allen, DeKalb, Jay and Steuben. The commercial banking business in this market is highly competitive, with approximately 45 other depository institutions currently doing business in the Bank’s primary market.  In our banking activities, we compete directly with other commercial banks, credit unions, farm credit services, and savings and loan institutions in each of our operating localities.  In a number of our locations, we compete against entities which are much larger than us, including Huntington National Bank, Fifth Third Bank, Wells Fargo Bank, NA, KeyBank NA and JPMorgan Chase Bank, NA.  Based on deposit data as of June 30, 2018 from the FDIC and using zip codes in our markets, the Bank ranked 4th with a 12.8% market share in markets served.  The primary factors in competing for loans and deposits are the rates charged as well as location and quality of the services provided.  

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At December 31, 2018, we had 288 full time equivalent employees.  The employees are not represented by a collective bargaining unit.  We provide our employees with a comprehensive benefit program, some of which is contributory.  We consider our employee relations to be good.

Supervision and Regulation

General

The Company is a corporation organized under the laws of the State of Ohio.  The business in which the Company and its subsidiaries are engaged is subject to extensive supervision, regulation and examination by various bank regulatory authorities.  The supervision, regulation and examination to which the Company and its subsidiaries are subject to are intended primarily for the protection of depositors and the deposit insurance funds that insure the deposits of banks, rather than for the protection of shareholders.

Several of the more significant regulatory provisions applicable to banks and bank holding companies to which the Company and its subsidiaries are subject to are discussed below along with certain regulatory matters concerning the Company and its subsidiaries.  To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions.  Any change in applicable law or regulation may have a material effect on the business and prospects of the Company and its subsidiaries.

Regulatory Agencies

The Company is a financial holding company and is subject to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) pursuant to the Bank Holding Company Act of 1956, as amended. As a financial holding company, the Company is still subject to all the bank holding company regulations.

The Bank is an Ohio chartered commercial bank.  It is subject to regulation and examination by both the Ohio Division of Financial Institutions (ODFI) and the Federal Deposit Insurance Corporation (FDIC).

The Captive is an insurance company incorporated in Nevada and regulated by the State of Nevada, Division of Insurance.

Holding Company Activities

As a financial holding company incorporated and doing business within the State of Ohio, the Company is subject to regulation and supervision under the Bank Holding Act of 1956, as amended (the "Act").  The Company is required to file with the Federal Reserve Board on quarterly basis information pursuant to the Act.  The Federal Reserve Board may conduct examinations or inspections of the Company and its subsidiaries.  

On November 12, 1999, the Gramm-Leach-Bliley Act (the "GLB Act") was enacted into law.  The GLB Act made sweeping changes with respect to the permissible financial services which various types of financial institutions may now provide.  The Glass-Steagall Act, which had generally prevented banks from affiliation with securities and insurance firms, was repealed.  Pursuant to the GLB Act, bank holding companies may elect to become a "financial holding company," provided that all of the depository institution subsidiaries of the bank holding company are “well capitalized” and “well managed” under applicable regulatory standards.  

Under the GLB Act, a bank holding company that has elected to become a financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature.  Activities that are "financial in nature" include securities underwriting, dealing and market-making, sponsoring mutual funds and investment companies, insurance underwriting and agency, merchant banking, and activities that the Federal Reserve Board has determined to be closely related to banking.  Federal Reserve Board approval is not required for the Company to acquire a company, other than a bank holding company, bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board.  Prior Federal Reserve Board approval is required before the Company may acquire the beneficial ownership or control of more than 5% of the voting shares, or substantially all of the assets, of a bank holding company, bank or savings association.  If any subsidiary bank of the Company ceases to be "well capitalized" or "well managed" under applicable regulatory standards, the Federal Reserve Board may, among other actions, order the Company to divest the subsidiary bank.  Alternatively, the Company may elect to conform its activities to those permissible for a bank holding company that is not also a financial holding company.  If any subsidiary bank of the Company receives a rating under the Community Reinvestment Act of 1977 of less than satisfactory, the Company will be prohibited from engaging in new activities or acquiring companies other than bank holding companies, banks or savings associations.  

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Affiliate Transactions

Various governmental requirements, including Sections 23A and 23B of the Federal Reserve Act and Regulation W promulgated thereunder limit borrowings by holding companies and non-bank subsidiaries from affiliated insured depository institutions, and also limit various other transactions between holding companies and their non-bank subsidiaries, on the one hand, and their affiliated insured depository institutions on the other.  Section 23A of the Federal Reserve Act also generally requires that an insured depository institution's loan to its non-bank affiliates be secured, and Section 23B of the Federal Reserve Act generally requires that an insured depository institution's transactions with its non-bank affiliates be on arms-length terms.

Interstate Banking and Branching

Under the Riegle-Neal Interstate Banking and Branching Efficiency Act ("Riegle-Neal"), subject to certain concentration limits and other requirements, adequately capitalized bank holding companies such as the Company are permitted to acquire banks and bank holding companies located in any state.  Any bank that is a subsidiary of a bank holding company is permitted to receive deposits, renew time deposits, close loans, service loans and receive loan payments as an agent for any other bank subsidiary of that bank holding company.  Banks are permitted to acquire branch offices outside their home states by merging with out-of-state banks, purchasing branches in other states and establishing de novo branch offices in other states.  The Company could from time to time use Riegle-Neal to acquire banks in additional states.  

Control Acquisitions

The Change in Bank Control Act prohibits a person or group of persons from acquiring "control" of a bank holding company, unless the Federal Reserve Board has been notified and has not objected to the transaction.  Under the rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company, would, under the circumstances set forth in the presumption, constitute acquisition of control of the bank holding company.  In addition, a company is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of outstanding voting stock of a bank holding company, or otherwise obtaining control or a "controlling influence" over that bank holding company.

Liability for Banking Subsidiaries

Under the current Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to maintain resources adequate to support each subsidiary bank.  This support may be required at times when the bank holding company may not have the resources to provide it.  In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a U.S. federal bank regulatory agency to maintain the capital of a subsidiary bank would be assumed by the bankruptcy trustee and entitled to priority of payment.  Any depository institution insured by the FDIC can be held liable for any loss incurred, or reasonably expected to be incurred, by the FDIC in connection with (1) the "default" of a commonly controlled FDIC-insured depository institution; or (2) any assistance provided by the FDIC to both a commonly controlled FDIC-insured depository institution "in danger of default."  The Bank is an FDIC-insured depository institution.  If a default occurred with respect to the Bank, any capital loans to the Bank from its parent holding company would be subordinate in right of payment to payment of the Bank's depositors and certain of its other obligations.

Regulatory Capital Requirements

The Company is required by the various regulatory authorities to maintain certain capital levels.  Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve Board capital adequacy guidelines.  If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non‑bank businesses.  The required capital levels in addition to the Bank’s and Company's capital position at December 31, 2018 and 2017 are summarized in the table included in Note 15 to the consolidated financial statements.  Beginning in 2018, the consolidated amounts and ratios for the Company are no longer required.

Beginning in 2015, the Company and Bank were required to measure capital adequacy using Basel III accounting. Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. Implementation of the rules will be overseen by the Federal Reserve, the FDIC and the OCC.  Reporting under the new rules began with the March 2015 quarterly regulatory filings.

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FDICIA

The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), and the regulations promulgated under FDICIA, among other things, established five capital categories for insured depository institutions-well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized-and requires U.S. federal bank regulatory agencies to implement systems for "prompt corrective action" for insured depository institutions that do not meet minimum capital requirements based on these categories.  Unless a bank is well capitalized, it is subject to restrictions on its ability to offer brokered deposits and on certain other aspects of its operations.  An undercapitalized bank must develop a capital restoration plan and its parent bank holding company must guarantee the bank's compliance with the plan up to the lesser of 5% of the bank’s assets at the time it became undercapitalized and the amount needed to comply with the plan.   As of December 31, 2018, the Bank was well capitalized pursuant to these prompt corrective action guidelines.

Dividend Restrictions

The ability of the Company to obtain funds for the payment of dividends and for other cash requirements will be largely dependent on the amount of dividends which may be declared by its banking subsidiary, which are limited to the Bank’s retained earnings during the current year and its prior two years. Various U.S. federal statutory provisions limit the amount of dividends the Company's banking subsidiary can pay to the Company without regulatory approval.  In 2009, The Board of Governors of the Federal Reserve Division of Banking Supervision and Regulation issued SR09-4 regarding the safe and sound payment of dividends by bank holding companies. See Note 16 to the consolidated financial statements for additional information on applicable dividend restrictions.

Deposit Insurance Assessments

The deposits of the Bank are insured up to the regulatory limits set by the FDIC.   The FDIC maintains the Deposit Insurance fund (“DIF”) by assessing depository institutions an insurance premium (assessment).  The amount assessed to each institution is based on statutory factors that take into account the degree of risk the institution poses to the DIF.   The primary purposes of the DIF are to (1) insure the deposits and protect the depositors of insured depository institutions; and (2) resolve failed banks.   The DIF is primarily funded through quarterly assessments on insured depository institutions, but it also earns interest income on its securities.   Decreases in the DIF result from loss provisions associated with the resolution of failed banks and FDIC operating expenses.  

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) revised the statutory authorities governing the FDIC’s management of the DIF.  A key requirement from the Dodd-Frank Act resulted in the FDIC’s adoption of new rules in February 2011 regarding Assessments, Dividends, Assessment Base, and Large Bank Pricing.   The new rules implemented the following changes:   (1) redefined the definition of an institution’s deposit insurance assessment base from one based on domestic deposits to one based on assets now defined as “average consolidated total assets minus average tangible equity” (2) changed the assessment rate adjustments to better account for risk based on an institution’s funding sources; (3) revised the deposit insurance assessment rate schedule in light of the new assessment base and assessment rate adjustments; (4) implemented Dodd-Frank Act dividend provisions; (5) revised the large insured depository institution assessment system to better differentiate for risk and to take into account losses the FDIC may incur from large institution failures; and (6) provided technical and other changes to the FDIC’s assessment rules.  Though deposit insurance assessments maintain a risk-based approach, the FDIC imposed a more extensive risk-based assessment system on large insured depository institutions with at least $10 billion in total assets since they are more complex in nature and could pose greater risk.  The rules became effective April 1, 2011 implementing the revised assessment rate schedule for the quarter beginning April 1, 2011.   The revised assessment rate schedule was used to calculate the June 30, 2011 assessments which were due September 30, 2011 and subsequent quarterly assessments thereafter.  

Due to the changes to the assessment base and assessment rates, as well as the DIF restoration time frame, the impact on the Company’s future deposit insurance assessments has been and should continue to be favorable.  

The Dodd-Frank Act permanently raised the standard maximum deposit insurance coverage amount to $250,000.

The FDIC deposit insurance coverage limit applies per depositor, per insured depository institution for each account ownership category.    

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Depositor Preference Statute

In the "liquidation or other resolution" of an institution by any receiver, U.S. federal legislation provides that deposits and certain claims for administrative expenses and employee compensation against the insured depository institution would be afforded a priority over general unsecured claims against that institution, including federal funds and letters of credit.

Government Monetary Policy

The earnings of the Company are affected primarily by general economic conditions and to a lesser extent by the fiscal and monetary policies of the federal government and its agencies, particularly the Federal Reserve.  Its policies influence, to some degree, the volume of bank loans and deposits, and interest rates charged and paid thereon, and thus have an effect on the earnings of the Company's subsidiary Bank.  

Additional Regulation

Provisions of the Dodd-Frank Act have resulted in additional rulemaking by the federal regulatory agencies and new rules yet to be issued. Implementing the new and expanded regulations involved extreme diligence to ensure compliance with the complexities of the rules, as well as extensive new disclosure and reporting requirements.

The Dodd-Frank Act created an independent regulatory body, the Bureau of Consumer Financial Protection (“Bureau”), with authority and responsibility to set rules and regulations for most consumer protection laws applicable to all banks – large and small - adds another regulator to scrutinize and police financial activities. Transfer to the Bureau of all consumer financial protection functions for designated laws by the other federal agencies was completed in July 2011.   The Bureau was given responsibility for mortgage reform and enforcement, as well as broad new powers over consumer financial activities, including consumer financial products and services and how they are provided.

Significant mortgage rules mandated by the Dodd-Frank Act provisions were enacted in response to the breakdown in the mortgage lending markets and to provide for consumer protections. Final rules issued by the Bureau or jointly with other regulatory agencies implemented requirements under the Dodd-Frank Act regarding mortgage-related matters such as ability-to-repay, qualified mortgage standards, mortgage servicing, mortgage loan originator compensation, escrow requirements for higher-priced mortgage loans, and providing appraisals.  These new mortgage rules, effective in January 2014, addressed problems consumers faced in the three major steps in buying a home – shopping for a mortgage, closing on a mortgage, and paying off a mortgage.  

Final rules and amendments to the integrated mortgage disclosure rules under the Real Estate Settlement Act (RESPA) and Truth in Lending Act (TILA) became effective in October 2015.  The TILA-RESPA Integrated Disclosure rule commonly referred to as TRID combined required disclosures into two single forms: 1) The Loan Estimate which is provided shortly after a mortgage loan application and 2) The Closing Disclosure which is provided prior to loan consummation.  In addition, a mandated appraisal notice under the Equal Credit Opportunity Act and the servicing application disclosure under RESPA were also combined into the new integrated disclosures.  Process and procedural adjustments were necessary to appropriately implement the new requirements. Implementation to achieve TRID compliance involved extensive collaboration with the Mortgage Loan Origination software vendor, as well as outreach and coordination efforts with real estate agents, attorneys, and closing agents to cultivate preparedness for the new integrated mortgage loan disclosure forms.  Amendments to the TRID rules effective in October 2017 with a mandatory compliance in October 2018 were intended to provide further clarity to certain provisions.  Due to the complexities of the TRID rules, remaining attentive to these matters will ensure practices and procedures remain compliant and not subject the Bank to unnecessary liability.  

Final rules, mostly effective in October 2015, were issued by the Board of Governors of the Federal Reserve System (FRB), the Farm Credit Administration, the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the Office of the Comptroller of the Currency (OCC) to implement provisions of the Homeowner Flood Insurance Affordability Act of 2014 (HFIAA) and the Biggert-Waters Flood Insurance Reform Act of 2012 (the Biggert-Waters Act).   These provisions amended regulations which apply to loans secured by properties located in special flood hazard areas.

Processes and procedural changes along with the implementation of new forms and notifications resulted.  Fines and penalties for compliance with flood insurance requirements promote a continued focus on adherence to the new flood rules and existing requirements.

The Department of Defense (DOD) new rules amending its regulation that implements the Military Lending Act (MLA) became effective in October 2016.  The MLA enacted as part of the John Warner National Defense Act of 2007, significantly expanded

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the scope of the Act to cover all consumer credit except residential mortgages and purchase money loans.  Compliance requirements for credit cards became effective in October 2017. Coverage applies to consumer credit defined as “credit offered or extended for personal, family, or household purpose and that is subject to a finance charge or payable by written agreement in more than four installments.”  A covered borrower is a consumer who at the time of becoming obligated on a consumer credit transaction or establishing an account for consumer credit, is a covered member or dependent (including a spouse) of a covered member.   A covered member is a member of the armed forces serving on active duty or active guard or reserve duty.

Providing a loan to a MLA-covered borrower that exceeds the 36% Military Annual Percentage Rate is prohibited.  Any covered loans made without providing proper disclosures or in violation of the MLA is void.  Creditors who knowingly or willfully violate the rules could be subject to a fine, imprisonment up to one year or both.   Implementation of these new rules involved understanding the impact on the covered consumer credit products offered, collaboration with Loan Origination System vendors for assistance with calculations and required disclosures, and an efficient and effective process for identifying covered borrowers.  

Under the TILA Ability to Repay requirements, the Bank meets the criteria to qualify as a small creditor based on the number of first-lien mortgage loans transactions and due to its asset size; however it is not a creditor that operates predominantly in rural or underserved areas as it did not extend more than 50% of its total first-lien covered transactions in rural or underserved areas in calendar year 2018.   The Bank focuses on Qualified Mortgage (QM) status for mortgage loans originated as they provide certain presumptions of compliance under the Ability to Repay rules adopted under the Dodd-Frank Act.   In satisfying QM requirements, any mortgage lender regardless of their size can make loans which are entitled to the QM presumption of compliance.  

Revised Regulation C rules which implement the Home Mortgage Disclosure Act (HMDA) published by the Bureau become effective on January 1, 2018 for reportable loan applications.  The Dodd-Frank Act provisions added new data points for HMDA and authorized the Bureau to require additional information.  The types of transactions reportable have expanded to include most consumer purpose transactions that are dwelling-secured loans or open-end lines of credit. Reportable data points were significantly expanded to 52 fields which included applicant or borrower age, credit score, automated underwriting system information, property value, application channel, points and fees, borrower-paid origination charges, discount points, lender credits, loan term, prepayment penalty, interest rate, loan originator identifier, as well as other data fields.   Ethnicity categories were expanded to include certain subcategories along with a means to capture information on how an applicant’s or borrower’s ethnicity, race, and sex were collected by the institution.  For 2018, a thorough review and validation of data fields to be reported for each application was conducted throughout the year.  Year-end submission of 2018 data to be reported will be completed using the web-based tool developed by the Bureau.      

Enactment of the Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA) on May 24, 2018, resulted in a regulatory reform law deemed to be relief from certain burdensome provisions of the Dodd-Frank Act.  The EGRRCPA included provisions with various effective dates, including some that were effective immediately.  Matters impacted included access to mortgage credit; access to credit; protections for veterans, consumers, and homeowners; rules for holding companies; capital access; and protections for student borrowers.  Though effective immediately, conforming regulations were required for certain provisions such as Reciprocal Deposits, Examination Cycles, and High Volatility Commercial Real Estate (HVCRE).  The Protecting Tenants in Foreclosure Act was restored and permanently extended as of June 23, 2018.  An interim final rule was jointly issued by the OCC, FRB, and FDIC allowing an extended examination cycle for qualifying insured depository institutions with less than $3 billion in total assets.  Effective September 21, 2018, consumers could freeze their credit information and place one-year fraud alerts for free.  Additionally, parents can freeze the credit information of their children under age 16 for free.  In many instances, regulators still need to issue proposals, provide guidance, and publish final rules.  Provisions, including but not limited to the following, still require regulations to become effective; Residential Mortgage Loans; Mortgage Appraisals; HMDA; Escrow Relief; TRID Revisions; Highly Capitalized Banks; Identity Fraud; and Improving Access to Capital. Though beneficial, there are new requirements mixed in with deregulation.  Thus, compliance changes must be monitored and effectively implemented.

Unfair or deceptive acts or practices (UDAP) standards originally developed years ago by the Federal Trade Commission focused on unacceptable practices that may not specifically be addressed elsewhere in banking or consumer finance law.  Banking regulatory agencies have increasingly used this authority over the last few years to address acts or practices that are deemed harmful, deceptive, or misleading to consumers.  The authority of the Federal Trade Commission (FTC) to issue credit practice rules under Section 5 of the Federal Trade Commission Act for financial institutions was repealed as a result of the Dodd-Frank Act.  Guidance issued collectively by the FDIC, FRB, the Bureau, NCUA, and OCC in August 2014 clearly indicated certain consumer credit practices were not permissible and remained subject to Section 5 of the Federal Trade Commission Act, as well as Sections 1031 and 1036 of the Dodd-Frank Act.  The interagency guidance further noted that the Agencies will continue to have supervisory authority and enforcement authority for unfair or deceptive acts or practices, which could include those

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practices previously addressed in the former credit practices rules.  Remaining attentive to the UDAP standards, in relation to the offering and marketing of Bank products and services is extremely important.

The Bank is also subject to federal regulation relating to such matters as required reserves, limitation as to the nature and amount of its loans and investments, regulatory approval of any merger or consolidation, issuance or retirement of their own securities, limitations upon the payment of dividends and other aspects of banking operations.  In addition, the activities and operations of the Bank are subject to a number of additional detailed, complex and sometimes overlapping laws and regulations. These include state usury and consumer credit laws, state laws relating to fiduciaries, the federal Equal Credit Opportunity Act and Regulation B, the federal Electronic Funds Transfer Act and Regulation E, the federal Fair Credit Reporting Act and Regulation V, the federal Real Estate Settlement Procedures Act (RESPA) and Regulation X, the federal Truth in Lending Act and Regulation Z, the federal Truth in Savings Act and Regulation DD, the Bank Secrecy Act, the federal Community Reinvestment Act, anti-discrimination laws and legislation, and antitrust laws.

Future Legislation

Changes to the laws and regulations, both at the federal and state levels, can affect the operating environment of the Company and its subsidiaries in substantial and unpredictable ways.  The Company cannot accurately predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon the financial condition or results of operations of the Company or its subsidiaries.  Various provisions and regulations authorized or required by the Dodd-Frank Act have not yet been proposed or implemented by federal regulators.  Uncertainty also exists with respect to the Dodd-Frank Act regulations authorized or required that have not yet been proposed or finalized.

Available Information

The Company maintains an Internet web site at the following internet address: www.fm.bank. The Company files reports with the Securities and Exchange Commission (SEC). Because the Company makes its filing with the SEC electronically, you may access such reports at the SEC’s website (www.sec.gov). The Company makes available, free of charge through its internet address, copies of its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports as soon as reasonable practicable after such materials have been filed with or furnished to the SEC. Copies of these documents may also be obtained, either in electronic or paper form, by contacting Barbara J. Britenriker, Chief Financial Officer of the Company at (419) 446-2501.

ITEM 1a. RISK FACTORS

Significant Competition from an Array of Financial Service Providers

Our ability to achieve strong financial performance and a satisfactory return on investment to shareholders will depend in part on our ability to expand our available financial services.  In addition to the challenge of attracting and retaining customers for traditional banking services, our competitors now include securities dealers, brokers, mortgage bankers, investment advisors and finance and insurance companies who seek to offer one-stop financial services to their customers that may include services that banks have not been able or allowed to offer to their customers in the past.  The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial services providers.  If we fail to adequately address each of the competitive pressures in the banking industry, our financial condition and results of operations could be adversely affected.

Credit Risk

The risk of nonpayment of loans is inherent in commercial banking.  Such nonpayment could have an adverse effect on the Company’s earnings and our overall financial condition as well as the value of our common stock.  Management attempts to reduce the Bank’s credit exposure by carefully monitoring the concentration of its loans within specific industries and through the loan approval process. However, there can be no assurance that such monitoring and procedures will totally mitigate the risks.  Credit losses can cause insolvency and failure of a financial institution and, in such event, its shareholders could lose their entire investment.  For more information on the exposure of the Company and the Bank to credit risk, see the section under Part II, Item 7 of this Form 10-K captioned “Loan Portfolio.”

Our loan portfolio has a large concentration of real estate loans

Real estate loans, which constitute a large portion of our loan portfolio, include home equity, commercial, construction and residential loans, and such loans are concentrated in the Bank’s primary markets in northwest Ohio and Northeast Indiana.  The

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market value of real estate can fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located.  Adverse developments affecting real estate values in our market could increase the credit risk associated with our loan portfolio.  Also, real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service.  Economic events or governmental regulations outside of the control of the borrower could negatively impact the future cash flow and market values of the affected properties.

If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition.

Our real estate loans also include construction loans, including land acquisition and development.  Construction, land acquisition and development lending involve additional risks because funds are advanced based upon estimates of costs and the estimated value of the completed project.  Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio.  As a result, commercial construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest.  If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project.

Payments on agricultural real estate loans are dependent on the profitable operation or management of the farm property securing the loan.  The success of the farm may be affected by many factors outside the control of the borrower, including adverse weather conditions that prevent the planting of a crop or limit crop yields (such as hail, drought and floods), loss of livestock due to disease or other factors, declines in market prices for agricultural products (both domestically and internationally) and the impact of government regulations (including changes in price supports, subsidies and environmental regulations). In addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the successful operation of the farm.  If the cash flow from a farming operation is diminished, the borrower’s ability to repay the loan may be impaired. The primary crops in our market areas are corn, wheat and soybeans.  Accordingly, adverse circumstances affecting these crops could have an adverse effect on our agricultural real estate loan portfolio.

Commercial loans make up a significant portion of our loan portfolio

Our commercial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower.  Repayment of our commercial loans is often dependent on the cash flows of the borrower, which may be unpredictable.  Most often, this collateral is accounts receivable, inventory, machinery or real estate.  In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.  The other types of collateral securing these loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.

We also originate agricultural operating loans.  As with agricultural real estate loans, the repayment of operating loans is dependent on the successful operation or management of the farm property.  Likewise, agricultural operating loans involve a greater degree of risk than lending on residential properties, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as farm equipment or assets such as livestock or crops.  The primary livestock in our market areas is hogs.  In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.  The majority of our agricultural customers utilize crop insurance to mitigate the possibility of a large loss within one year on their grain operations. Crop insurance can be structured to be triggered by different factors and claim payment may also be customized, such as based on harvest yields, income generation.  Farmers may also use hedging techniques to lock in crop prices, input costs for future production.

Susceptibility to Changes in Regulation

Any changes to state and federal banking laws and regulations may negatively impact our ability to expand services and to increase the value of our business.  We are subject to extensive state and federal regulation, supervision, and legislation that govern almost all aspects of our operations.  These laws may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds.  In addition, the Company’s earnings are affected by the monetary policies of the Board of Governors of the Federal Reserve.  These policies, which include regulating the national supply of bank reserves and bank credit, can have a major effect upon the source and cost of funds and the rates of return earned on loans and investments.  The Federal Reserve influences the size and distribution of bank reserves through its open market operations and changes in cash reserve

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requirements against member bank deposits.  We cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, but such changes could be materially adverse to our financial performance.  For more information on this subject, see the section under Part I, Item 1 of this Form 10-K captioned “Supervision and Regulation.”

Interest Rate Risk

Changes in interest rates affect our operating performance and financial condition in diverse ways.  Our profitability depends in substantial part on our “net interest spread,” which is the difference between the rates we receive on loans and investments and the rates we pay for deposits and other sources of funds.  Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally.  Historically, net interest spreads for other financial institutions have widened and narrowed in response to these and other factors, which are often collectively referred to as “interest rate risk.”  After many years of a low and flat rate environment, the Federal Reserve began increasing the Federal Funds rate in 2015. The Company did not experience improvement in its asset yield on loans until such time that the rate increases enabled the loan rates to rise above the floors which had been on the majority of the variable rate loans.  During 2017, the increasing rates having reached over 100 basis points, triggered rate changes above the floors and the Company experienced improvement in the interest spread. The improvement in the net interest spread during 2016 through 2018 directly correlated to the improvement of the Bank’s loan to asset ratio.

The Bank manages interest rate risk within an overall asset/liability framework.  The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net interest income to potential changes in interest rates.  Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed.  In the event that our asset/liabilities management strategies are unsuccessful, our profitability may be adversely affected.  For more information regarding the Company’s exposure to interest rate risk, see Part II, Item 7A of this Form 10-K.

Attraction and Retention of Key Personnel

Our success depends upon the continued service of our senior management team and upon our ability to attract and retain qualified financial services personnel.  Competition for qualified employees is intense.  In our experience, it can take a significant period of time to identify and hire personnel with the combination of skills and attributes required in carrying out our strategy.  If we lose the services of our key personnel or are unable to attract additional qualified personnel, our business, financial condition, results of operations and cash flows could be adversely affected.

A key component of employee retention is providing a fair compensation base combined with the opportunity for additional compensation for above average performance.  In this regard, the Company and the Bank use two incentive programs. The Company uses a stock award program to recognize and incentivize officers of the Bank.  Under the long-term incentive compensation plan, restricted stock awards may be granted to officers.  The amount of shares to be granted each year is determined by the Board Compensation Committee and may vary each year in its amount of shares and the number of recipients.  The Compensation Committee determines the number of shares to be awarded overall and to the Chief Executive Officer (“CEO”) specifically.  The CEO then makes recommendations to the committee as to the recipients of the remaining shares.  The full Board of Directors approves the action of the Committee.  Since the plan’s inception in 2005, all granted stock awards have utilized a three year cliff vesting feature.  This is viewed as a retention aid as the awards may be forfeited should an officer leave employment during the vesting period.

A second incentive program of the Bank is based on cash compensation of which almost all employees participate (excluding commission based employees and other employees paid for specific higher paid positions, such as peak time).  A discussion of executive officer pay is incorporated within the proxy and as such, this discussion will pertain to all other employees.  Non-officer employees are paid a cash incentive based on the projected overall performance of the Bank in terms of Return of Average Assets (“ROA”).  The Compensation Committee determines the target performance levels on which the percentage of pay will be based.  The Committee takes into account the five and ten year trend of ROA along with budget forecasted for the next year and the Bank’s past year performance. The Committee also considers the predicted banking environment under which the Bank will be operating. With the formation of the Captive, the ROA goal has been exclusive of the effect of the additional insurance expense at the Bank level. Non-officers receive incentive pay in December of the same year based on the year-to-date base compensation through the last pay received in November.

Officers, other than executive officers, receive incentive pay based on additional criterion.  The officers are rewarded based on overall ROA of the Bank along with individual pre-established goals.  Officers, therefore, have incentive pay at risk for individual performance.  The individualized goals are recommended by each officer’s supervisor and are approved by an incentive committee of the Bank.  The goals are designed to improve the performance of the Bank while also limiting the risk of a short-term performance focus.  For example, a lending officer may be given two goals of which one is to grow loans within

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specific targets and another is tied to a specific level of past dues and charge-offs.  The second goal limits the ability to be rewarded for growth at all costs along with the specific target levels within the growth goal itself.  Officers in a support department may be given goals which create efficiencies, ensure compliance with procedures, or generate new fee or product opportunities. On average, three to four goals were given to each officer in 2018.  Officers are paid cash incentives based on the year-end ROA of the Bank and receive it within the first quarter of the following year.  Should the ROA be forecasted to be positive but below the base target set by the Board, the officers are paid an incentive under the same basis and timing as non-officers disclosed above.

The percentages of base pay on which the incentive is calculated graduates higher as does the responsibility level of the employee and their ability to impact the financial performance of the Bank.  These percentages are recommended by management to the Compensation Committee and Board for approval.  The cash incentive plan along with its targets and goals are subject to modification at the Compensation Committee and Board’s discretion throughout each year.

Dividend Payout Restrictions

We currently pay a quarterly dividend on our common shares.  However, there is no assurance that we will be able to pay dividends in the future.  Dividends are subject to determination and declaration by our Board of Directors, which takes into account many factors.  The declaration of dividends by us on our common stock is subject to the discretion of our Board and to applicable state and federal regulatory limitations.  The Company may receive dividends from the Bank which is subject to restrictions and limitations in the amount and timing of the dividends it may pay to the Company. The Bank has been declaring additional dividends each quarter to provide this liquidity to the Company. The Captive also upstreams dividends to the Company when reserve levels are adequately provided for and may not exceed the net income of the prior twelve months.

Anti-Takeover Provisions

Provisions of our Articles of Incorporation and Ohio law could have the effect of discouraging takeover attempts which certain stockholders might deem to be in their interest.  These anti-takeover provisions may make us a less attractive target for a takeover bid or merger, potentially depriving shareholders of an opportunity to sell their shares of common stock at a premium over prevailing market prices as a result of a takeover bid or merger.

Technological Change

Our industry is susceptible to significant technological changes in the future as there continue to be a high level of new technology driven products and services introduced. Technological advancement aids the Company in providing customer service and increases efficiency.  Our national competitors have more resources to invest in technological changes and associated required resources.  As a result, they may be able to offer products and services that are more technologically advanced and that may put us at a competitive disadvantage.  Our future depends on our ability to analyze technological changes to determine the best course of action for our business, customers and shareholders.

Operational Risks

We are subject to certain operational risks, including, but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters.  We maintain a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks that are insurable, but should such an event occur that is not prevented or detected by our internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on our business, financial condition or results of operations.

In addition, our operations are dependent on our ability to process financial transactions in a secure manner.  Failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers could disrupt our businesses or the businesses of our customers, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. We must ensure that information is properly protected from a variety of threats such as cyber-attacks, error, fraud, sabotage, terrorism, industrial espionage, privacy violation, service interruption, and natural disaster.  The Company, with the assistance of third-party service providers, intends to continue to implement security technology and establish procedures to maintain network security, but there is no assurance that these measures will be successful. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities. Any activity that jeopardizes our network and the security of the information stored on our network may result in significant cost to the Company and have a significant negative effect on our reputation.

Potential Inadequacy of our allowance for loan losses

Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and non-performance.  Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan

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portfolio, including the size and composition of the loan portfolio, current economic conditions and concentrations within the portfolio.  The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes.  Economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses.  In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management.  In addition, if charge-offs in future periods exceed expectations, we will need additional provisions to increase the allowance for loan losses.  Any increases in the allowance for loan losses may result in a decrease in net income and capital, and may have a material adverse effect on our financial condition and results of operations.

In June 2016, the Financial Accounting Standards Board (FASB) issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments," which replaces the current "incurred loss" model for recognizing credit losses with an "expected loss" model referred to as the Current Expected Credit Loss model, or “CECL.” Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. Moreover, the CECL model may create more volatility in the level of our allowance for loan losses. If we are required to increase our level of allowance for loan losses for any reason, such increase could adversely affect our business, financial condition and results of operations.

The new CECL standard will become effective for us for fiscal years beginning after December 15, 2019 and for interim periods during 2020. We are currently evaluating the impact the CECL model will have on our accounting, but we expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective.

Attraction of Deposits and other Short-term Funding

In managing our liquidity, our primary source of short-term funding is customer deposits.  Our ability to continue to attract these deposits, and other short-term funding sources, is subject to variability based upon a number of factors, including the relative interest rates we are prepared to pay for these liabilities and the perception of safety of those deposits or short-term obligations relative to alternative short-term investments.  The availability and cost of credit in short-term markets depends upon market perceptions of our liquidity and creditworthiness.  Our efforts to monitor and manage liquidity risk may not be successful or sufficient to deal with dramatic or unanticipated changes in event-driven reductions in liquidity.  In such events, our cost of funds may increase, thereby reducing our net interest revenue, or we may need to dispose of a portion of our investment portfolio, which, depending on market conditions, could result in our realizing a loss or experiencing other adverse consequences

Vendor Relationship Risk

We rely on third-party vendors to provide key components of our business operations such as data processing, recording and monitoring transactions, online and mobile banking interfaces and services, internet connections and network access. While we have performed due diligence procedures in selecting vendors, we do not control their actions. In the event that one or more of our vendors suffers a bankruptcy or otherwise becomes unable to continue to provide products or services, or fails to protect non-public personal information of our customers or employees, we may suffer operational impairments, reputational damage and financial losses. Replacing these third-party vendors could create significant delay and expense. Accordingly, use of such third parties creates an inherent risk to our business operations.

Limited Trading Market

The Company has its shares of stock listed and traded on the NASDAQ Capital Market.  The Company’s trading symbol is “FMAO.”

ITEM 1b. UNRESOLVED STAFF COMMENTS

None.  

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ITEM 2. PROPERTIES

Our principal office is located in Archbold, Ohio.

The Bank operates from its principal office located at 307 North Defiance Street, Archbold, Ohio. In addition, the Bank owns the property from 200 to 208 Ditto Street, Archbold, Ohio, which it uses for Bank parking and a community mini-park area. The Bank owns real estate at two locations, 207 Ditto Street and 209 Ditto Street in Archbold, Ohio upon which the bank built a commercial building to be used for storage, and a parking lot for company vehicles and employee parking. The Bank also owns real estate across from the main facilities to provide for parking.

The Bank occupies an Operations Center at 620 S. Clyde’s Way in Archbold, Ohio to accommodate our growth over the years. The bank owns a parking lot in downtown Montpelier which is provided for community use.

The Bank owns all of its office locations, with the exception of Angola, Indiana and Bowling Green, Ohio.  Both of these office locations are leased.

The Bank currently maintains retail banking offices at the following locations:

All but one of the above locations has drive-up service facilities and an ATM. The Captive operates from leased office space at 101 Convention Center Dr., Suite 850, Las Vegas, NV 89109.

On January 1, 2019, the Company acquired Limberlost Bancshares, Inc. and its subsidiary, Bank of Geneva.  Six offices located in Indiana, were merged into the Bank as listed below:

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ITEM 3. LEGAL PROCEEDINGS

There are no material pending legal proceedings, other than ordinary routine proceedings incidental to the business of the Company or its subsidiaries, to which we are a party or of which any of our properties are the subject.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

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PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company’s common stock is listed on the NASDAQ Stock Market LLC under the trading symbol “FMAO.”

On August 18, 2017, the Company’s Board of Directors authorized a two-for-one stock split payable on September 20, 2017, for shareholders of record on September 5, 2017.

The Company utilizes Computershare as its transfer agent.

As of December 31, 2018, there were 1,776 record holders of our common stock of which 39.46% of the outstanding shares are being held in brokerage accounts or “street name” and only considered as one record holder.  

On the following page is a line-graph presentation comparing the cumulative total shareholder returns for the Corporation, an index for NASDAQ Stock Market (U.S. Companies) comprised of all domestic common shares traded on the NASDAQ National Market System and the NASDAQ Bank Index for the five-year period ended December 31, 2018.  The chart compares the value of $100 invested in the Corporation and each of the indices and assumes investment on December 31, 2013 with all dividends reinvested.

The Board of Directors recognizes that the market price of stock is influenced by many factors, only one of which is performance.  The stock price performance shown on the graph is not necessarily indicative of future performance.

Dividends are declared and paid quarterly.  Per share dividends declared for the years ended 2018 and 2017 adjusted for a 2-for-1 stock split on September 20, 2017 are as follows:

The ability of the Company to pay dividends is impacted by the dividend that the Company receives from the Bank.  The Bank may pay as dividends to the Company its retained earnings during the current year and its prior two years. Various U.S. federal statutory provisions also limit the amount of dividends the Company’s banking subsidiary can pay to the Company without regulatory approval. In 2009, The Board of Governors of the Federal Reserve Division of Banking Supervision and Regulation issued SR09-4 regarding the safe and sound payment of dividends by bank holding companies.  Currently, such limitation on the payment of dividends from the Bank to the Company does not materially restrict the Company’s ability to pay dividends to its shareholders. See Note 16 to the consolidated financial statements for additional information on applicable dividend restrictions.

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Dividends declared during 2018 were $0.56 per share totaling $5.14 million, 12% higher than 2017 declared dividends of $0.50 per share. During 2018, the Company awarded 33,000 shares to 80 employees and 2,620 shares were forfeited under its long term incentive plan. At year end, 2018, the Company held 1,114,739 shares in Treasury stock and 93,940 in unearned stock awards.

Dividends declared during 2017 were $0.50 per share totaling $4.58 million, 8.7% higher than 2016 declared dividends of $0.46 per share.  During 2017, the Company awarded 32,000 restricted shares to 74 employees and 1,080 shares were forfeited under its long term incentive plan. At yearend 2017, the Company held 1,134,120 shares in Treasury stock and 92,350 in unearned stock awards.

The Company continues to have a strong capital base.

On January 18, 2019, the Company announced the authorization by its Board of Directors for the Company’s repurchase, either on the open market, or in privately negotiated transactions, of up to 500,000 shares of its outstanding common stock commencing January 18, 2019 and ending December 31, 2019.

ISSUER PURCHASES OF EQUITY SECURITIES

ITEM 6. SELECTED FINANCIAL DATA

Reclassification

Certain amounts in the 2017 and 2016 consolidated financial statements have been reclassified to conform with the 2018 presentation.  

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SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA

ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Critical Accounting Policies and Estimates

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event.

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All significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the notes to the consolidated financial statements and in the management discussion and analysis of financial condition and results of operations, provide information on how significant assets and liabilities are valued and how those values are determined for the financial statements. Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates and judgments underlying those amounts, management has identified the determination of the Allowance for Loan and Lease Losses (ALLL) and the valuation of its Mortgage Servicing Rights (MSR) and Other Real Estate Owned (OREO) as the accounting areas that requires the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available.

OREO, which is comprised of assets acquired by the Bank, through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value at the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell.

The ALLL represents management's estimate of credit losses inherent in the Bank's loan portfolio at the report date. The estimate is a composite of a variety of factors including experience, collateral value, and the general economy. ALLL includes a specific portion, a formula driven portion, and a general nonspecific portion. The collection and ultimate recovery of the book value of the collateral, in most cases, is beyond our control.

The Company is also required to estimate the value of its MSR.  The Company recognizes as separate assets rights to service fixed rate single-family mortgage loans that it has sold without recourse but services for others for a fee. Mortgage servicing assets are initially recorded at fair value, based upon pricing multiples as determined by the purchaser, when the loans are sold. Mortgage servicing assets are carried at the lower of the initial carrying value, adjusted for amortization, or estimated fair value. Amortization is determined in proportion to and over the period of estimated net servicing income using the level yield method. For purposes of determining impairment, the mortgage servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. The valuation is completed by an independent third party.

The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.

The Company’s mortgage servicing rights relating to loans serviced for others represent an asset of the Company. This asset is initially capitalized and included in other assets on the Company’s consolidated balance sheet. The mortgage servicing rights are then amortized against noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying mortgage servicing rights. There are a number of factors, however, that can affect the ultimate value of the mortgage servicing rights to the Company, including the estimated prepayment speed of the loan and the discount rate used to present value the servicing right. For example, if the mortgage loan is prepaid, the Company will receive fewer servicing fees, meaning that the present value of the mortgage servicing rights is less than the carrying value of those rights on the Company’s balance sheet. Therefore, in an attempt to reflect an accurate expected value to the Company of the mortgage servicing rights, the Company receives a valuation of its mortgage servicing rights from an independent third party. The independent third party’s valuation of the mortgage servicing rights is based on relevant characteristics of the Company’s loan servicing portfolio, such as loan terms, interest rates and recent national prepayment experience, as well as current national market interest rate levels, market forecasts and other economic conditions. Management, with the advice from its third party valuation firm, review the assumptions related to prepayment speeds, discount rates, and capitalized mortgage servicing income on a quarterly basis.  Changes are reflected in the following quarter’s analysis related to the mortgage servicing asset.  In addition, based upon the independent third party’s valuation of the Company’s mortgage servicing rights, management then establishes a valuation allowance by each strata, if necessary, to quantify the likely impairment of the value of the mortgage servicing rights to the Company. The estimates of prepayment speeds and discount rates are inherently uncertain, and different estimates could have a material impact on the Company’s net income and results of operations. The valuation allowance is evaluated and adjusted quarterly by management to reflect changes in the fair value of the underlying mortgage servicing rights based on market conditions.  The accuracy of these estimates and assumptions by management and its third party can be directly tied back to the fact that management has not been required to record a valuation allowance through its income statement based upon the valuation of each stratum of serving rights.  

For more information regarding the estimates and calculations used to establish the ALLL and the value of Mortgage Servicing Rights, please see Note 1 to the consolidated financial statements provided herewith.

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2018 in Review

The Federal Reserve rate hikes in 2018 facilitated both a flattening of the yield curve and an opportunity to widen the net interest margin through asset yield improvement. In the second half of the year, the widening of the net interest margin was pressured by the competition for deposits. The cost of funds rose more quickly in the second half of the year, specifically the fourth quarter. This pressure is expected to continue for 2019 with the added concern of an inverted yield curve throughout the first quarter.

The Company again reports record earnings in total and in earnings per share. This was achieved even with the acquisition costs associated with the merger deal completed January 1, 2019.  Earnings per share, with acquisition costs excluded, would have been higher than $1.61 as reported in Note 12. The improvement is credited to a widening of the net interest margin and the change in the effective income tax rate, offset by increases in noninterest expense, primarily attributable to salaries, wages and employee benefits.

Unemployment levels remain low and the economies in the Company’s market area are strong. The continuation of reasonable gasoline prices has been a contributor. Strong asset quality enabled loan provision to remain low throughout 2018 and is expected to continue in the foreseeable future as the Bank prepares for the CECL implementation in 2020. Strong asset quality is evidenced by low nonaccruals, watch list and impaired loans along with low net charge-offs. Loan payoffs and paydowns were higher than expected during 2018 and hampered overall loan growth. The Company’s asset size grew a modest $9.2 million with net loans accounting for $23.4 million. The difference coming from a decrease in securities and modest growth of $9.5 million in deposits.

During the first quarter of 2018 we opened an office in Findlay, Ohio. This office was our first to utilize ITM equipment, offering traditional service with a self-service option. An ITM completes teller transactions using a debit card for recognition - the self-service option. The traditional service completes the transaction by the customer requesting teller assistance and talking to a remote customer assistance representative on-line. Personal Relationship Bankers (PRBs) welcome our customers to the office and provide exceptional customer service as they can complete a teller transaction, open a new deposit account and complete a consumer loan. Two more existing offices were physically transformed during 2018 with ITMs. Our other offices have begun the personnel transformations with PRBs at each office and Community Relationship Bankers (CRBs) covering specific market areas.  CRBs focus on the community and especially small business customers. F&M will serve our customers where they want, and how they want. The Bank will continue the physical transformation with our newest office in 2019 in Decatur, Indiana.

As mentioned previously, the Company acquired Limberlost Bancshares, Inc. on January 1, 2019 and the two subsidiary banks were merged.  During 2018, $742.1 thousand of additional expenses attributed to the acquisition were incurred. The acquisition becomes accretive to earnings in 2019 and the foot print of the Company is expanded. Additional products and services are made available to the customers as a strong relationship focused community bank presence is maintained. The Company continues to remain focused on a strategy of expansion as the best use of capital to enhance profitability for our shareholders. For additional information on the projections related to the acquisition, please see the proforma statements shown in Note 20 as it relates to subsequent events.

A trend of increasing improvement in net income continued from 2016 through 2018.  2018 increased 17.5% over 2017 and 2017 was 9.1% higher than 2016. Dividends declared also increased over the corresponding years. 2018’s declared dividends at $0.56 a share was 12.0% higher than 2017’s $0.50 per share and 2017 was 8.7% than 2016’s $0.46 per share. The Company remains strong, stable and well capitalized and has the capacity to continue to cover the increased costs of doing business. The Company continues to look for new opportunities to generate and protect revenue while providing additional channels through which to serve our customer and maintain our high level of customer satisfaction. The Company plans to continue our strategy of expansion into new markets, whether by acquisition or the establishment of new branch office locations.

Material Changes in Results of Operations

Net Interest Income

The discussion now centers on the individual line items of the consolidated statement of income and their effect on net income. This section will focus on the most traditional source of revenue contributing to the profitability of the Company which is net interest income.

Net interest income is the difference between interest income earned on interest earning assets, such as loans and securities, and interest expense paid on interest bearing liabilities used to fund those assets, such as interest bearing deposits and other borrowings.  Net interest income is affected by changes in both interest rates and the amount and composition of earning assets and liabilities.  The change in net interest income is most often measured by two statistics – interest spread and net interest margin.  The difference between the yields earned on earning assets and the rates paid for interest bearing liabilities represents the interest spread. The net interest margin is the difference of funds (interest expense) between the yield on earning assets and

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the cost as a percentage of earning assets.  Because noninterest bearing sources of funds such as demand deposits and stockholders’ equity also support earning assets, the net interest margin exceeds the net interest spread.

As mentioned previously, the largest factor of the record earnings for 2018 was the $3.7 million improvement in net interest income as compared to 2017.  In 2017, net interest income increased $2.6 million as compared to 2016. Interest and fee income from loans were responsible for the improvement. Interest income from loans, including fees, increased $5.1 million in 2018 as compared to 2017. This was preceded by an increase in 2017 of $3.5 million as compared to 2016.  The underlying factors for the reason of the increase differed between the two time periods; however, both years were aided by prime rate increases which drove the effective interest rates on the Bank’s variable loans over their floor rates.  2018’s improvement was almost equally impacted by the increased volume and the increased rates.  As a comparison to 2017, the volume of loan growth was the largest contributing factor to the improved profitability over 2016.  Given that securities were sold or matured and proceeds used to fund the loan growth, interest income from that balance sheet component has declined each of the last three years. Overall, total interest income was $5.2 million higher for 2018 than 2017 and was $3.5 million higher for 2017 than 2016.

Interest expense increased from all interest bearing funding sources with the exception of other borrowed money over the time periods shown of 2016 through 2018. This reversed a previous trend of declining interest expense that occurred in 2014 and 2015. Overall, the funding goal the last three years has been to grow core deposits. Two strategies have been employed through the years, one of allowing expensive time deposits to run off until needed for funding and secondly to offer new non-interest bearing deposit products.  Both of these strategies were to assist in controlling interest expense in a rising rate environment. During 2018, interest expense from deposits increased by $1.5 million over 2017 and 2017 increased $866 thousand over 2016.  The majority, approximately 94.3%, of the increased expense of 2018 was influenced by increased rates rather than due to additional cost associated with deposit growth.

Total interest expense (which includes deposit, federal funds purchased, securities sold under agreement to repurchase, and borrowed funds) totaled $6.6, $5.1 and $4.2 million for 2018, 2017 and 2016 respectively. The increased expense is almost entirely attributable to the rising interest rate environment in 2018 as compared to 2017 as well as the 2017 to 2016 comparison.  Borrowed fund balances increased in December of 2015, which impacted 2016, 2017 and 2018. All of 2015’s borrowings have since matured in December of 2017 and December of 2018.

The success in improving net interest income confirmed that management’s long term strategy of repositioning the balance sheet and increasing loan balances was the correct approach. Funding loan growth with internal funds, whether from the liquidation of investment securities or core deposits, was a beneficial move.

The dollar amount of improvement has been shown. Now the discussion moves on to the percentages and the change in the net interest margin and spread.

Overall, we have seen increased improvement in the net interest margin and spread since 2016.  Looking at the components behind the change in net interest margin for 2018 as compared to 2017, increased average balances in loans of $48.5 million stands out.  The additional revenue of almost $5.1 million that those balances were responsible for was the largest contributor to the improved net yield on loans of 33 basis points.  Beginning in 2017, loan revenue was positively impacted by the change in the interest rate. The majority of variable loans with floor rates attained the point where rate increases caused the rate to go above the floor.  The Bank had expected 100 basis points of change was needed for this to occur which was reached with the June 2017 Fed Funds rate hike.  The next hike did not occur until December of 2017, too late to largely impact 2017 though it benefitted 2018.  2018 saw four additional rate hikes of 25 basis points.  The large revenue gain in loan interest was offset by the decrease earnings in securities which were used to fund the loan growth. However, the overall asset yield in 2018 still improved by 30 basis points over 2017, as loans earn at a higher rate than the securities.

Increased interest expense correlated to the higher rate environment in which the deposits needed to be garnered.  The Bank experienced pressure to offer higher rates to public funds in Ohio due to competition. In the area where the strategic plan was to gather core deposits, the average balance in savings grew by $32.2 million during 2018 as compared to 2017’s average balance.  The other average balance increase for core deposits would be the change in non-interest bearing demand deposits.  2018’s average balance in this portfolio was $14.4 million higher than 2017’s average balance. Overall, cost of funds increased 18 basis points for 2018 over 2017.  The reason behind the increase was due to rate increases not the volume increases.

The net interest margin for 2018 was 3.83% compared to 2017 which was 3.65%.  The 0.18% increase for 2018 was an important factor in the improved profitability for 2018.  Net interest spread was 3.60% for 2018 compared to 2017’s 3.48%, creating an 12 basis point difference in the spread.  Variable and new loans will reprice higher if the Federal Reserve continues with their stated monetary policy and the challenge will be to control the rate of increase on the deposits.  The goal is, as always, to improve the net interest margin and spread and thereby improve profitability.

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In comparing 2017 to 2016, loan volume was primarily responsible for the improvement in interest income as the yield on the overall loan portfolio increased 9 basis points during 2017. The only category of asset yield to decrease was the investment securities which were used to fund growth.  Overall, asset yield increased 18 basis points in 2017 as compared to 2016.

The net interest margin also climbed up in 2017, ending 10 basis points over 2016. Asset yield raised 18 basis points and the cost of funds increased only 9 basis points. The yields on the individual segments did cause the overall improvement as all increased. The improvement in the asset yield was primarily a result of the change in volume.  In addition, loans as a percentage of earning assets increased to 77.8% in 2017 compared to 75.0% in 2016. Loans to assets also increased to 72.8% for 2017 compared to 2016’s 70.7%.  Overall yield improves when the balances of the highest yield asset increases, which is loans.

With respect to the cost of funds, the Bank’s goal is to grow the least expensive category of funding sources. The largest average balance increase for 2017 was $72.6 million in savings deposits over 2016’s average balances. This helped to keep the increase in funding expense to just 9 basis points when comparing 2017 to 2016.

The Company will always prefer to see improvement in real dollars over percentages. The strategy for increasing core deposits, in order to mitigate the higher interest rates and interest expense and to continue to establish the opportunity for fee dollars from services provided, remains for 2019.  

Total assets of the Company increased overall as did the earning assets in both average and year end during 2018 and 2017. This matched the movement in interest dollars and in yields.  The percentage of average earning assets to total average assets reflects the best utilization of funds.  For 2018, the percentage at 94.23% was slightly higher than 2017 at 93.47%.  The addition of offices in 2016, 2017 and 2018 increased the non-earning assets with cash balances held at the new offices and also the investment in the capital assets of their building and furniture. What made 2018 more profitable was the percentage of average loans to total assets.  For 2018 the average balance of loans to total average assets was 74.77%, for 2017, 72.76%, for 2016, 70.69%.  Loans are the highest yielding asset for the Company.

Net interest spread is the difference between what the Company earns on its assets and what it pays on its liabilities.  It is generally from this spread that the Company must fund its operations and generate profit.  When the asset yield decreases so must funding costs in order to maintain profitability.  It becomes increasingly challenging as the asset yield gets closer to the prime lending rate, or the break-even point, of operations. The challenge began to change in 2016 as rates increased in December 2015.  In a rising rate environment, the challenge is to hold the cost steady while allowing time for the asset portfolio to rise. Floors and ceilings on variable products also impact the level of increase in either scenario. The 25 basis point prime rate increase of 2015 did little to increase the rate on the variable loans because of the floors in place and the spread of rate to prime. The floors provided yield protection in the previous lower rate environment and the rising rates wouldn’t benefit the asset yield until the spread plus prime is higher than the floor. The challenge is to increase the spread during renewals and on new loans. After the December 2015 rate increase, it was another year before the next rate hike in December of 2016. These two rate hikes had little effect on the profitability as the majority of loans were still below the floors.  It wasn’t until the third and fourth rate hikes of March and June 2017, that the majority of loans were now either equal to or over the floors.  This helped the asset yield in 2017.  In December 2017 along with March, June and September of 2018, there were rate hikes which contributed to the increased asset yield for 2018.  The most recent rate hike in December of 2018 will help increase the asset yield for 2019.

In terms of interest expense, 2018’s increase as compared to 2017 was due to the increase in rates.  2017’s increase was also due to an increase in rates as compared to 2016.

The impact of the change in the portfolio mix was a factor in the liabilities as it was in the assets. In comparing to 2017, 2018 had movements as average balances decreased in all categories other than savings deposits and non-interest bearing liabilities.  Other time deposits continued to run off and $5 million of other borrowed money was paid off in December that had been originally borrowed in December 2015 to fund loan growth. Time deposits and saving deposits increased in interest expense for 2017 as compared to 2016. Fed Funds purchased and securities sold under agreement to repurchase increased for 2017 and was due to increased balance and rate.

The following tables present net interest income, interest spread and net interest margin for the three years 2016 through 2018, comparing average outstanding balances of earning assets and interest bearing liabilities with the associated interest income and expense.  The tables show the corresponding average rates of interest earned and paid.  The tax-exempt asset yields have been tax adjusted to reflect a marginal corporate tax rate of 34% for 2016 and 2017 and a marginal corporate tax rate of 21% for 2018.  Average outstanding loan balances include non-performing loans and mortgage loans held for sale.  Average outstanding security balances are computed based on carrying values including unrealized gains and losses on available-for-sale securities.  The average cost of funds for 2018 was 0.86%, 18 basis points higher than 2017’s 0.68% for interest bearing liabilities.

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The yield on Tax-Exempt investment securities shown in the following charts were computed on a tax equivalent basis.  The yield on Loans has been tax adjusted for the portion of tax-exempt IDB loans included in the total.  Total Interest Earning Assets is therefore also reflecting a tax equivalent yield in both line items, also with the Net Interest Spread and Margin.  The adjustments were based on a 34% tax rate for 2016 and 2017 and a 21% tax rate for 2018 and 27 basis points higher than 2016’s 0.59%.

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The following tables show changes in interest income, interest expense and net interest resulting from changes in volume and rate variances for major categories of earnings assets and interest bearing liabilities.

Non-Interest Income

The discussion now focuses on the non-interest income and expense generated from the Company. Non-interest income increased overall in 2018 as compared to 2017. This followed a year of decrease in 2017 as compared to 2016. 2018 did not reach the level of 2016’s non-interest income, lower by $504 thousand.

Components of non-interest income which improved over 2017 and 2016 were service charge revenue from both the business accounts and consumer accounts.  2018 service charge revenue was $53.1 thousand higher than 2017, mainly due to the increased number of accounts that had service charges attached to them. During the second quarter 2017, new business checking products were announced and existing business accounts were converted to one of three new products, Business Essential, Edge or Elite.  The new products provided customers with new options to bundle services and for the Bank to utilize the full relationship to determine pricing. This was a continuation of the Bank’s “earn to free” strategic initiative. It also aided the increase of $292.7 thousand in service charge revenue in 2017 as compared to 2016. Upgrades to our digital products and services continue to occur

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in both retail and business lines. Increases in the number of accounts and the number of services being utilized by our customers accounted for the increase in fees over the last two years.

The Bank has long promoted the use of debit cards by its customers and continues to build on that philosophy with the introduction of new products. During 2018 the Bank collected interchange revenue, combined with fees collected on foreign ATM fees (noncustomers utilizing our ATMs), of $2.9 million which was $167.5 thousand higher than 2017 and $340.0 thousand higher than 2016. While this revenue stream continues to improve with more depositors using electronic methods for purchasing, the expense attributable to card fraud has offset a portion of the revenue gain. Further discussion can be found in the non-interest section regarding the net effect of debit card activity.

Noninterest income form net gain on sales of loans was the highest in 2016 of the three year periods shown. The change may be related to the increase in rates after the long duration of the flat interest rate environment. The net gain on sale of loans is derived from sales of real estate loans into the secondary market. Of these loan types, the Bank sells 100% of the residential loans and 90% of the agricultural loans. 66.5% of the gains are attributed to the residential loans in 2018, 80% in 2017 and 77% in 2016. In conjunction with these sales, the Bank maintains servicing rights and those income amounts during all three years are included in the customer service fee income line item and accounted for $449 thousand in 2018, $460 thousand in 2017 and $555.3 thousand in revenue for 2016.

The last item in the non-interest income section is the net gain of sale of investments. The Bank has sold securities over the last three years for two main purposes: to provide funds for loan growth and to take advantage of the position of the yield curve when a gain can be recognized on sales without extending the duration of the portfolio longer than wanted. 2018 had limited sales for gain recognition due to the flatness of the yield curve which began to occur in second half 2017. The Bank will not increase short-terms gains at the sacrifice of long-term profitability. The available for sale security portfolio switched from an unrealized gain position into an unrealized loss position in 2017. Sales in 2017 were made early in the first quarter before the additional Federal Reserve rate hike in March and again in May before the June rate hike. These sales recognized much lower gains than in prior years.  The Bank recognized gains of $9.8 thousand in 2018, $47 thousand for 2017 and $588 thousand for 2016. This line item was largely responsible for the lower non-interest income of 2017 as compared to 2016. The Company also recognized a loss on sale of securities from the holding company.  These proceeds were used to provide cash for the acquisition with the losses totaling $19.2 thousand. The net effect of the consolidated number is what shows on the line item of net loss of $9 thousand for 2018.

Non-Interest Expense  

Noninterest expense increased 12.2% in 2018 as compared to 2017 and was preceded by a 4.7% increase in 2017 as compared to 2016. Represented in dollars, 2018 was $3.5 million higher than 2017 and 2017 was $1.3 million higher than 2016. The largest factor behind the increase in both years was the expense of employee salaries and wages. During 2018, an additional $1.1 million was spent over 2017 which correlates to an 9.1% increase. When making the same analysis for 2017 as compared to 2016, 2017’s costs increased $993 thousand or 8.6%.   Three main components flow into salaries and wages: base salary, deferred costs, and incentives composed of the expense of restricted stock awards and performance incentives. Base pay has increased with the addition of the four offices of Findlay, Huntertown, Bowling Green and Sylvania, as well as from the operations of the Captive and through normal yearly increases to the remainder of the employees. Base pay was up $768.3 thousand for 2018 over the previous year and 2017 was up $731.2 thousand over 2016. The full time equivalent number of employees at each yearend increased to 288 for 2018, to 275 for 2017 compared to 2016’s 273.  The Company had also chosen to invest a portion of the tax savings dollars of 2018 to increase the base pay of our lowest paid employees.

Incentive pay as it related to performance was up $181.7 thousand in 2018 over 2017 and up $234.2 thousand in 2017 over 2016.  Measurements used for award incentive pay had improved in 2018 and 2017 and employees benefited accordingly.  The measurements used for 2018 were increased to negate the paying of incentive for the benefit of the lower tax rate.  The effect of acquisition costs incurred in 2018 were also removed. The expense for the restricted stock awards has also increased each of the last three years as more shares have been granted to a larger number of employees and the market value of the shares has increased. The market value of the Company’s stock increased significantly with the listing on NASDAQ and being included in the Russell 3000 Index during the second quarter of 2017. 700 more shares were awarded in 2018 and with a higher value as compared to 2017.  An equivalent number of restricted shares were awarded as compared to 2016 though the value of these rewards was higher; therefore, the expense for 2018 was higher by $237.7 thousand as compared to 2017 and will likely be higher in 2019 due to the value of the 2018 awards.  2017’s cost for this program was $105.3 thousand higher than 2016.  The awards incorporate a three year vesting period so the increase of any one year carries forward through the next two years. This expense should continue to increase as the Company continues its expansion strategy. For further discussion in incentive pay and restricted stock awards, see Note 11 of the consolidated financial statements.

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Along with the salary and wage increase was an increase in employee benefits in 2018 as compared to 2017. Employee group insurance accounted for the largest portion of the cost, which was an increase of $293.3 thousand over 2017. This was due to an increase in the cost to provide to a larger number of employees along with a higher level of medical claims. The cost of the 401-K retirement plan also increased $79.7 thousand for 2018 as compared to 2017.  Due to the increased profitability achieved in 2018 over 2017, the contribution portion relating to the discretionary profit-sharing percentage was raised from 5.5% to 6% for 2018.  Overall, employee benefits increased $480.0 thousand or 13.2% from 2017.

Along with the salary and wage increase was an increase in employee benefits in 2017 as compared to 2016. Employee group insurance accounted for the largest portion of the cost, which was an increase of $181.9 thousand over 2016. This was due to an increase in the cost to provide to a larger number of employees along with a higher level of medical claims. The cost of the 401-K retirement plan also increased $72.7 thousand for 2017 as compared to 2016.  Overall, employee benefits increased $312 thousand or 9.4% from 2016.

Net occupancy expense typically increases as the Company expands, which is what has occurred for 2018 and 2017. One factor that can offset occupancy expense is the receipt by the Company of building rent as it is netted out of occupancy expense. The greatest contributor to building rent comes from the division of FM Investments within the Bank. This division experienced a weaker 2018; however, the department was short staffed most of 2018 and 2017.  For 2018, building rent as generated from FM Investments was lower by $151.2 thousand due to staff turnover.  Rent is received in lieu of commissions.  This loss of revenue contributed to the increased net occupancy expense of $268 thousand for 2018 as compared to 2017.  The improved performance of $85.9 thousand in 2017 assisted in keeping the overall increase to net occupancy to $30 thousand in 2017 as compared to 2016.

The 1-4 family mortgage refinancing activity has been slow over the last three years though increasing slightly each year.  A correlating expense to that activity is the amortization of mortgage servicing rights.  The amortization is the expense that offsets the income recognized when the loan is first made.  Income is recorded when the mortgage loan is first sold with servicing retained and is therefore recognized within one year.  The amortization, however, is calculated over the life of the loan and accelerated as loans are paid off early.  An increase in this expense can be driven by two activities: an increase in the number of sold loans and/or by the acceleration of the expense from payoff and refinance activity.  The best picture of the bottom line impact is achieved by netting the income with the expense each year.  The net income for 2018 was $86 thousand; 2017 had net income of $107 thousand and was preceded by net income of $136 thousand for 2016. Of course, the value (or income) of the mortgage servicing right when sold also impacts the net position. As of December 31, 2018, 3,588 loans are being serviced with corresponding balances of $289.2 million.  2017 had 3,636 loans serviced with corresponding balances of $288.6 million. As of December 2016, 3,599 loans were being serviced with balances of $280.4 million.  

The impact of mortgage servicing rights to both noninterest income and expense is shown in the following table:

Furniture and equipment steadily increases as we continue to add facilities and invest in technology. Annual maintenance costs continue to grow and become a greater piece of the overall cost. As new services are provided to our customers, the backroom cost to supply them continues to rise. The Company accepts it is an expected cost of doing business and keeping our services relevant to the industry.

Data processing costs were actually lower in 2017 as compared to 2016 by $196 thousand. Two reasons for the improvement was the negotiation of an extended contract with our core processor and 2016 had the additional cost of upgrading Bank customer debit cards to incorporate EMV chip card technology.  Both already better align with our future strategies while controlling costs.  Data processing expense increased $105 thousand during 2018 as compared to 2017.  As we continue to expand this line item is expected to also increase.

As the pricing on many services, however, is based on number of accounts and the Bank fully expects those to increase with the growth from the newer offices and overall Bank growth. Overall, data processing expense for 2019 will be higher than 2018 with the addition of the six Indiana offices.

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The FDIC assessment has a decreasing cost trend over the years shown. This line item speaks to the health of the Bank and the financial industry. The assessment for 2018 was down only $4 thousand from 2017 and the assessment for 2017 was down $77 thousand from 2016.

The last line items with significant variation in noninterest expense to discuss is “consulting fees” and “other general and administrative.” Two main events are behind the increase of $865 thousand in 2018 as compared to 2017 in this line item.  Both events incurred one-time costs which required the use of outside consultants.   First related to the use of an executive recruiter firm to conduct a search for a CEO due to an upcoming retirement.  The second related to the costs of researching, analyzing and negotiating possible mergers and acquisition opportunities.  The consulting fees were beneficial in both instances as a new CEO was hired and a merger was closed on January 1, 2019.  Consulting fees increased by $551.2 thousand in 2018 over 2017.  Acquisition costs incurred in 2018 total $742.1 thousand with expenses being recorded in multiple line items.  Though 2017 did not increase by as large an amount as 2016 had when compared to 2015, it was still an increase of $207 thousand. The two main reasons behind the increase in 2017 were the costs associated with listing on the NASDAQ stock market and the cost of offering the Insured Cash Sweep product.  Both of these costs have been previously explained along with the benefits that have been provided by incurring said costs.   Advertising and public relations increased also in 2018 by $129.9 thousand following an increase of $113 thousand in 2017. With the addition of new offices in both years behind the increases, 2019 is also expected to increase due to additional offices being added.  The Bank also celebrates the anniversary of office openings with a special event in each community.

Allowance for Credit Losses

Provision expense increased by $102 thousand for 2018 as compared to 2017 to account for the net charge-off activity of 2018.  Provision expense decreased by $899 thousand for 2017 due to the consistent strong asset quality of the Bank’s loan portfolio as evidenced by low levels of both net charge-offs and delinquencies.  Sustained strong asset quality kept the provision expense lower than the growth alone would have warranted. Provision expense increased by $496 thousand for 2016 in response to the significant growth for the period.  Net charge-offs were $417, $138 and $394 thousand for 2018, 2017 and $2016, respectively. The consumer portfolios had the highest levels of charge-off activity in 2018, 2017 and 2016 at $359, $263 and $310 thousand respectively.  Net charge offs in the consumer portfolio was $245, $161 and $223 thousand for 2018, 2017 and 2016 respectively.

The Company segregates its Allowance for Credit Losses (ACL) into two reserves:  The ACL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC).  When combined, these reserves constitute the total ACL. The AUCL is included in other liabilities on the consolidated balance sheets.

The Bank’s ALLL methodology captures trends in leading, current, and lagging indicators which will directly affect the Bank’s allocation amount.  The Bank monitors trends in such leading indicators as delinquency, unemployment changes in the Bank’s service area, experience and ability of staff, regulatory trends, and credit concentrations.  A current indicator such as the total watch list loan amount to Capital, and a lagging indicator such as the charge off amount are referenced as well.  A matrix formed by loan type from these indicators is used in making ALLL adjustments.

Watch list loan balances are comprised of loans graded 5-8.  At yearend December 31, 2018 these loans totaled $7.9 million and were $13.3 million lower than December 31, 2017.  Grade 5 decreased $6.6 million in 2018 as compared to 2017 and Grade 6 decreased by $7.3 million in the same comparison.  Much of the decrease is represented by the payoff of two loan relationships in the Bank’s commercial real estate portfolio.  During 2018, one commercial real estate loan relationship was upgraded from a risk category of 6 to a risk category of 4 while one new commercial real estate loan relationship was added to the risk category 5.  Those associated loans are adequately secured by collateral.  These loan balances increased $800 thousand as of December 31, 2017 as compared to same date 2016. The largest increases occurring in the risk grade of 6. The loan grades of 5, which have the least likelihood of default decreased for 2017.  

At December 31, 2018, 47.5% of the watch list was classified as special mention, with an additional 41.4% classified as substandard. A small 11.1% or $886 thousand of the $7.9 million watch list was classified as doubtful. At yearend 2017, 49.0% of the watch list was comprised of loans classified as special mention, with an additional 50.1% classified as substandard and the remaining 0.9% classified as doubtful. The large decreases in special mention and substandard were mainly driven by two loan relationships in the Bank’s commercial real estate portfolio.

Of the aggregate watch list loan balances, as of December 31, 2016, special mention accounted for 59.7% with substandard comprising 39.0% and doubtful accounting for the final 1.3%.

In response to these fluctuations and loan growth during 2016 through 2018, the Bank’s ALLL to outstanding loan coverage percentage changed to 0.80% as of December 31, 2018, 0.83% as of December 31, 2017, and 0.89% as of December 31, 2016.

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The above indicators impacting ALLL are reviewed quarterly. Some of the indicators are quantifiable and, as such, will automatically adjust the ALLL once calculated.  These indicators include the ratio of past due loans to total loans, loans past due greater than 30 days, and the ratio of watch list loans to capital, with the watch list made up of loans graded 5, 6 or 7 on a scale of 1 (best) to 7 (worst). Other indicators consist of more subjective data used to evaluate the potential for inherent losses in the Bank’s loan portfolio.  For example, the economic indicator uses the unemployment statistics from the communities in our market area to help determine whether the ALLL should be adjusted.  At the end of each of 2016, 2017 and 2018, improvements were noted in unemployment figures.  

All aggregate commercial and agricultural credits including real estate loans of $250,000 and over are reviewed annually by both credit committees and internal loan review to look for early signs of deterioration.

To establish the specific reserve allocation for real estate, a discount to the market value is established to account for liquidation expenses.   The discounting percentage used for real estate mirrors the discounting of real estate as provided for in the Bank’s Loan Policy.   However, unique or unusual circumstances may be present which will affect the real estate value and, when appropriately identified, can adjust the discounting percentage at the discretion of management.

The ACL decreased $46 thousand during 2018 while increased $94 thousand and $736 thousand during 2017 and 2016 respectively. The large increase in 2016 directly correlates to the large increase in loan balances and related unfunded commitments. With the improved asset quality, the metrics upon which the ACL is calculated did not support a larger increase in 2017 even though loan growth occurred. The percentage of ACL to the total loan portfolio was 0.92% as of December 31, 2016 and 0.86% as of December 31, 2017, and 0.83% as of December 31, 2018.   December 31, 2018 had the lowest loans past due 30+ day percentage at 0.09% in the last ten years. December 31, 2016 and 2017 were still at respectable lows of 0.23% and 0.13%.

Please see Note 4 in the consolidated financial statement for additional tables regarding the composition of the ACL.

Federal Income Taxes

Federal income tax expense was approximately $2.0 million less for 2018 than 2017 as result of tax reform legislation under the Tax Cuts and Jobs Act, which was signed into law on December 22, 2017 and became effective for the Company’s 2018 fiscal year.  Effective tax rates were 17.75%, 28.95% and 28.53%, for 2018, 2017 and 2016 respectively. The effect of tax-exempt interest from holding tax-exempt securities and Industrial Development Bonds (IDBs) was $229, $413 and $468 thousand for 2018, 2017, and 2016, respectively. 2016 and 2017 included an increase into a higher tax bracket for income over $10 million. 2018 had a flat corporate tax rate of 21%.  One of the benefits from the establishment of the Captive subsidiary was a lower effective tax rate.

Material Changes in Financial Condition

The shifts in the balance sheet during 2018 and 2017 have positioned the Company for continued improvement in profitability. On the asset side, interest income increased primarily from loan growth with funding for the increase provided by a decrease in the investment portfolio, growth in core deposits and growth in other borrowings generated in 2015 which had laddered maturities, that were then paid off in the following years.  $5 million of other borrowings were paid off in December of 2017 and 2018. Other assets increased $9.2 million in 2018 with $8.5 prefunded for the pending acquisition.  The cost of funds has been impacted by the increase of both interest bearing liabilities and the pressure on rates from competition for funds. Increased balances in non-interest bearing deposits aided in profitability also. Loan growth and a widened net interest margin contributed to improved profitability in 2018 and 2017, and the Company expects continued improvement through 2019.

Average earning assets increased in balances throughout 2018 and 2017. Newer offices have contributed the most towards new loan production.  Loan growth in both years was the main factor. 2016 had two offices open, one in each half of the year and operating fully throughout 2017.  An additional office opened in early 2018.

Securities

The investment portfolio is primarily used to provide overall liquidity for the Bank.  It is also used to provide required collateral for pledging to the Bank’s Ohio public depositors for amounts on deposit in excess of the FDIC coverage limits.  It may also be used to pledge for additional borrowings from third parties.  Investments are made with the above criteria in mind while still seeking a fair market rate of return and looking for maturities that fall within the projected overall strategy of the Bank. The possible need to fund future loan growth is also a consideration.

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During 2016, the Bank began to utilize Promontory’s ICS, product to replace pledged securities; thereby increasing liquidity. ICS utilizes a nation-wide bank network to provide FDIC insurance coverage to the Bank’s depositors. The Bank is using the product to replace pledged securities to the Bank’s Ohio public customers and for commercial sweep customers previously utilizing daily repurchase agreements to protect balances over $250 thousand. The majority of the commercial accounts converted in 2017 and is evidenced by the movement of funds out of repurchase agreements into interest bearing deposits.

All of the Bank’s security portfolio is categorized as available for sale and as such is recorded at market value.

Security balances as of December 31 are summarized below:

The following table sets forth the maturities of investment securities as of December 31, 2018 and the weighted average yields of such securities calculated on the basis of cost and effective yields weighted for the scheduled maturity of each security.  Tax-equivalent adjustments, using a twenty-one percent rate, have been made in yields on obligations of state and political subdivisions.  Stocks of domestic corporations have not been included. Maturities of mortgage-backed securities are based on the stated maturity date of the security. Due to prepayments, actual maturities may be different.