FIRST BANCORP /NC/ - Annual Report: 2017 (Form 10-K)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2017

Commission File Number 0-15572

FIRST BANCORP

(Exact Name of Registrant as Specified in its Charter)

Securities Registered Pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933. o YES x NO

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934. o YES x NO

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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. x YES o NO

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x YES o 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 the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to the Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one)

x Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer o Smaller Reporting Company

Indicate by check mark whether the registrant is an emerging growth company as defined in Rule 405 of the Securities Act of 1933 (§230.405 of this chapter) or Rule 12b-2 of the Securities Exchange Act of 1934 (§240.12b-2 of this chapter. o Emerging growth company

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

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

The aggregate market value of the Common Stock, no par value, held by non-affiliates of the registrant, based on the closing price of the Common Stock as of June 30, 2017 as reported by The NASDAQ Global Select Market, was approximately $757,969,473.

The number of shares of the registrant’s Common Stock outstanding on February 28, 2018 was 29,654,718.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement to be filed pursuant to Regulation 14A are incorporated herein by reference into Part III.

TABLE OF CONTENTS

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995, which statements are inherently subject to risks and uncertainties. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Further, forward-looking statements are intended to speak only as of the date made. Such statements are often characterized by the use of qualifying words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” or other statements concerning our opinions or judgment about future events. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. Factors that could influence the accuracy of such forward-looking statements include, but are not limited to, the financial success or changing strategies of our customers, our level of success in integrating acquisitions, actions of government regulators, the level of market interest rates, and general economic conditions. For additional information about factors that could affect the matters discussed in this paragraph, see the “Risk Factors” section in Item 1A of this report.

PART I

Item 1. Business

General Description

First Bancorp (the “Company”) is the fourth largest bank holding company headquartered in North Carolina.  At December 31, 2017, the Company had total consolidated assets of $5.5 billion, total loans of $4.0 billion, total deposits of $4.4 billion, and shareholders’ equity of $0.7 billion.  Our principal activity is the ownership and operation of First Bank (the “Bank”), a state-chartered bank with its main office in Southern Pines, North Carolina. 

The Company was incorporated in North Carolina on December 8, 1983, as Montgomery Bancorp, for the purpose of acquiring 100% of the outstanding common stock of the Bank through a stock-for-stock exchange. On December 31, 1986, the Company changed its name to First Bancorp to conform its name to the name of the Bank, which had changed its name from Bank of Montgomery to First Bank in 1985.

The Bank was organized in 1934 and began banking operations in 1935 as the Bank of Montgomery, named for the county in which it operated. Until September 2013, the Bank’s main office was in Troy, North Carolina, located in the center of Montgomery County. In September 2013, the Company and the Bank moved their main offices approximately 45 miles to Southern Pines, North Carolina, in Moore County. As of December 31, 2017, we conducted business from 104 branches covering a geographical area from Florence, South Carolina to the south, to Wilmington, North Carolina to the east, to Kill Devil Hills, North Carolina to the northeast, to Mayodan, North Carolina to the north, and to Asheville, North Carolina to the west. We also have several mortgage loan production offices in the Triad Region of North Carolina (which includes Greensboro, High Point and Winston-Salem and the surrounding areas). Of the Bank’s 104 branches, 98 branches are in North Carolina and six branches are in South Carolina. Ranked by assets, the Bank was the fourth largest bank headquartered in North Carolina as of December 31, 2017.

As of December 31, 2017, the Bank had three wholly owned subsidiaries, First Bank Insurance Services, Inc. (“First Bank Insurance”), SBA Complete, Inc. (“SBA Complete”), and First Troy SPE, LLC. First Bank Insurance’s primary business activity is the placement of property and casualty insurance coverage. SBA Complete is a firm that specializes in providing consulting services for financial institutions across the country related to Small Business Administration (“SBA”) loan origination and servicing. First Troy SPE, LLC, which was organized in December 2009, is a holding entity for certain foreclosed properties.

Our principal executive offices are located at 300 SW Broad Street, Southern Pines, North Carolina, 28387, and our telephone number is (910) 246-2500. Unless the context requires otherwise, references to the “Company,” “we,”

“our,” or “us” in this annual report on Form 10-K shall mean collectively First Bancorp and its consolidated subsidiaries.

General Business

We engage in a full range of banking activities, with the acceptance of deposits and the making of loans being our most basic activities. We offer deposit products such as checking, savings, and money market accounts, as well as time deposits, including various types of certificates of deposits (“CDs”) and individual retirement accounts (“IRAs”). We provide loans for a wide range of consumer and commercial purposes, including loans for business, agriculture, real estate, personal uses, home improvement and automobiles. We offer residential mortgages through our Mortgage Banking Division, and we offer SBA loans to small business owners across the nation through our SBA Lending Division. We also offer credit cards, debit cards, letters of credit, safe deposit box rentals and electronic funds transfer services, including wire transfers. In addition, we offer internet banking, mobile banking, cash management and bank-by-phone capabilities to our customers, and are affiliated with ATM networks that give our customers access to thousands of ATMs across the country, with no surcharge fee. We also offer a mobile check deposit feature for our mobile banking customers that allows them to securely deposit checks via their smartphone. For our business customers, we offer remote deposit capture, which provides them with a method to electronically transmit checks received from customers into their bank account without having to visit a branch. We are a member of the Certificate of Deposit Account Registry Service (“CDARS”), which gives our customers the ability to obtain FDIC insurance on deposits of up to $50 million, while continuing to work directly with their local First Bank branch.

Because the majority of our customers are individuals and small to medium-sized businesses located in the markets we serve, management does not believe that the loss of a single customer or group of customers would have a material adverse impact on the Bank. There are no seasonal factors that tend to have any material effect on the Bank’s business, and we do not rely on foreign sources of funds or income. Because we operate primarily within North Carolina and northeastern South Carolina, the economic conditions of these areas could have a material impact on the Company. See additional discussion below in the section entitled “Territory Served and Competition.”

We also offer various ancillary services as part of our commitment to customer service. Through First Bank Insurance, we offer the placement of property and casualty insurance. We also offer non-FDIC insured investment and insurance products, including mutual funds, annuities, long-term care insurance, life insurance, and company retirement plans, as well as financial planning services through our “investments division.”

First Bank also offers SBA loans to small business owners throughout the nation, which is supported by First Bank’s subsidiary, SBA Complete. SBA Complete is a firm that specializes in providing consulting services for financial institutions across the country related to SBA loan origination and servicing.

First Bancorp Capital Trust II and First Bancorp Capital Trust III were organized in December 2003 for the purpose of issuing $20.6 million in debt securities ($10.3 million was issued from each trust). These borrowings are due on January 23, 2034 and are also structured as trust preferred capital securities in order to qualify as regulatory capital. These debt securities became callable by the Company at par on any quarterly interest payment date beginning on January 23, 2009. The interest rate on these debt securities adjusts on a quarterly basis at a weighted average rate of three-month LIBOR plus 2.70%.

First Bancorp Capital Trust IV was organized in April 2006 for the purpose of issuing $25.8 million in debt securities. These borrowings are due on June 15, 2036 and are also structured as trust preferred capital securities that qualify as regulatory capital. These debt securities became callable by the Company at par on any quarterly interest payment date beginning on June 15, 2011. The interest rate on these debt securities adjusts on a quarterly basis at a rate of three-month LIBOR plus 1.39%.

The Company acquired Carolina Capital Trust in the March 3, 2017 acquisition of Carolina Bank Holdings, Inc. Carolina Capital Trust was organized in December 2004 for the purpose of issuing $10.3 million in debt securities. These borrowings are due on January 7, 2035 and are also structured as trust preferred capital securities that qualify as

regulatory capital. These debt securities became callable by the Company at par on any quarterly interest payment date beginning on January 7, 2010. The interest rate on these debt securities adjusts on a quarterly basis at a rate of three-month LIBOR plus 2.00%.

Territory Served and Competition

Our headquarters are located in Southern Pines, Moore County, North Carolina, where we have a significant concentration of deposits. At the end of 2017, we served several regions across most of North Carolina, with additional operations in northeastern South Carolina. The following table presents, for each county where we operated as of December 31, 2017, the number of bank branches operated by the Company within the county, the approximate amount of deposits with the Company in the county as of December 31, 2017, our approximate deposit market share at June 30, 2017, and the number of bank competitors located in the county at June 30, 2017.

(*) Pro forma information for market share and number of competitors is included as of June 30, 2017 to reflect the acquisition of Asheville Savings Bank, which occurred on October 1, 2017.

Historically, our branches and facilities have been primarily located in small communities whose economies are based primarily on services, manufacturing and light industries. Although these markets are predominantly small communities and rural areas, the market area is not dependent on agriculture. Textiles, furniture, mobile homes, electronics, plastic and metal fabrication, forest products, food products, and chicken hatcheries are among the leading manufacturing industries in the market. Leading producers of lumber and rugs are located in Montgomery County, North Carolina. The Pinehurst area within Moore County, North Carolina, is a widely known golf resort and retirement area. The High Point, North Carolina, area is widely known for its furniture market. New Hanover and Brunswick Counties, located in the southeastern coastal region of North Carolina, are popular with tourists and have significant retirement populations. Buncombe County, located in the western region of North Carolina, is a highly diverse area with industries in manufacturing, service, and tourism. Additionally, several of the communities served by the Bank are “bedroom” communities of large cities like Charlotte, Raleigh and Greensboro, while several branches are located in medium-sized cities such as Albemarle, Asheboro, Fayetteville, Greenville, Jacksonville, High Point, Southern Pines and Sanford. We also have branches in small communities such as Bennett, Polkton, Vass, and Harmony.

In recent years, we have implemented a branch strategy of expansion into larger, higher growth markets. In 2016, this expansion continued with additional investments in Charlotte, Raleigh and the Triad region of North Carolina. Several seasoned bankers joined the Bank and have led our expansion efforts in these markets. We opened our first full service branch in Charlotte in August 2016, after opening a loan production office there in 2015. In Raleigh, we opened a loan production office early in 2016 and upgraded that location to a full service branch in April 2017. In the Triad region, experienced bankers joined us in early 2016 as we opened our first loan production office in Greensboro. Our expansion into higher growth markets was enhanced by three strategic transactions discussed in the following paragraphs.

In March 2016, we announced an agreement to exchange our seven Virginia branches, with approximately $151 million in loans and $134 million in deposits, for six North Carolina branches of a community bank with a large Virginia presence that included approximately $152 million in loans and $111 million in deposits. Four of the six branches we assumed were in Winston-Salem, with the other two branches located in the Charlotte-metro markets of Mooresville and Huntersville. The Winston-Salem branches we assumed improved the Triad expansion initiative, while the Mooresville and Huntersville branches increased our Charlotte expansion. This transaction, which was completed in July 2016, resulted in our exit from Virginia, which was a good market for our Bank, but created challenges due to the distant proximity to our core market.

In March 2017, we acquired Carolina Bank Holdings, Inc. (“Carolina Bank”), the parent company of Carolina Bank. Carolina Bank was a community bank headquartered in Greensboro with $682 million in assets, with eight branches located in Greensboro, Winston-Salem, Burlington and Asheboro. This acquisition built on the Winston-Salem expansion previously discussed and significantly accelerated our recent expansion initiative in the Greensboro market.

In October 2017, we acquired ASB Bancorp, Inc. (“Asheville Savings Bank”), the parent company of Asheville Savings Bank, SSB. Asheville Savings Bank operated in the attractive and high-growth market of Asheville, North Carolina, with $798 million in assets and 13 branches located throughout the Asheville area.

As a result of the acquisitions of Carolina Bank and Asheville Savings Bank, the number of counties that are the home to 10% or more of our deposit base has increased to three counties from one county a year earlier. Moore County, the headquarters of the Company, has total deposits comprising approximately 10% of our deposit base, while Guilford County, the former headquarters of Carolina Bank, also holds 10% of our deposit base and Buncombe County, the former headquarters of Asheville Savings Bank, now holds 13% of our total deposit base. Accordingly, material changes in competition, the economy or the population of these counties could materially impact the Company. No other county comprises more than 10% of our deposit base.

We compete in our various market areas with, among others, several large interstate bank holding companies. These large competitors have substantially greater resources than our Company, including broader geographic markets,

higher lending limits and the ability to make greater use of large-scale advertising and promotions. A significant number of interstate banking acquisitions have taken place in the past decade, thus further increasing the size and financial resources of some of our competitors, some of which are among the largest bank holding companies in the nation. In many of our markets, we also compete against smaller, local banks. With interest rates still near historic lows and banks of all sizes attempting to maximize yields on earning assets, the competition for high-quality loans has become intense. Accordingly, loan rates in our markets continue to be under competitive pressure. The pricing competition for deposits has lessened in recent years, but at any given time in many of our markets, there are frequently smaller banks offering higher rates on deposits than we are willing to match. This has resulted in the loss of some deposits from price-sensitive customers, which has been primarily responsible for the declines in our time deposit accounts that are discussed below in Management’s Discussion and Analysis of Financial Condition and Results of Operation. With the recent and expected interest rate increases initiated by the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the competitive pressure on increasing rates on deposits is intensifying. Many of the markets we operate in are particularly competitive markets, with at least ten other financial institutions having a physical presence within those markets.

We compete not only against banking organizations, but also against a wide range of financial service providers, including federally and state-chartered thrift institutions, credit unions, investment and brokerage firms and small-loan or consumer finance companies. One of the credit unions in our market area is among the largest in the nation. Competition among financial institutions of all types is virtually unlimited with respect to legal ability and authority to provide most financial services. We also experience competition from internet loan providers, especially for mortgage loans, and from internet banks, particularly in the area of time deposits.

Despite the competitive market, we believe we have certain advantages over our competition in the areas we serve. We are large enough to be able to more easily absorb higher costs being experienced in the banking industry, particularly regulatory costs and technology costs, than the smaller banks with which we compete. We are also able to originate significantly larger loans than many of our smaller bank competitors. At the same time, we attempt to maintain a banking culture associated with smaller banks – a culture that has a personal and local flavor that appeals to many retail and small business customers. Specifically, we seek to maintain a distinct local identity in each of the communities we serve and we actively sponsor and participate in local civic affairs. Most lending and other customer-related business decisions can be made without the delays often associated with larger institutions. Additionally, employment of local managers and personnel in various offices and low turnover of personnel enable us to establish and maintain long-term relationships with individual and corporate customers.

Lending Policy and Procedures

Conservative lending policies and procedures and appropriate underwriting standards are high priorities of the Bank. Loans are approved under our written loan policy, which provides that lending officers, principally branch managers, have authority to approve loans of various amounts up to $350,000 with lending limits varying depending upon the experience of the lending officer and whether the loan is secured or unsecured. We have seven senior lending officers who have authority to approve secured loans up to $500,000 and each of our five Regional Presidents has authority to approve secured loans up to $1,000,000. Loans up to $3,000,000 are approved by the Bank’s Regional Credit Officers through our Credit Administration Department. The Bank’s President and Chief Credit Officer have authority to approve loans up to $10,000,000, while the Chief Credit Officer and the Bank’s President have joint authority to approve loans up to $25,000,000. The Bank’s board of directors maintains loan authority in excess of the Bank’s in-house limit, currently $25,000,000, and generally approves loans through its Executive Loan Committee. All lending authorities are based on the borrower’s Total Credit Exposure (“TCE”), which is an aggregate of the Bank’s lending relationship to the borrower. TCE is based on the borrower’s total credit exposure with the Bank either directly or indirectly through loan guarantees or other borrowing entities related to the borrower through control or ownership.

The Executive Loan Committee reviews and approves loans that exceed the Bank’s in-house limit, loans to executive officers, directors, and their affiliates and, in certain instances, other types of loans. New credit extensions are reviewed daily by our senior management and the Credit Administration Department.

We continually monitor our loan portfolio to identify areas of concern and to enable us to take corrective action. Lending and credit administration officers and the board of directors meet periodically to review past due loans and portfolio quality, while assuring that the Bank is appropriately meeting the credit needs of the communities it serves. Individual lending officers are responsible for monitoring any changes in the financial status of borrowers and pursuing collection of early-stage past due amounts. For certain types of loans that exceed our established parameters of past due status, the Bank’s Asset Resolution Group assumes the management of the loan, and in some cases we engage a third-party firm to assist in collection efforts.

The Bank has an internal Loan Review Department that conducts on-going and targeted reviews of the Bank’s loan portfolio and assesses the Bank’s adherence to loan policies, risk grading and accrual policies. Reports are generated for management based on these activities and findings are used to adjust risk grades as deemed appropriate. In addition, these reports are shared with the Company’s board of directors. The Loan Review Department also provides training assistance to the Bank’s Training and Credit Administration departments.

To further assess the Bank’s loan portfolio and as a secondary review of the Bank’s Loan Review Department, we also contract with an independent consulting firm to review new loan originations meeting certain criteria, as well as to assign risk grades to existing credits meeting certain thresholds. The consulting firm’s observations, comments, and risk grades, including variances with the Bank’s risk grades, are shared with the audit committee of the Company’s board of directors and are considered by management in setting Bank policy, as well as in evaluating the adequacy of our allowance for loan losses. For additional information, see “Allowance for Loan Losses and Loan Loss Experience” under Item 7 below.

Investment Policy and Procedures

We have adopted an investment policy designed to maximize our income from funds not needed to meet loan demand, in a manner consistent with appropriate liquidity and risk objectives. Pursuant to this policy, we may invest in federal, state and municipal obligations, federal agency obligations, public housing authority bonds, Federal Home Loan Bank bonds, Fannie Mae bonds, Government National Mortgage Association bonds, Freddie Mac bonds, SBA bonds, and, to a limited extent, corporate bonds. We may also invest up to $60 million in time deposits with other financial institutions. Time deposit purchases from any one financial institution exceeding FDIC insurance coverage limits are evaluated as a corporate bond and are subject to the same due diligence requirements as corporate bonds (described below).

In making investment decisions, we do not solely rely on credit ratings to determine the credit-worthiness of an issuer of securities, but we use credit ratings in conjunction with other information when performing due diligence prior to the purchase of a security. Securities that are not rated investment grade will not be purchased. Securities rated below Moody’s BAA or Standard and Poor’s BBB generally will not be purchased. Securities rated below A are periodically reviewed for credit-worthiness. We may purchase non-rated municipal bonds only if such bonds are in our general market area and we determine these bonds have a credit risk no greater than the minimum ratings referred to above. We are also authorized by our board of directors to invest a portion of our securities portfolio in high quality corporate bonds, with the amount of such bonds not to exceed 15% of the entire securities portfolio. Prior to purchasing a corporate bond, the Company’s management performs due diligence on the issuer of the bond, and the purchase is not made unless we believe that the purchase of the bond bears no more risk to the Company than would an unsecured loan to the same company.

Our Chief Investment Officer implements the investment policy, monitors the investment portfolio, recommends portfolio strategies and reports to the Company’s Investment Committee. The Investment Committee generally meets on a quarterly basis to review investment activity and to assess the overall position of the securities portfolio. The Investment Committee compares our securities portfolio with portfolios of other companies of comparable size. In addition, reports of all purchases, sales, issuer calls, net profits or losses and market appreciation or depreciation of the securities portfolio are reviewed by our board of directors. Once a quarter, our interest rate risk exposure is evaluated by our board of directors. Each year, the written investment policy is approved by the board of directors.

Mergers and Acquisitions

As part of our operations, we have pursued an acquisition strategy over the years to augment our internal growth. We regularly evaluate the potential acquisition of various financial institutions. Our acquisitions have generally fallen into one of three categories: 1) an acquisition of a financial institution or branch thereof within a market in which we operate, 2) an acquisition of a financial institution or branch thereof in a market contiguous or nearly contiguous to a market in which we operate, or 3) an acquisition of a company that has products or services that we do not currently offer. Historically, we have paid for our acquisitions with cash and/or common stock and any operating income or loss has been fully borne by the Company beginning on the closing date of the acquisition.

Since becoming a public company in 1987, we have completed numerous acquisitions in each of the three categories described above. We have completed several whole-bank traditional acquisitions in our existing and contiguous markets; we have purchased numerous bank branches from other banks (both in existing market areas and in contiguous/nearly contiguous markets) and we have acquired several insurance agencies, which has provided us with the ability to offer property and casualty insurance coverage.

In 2009, FDIC-assisted acquisitions began to occur frequently as banking regulators closed problem banks. In FDIC-assisted transactions, the acquiring bank often does not pay any consideration for the failed bank, and in some cases receives cash from the FDIC as part of the transaction. In addition, the acquiring bank usually enters into one or more loss share agreements with the FDIC, which affords the acquiring bank significant loss protection. In both 2009 and 2011 we acquired the operations of failed banks in FDIC-assisted transactions. See the Company’s Annual Reports on Form 10-K for those years for more information on these acquisitions.

The following paragraphs describe the other acquisitions that we have completed in the past three years.

In January 2016, we acquired Bankingport, Inc., an insurance agency based in Sanford, North Carolina. Although not material to the Company’s consolidated operations, the acquisition provided us with the opportunity to enhance our product offerings, as well as expand our insurance agency operations into a significant banking market for our Company. Also this acquisition provides us a larger platform for leveraging insurance services throughout our bank branch network.

In May 2016, we completed the acquisition of SBA Complete. SBA Complete is a consulting firm that specializes in consulting with financial institutions across the country related to SBA loan origination and servicing. Many community banks do not have the in-house capability to comprehensively originate and service those types of loans, so they contract with SBA Complete for assistance. To learn more about this subsidiary of the Bank, please visit www.sbacomplete.com. Information included on our Internet site is not incorporated by reference into this annual report.

Soon after the acquisition of SBA Complete, we leveraged its capabilities by launching our own SBA loan origination division. Through a network of specialized First Bank loan officers, this division offers SBA loans to small business owners throughout the United States. We typically sell the portion of each loan that is guaranteed by the SBA at a premium and record the non-guaranteed portion to our balance sheet. To learn more about this division of our Bank, please visit www.firstbanksba.com. Information included on our Internet site is not incorporated by reference into this annual report.

In July 2016, we completed a branch exchange with First Community Bank, headquartered in Bluefield, Virginia. In the branch exchange transaction, we acquired six of First Community Bank’s branches located in North Carolina, while concurrently selling seven of our branches in the southwestern area of Virginia to First Community Bank. We entered Virginia in 2001 with a branch in Wytheville and had grown that presence to a total of seven branches.  The distant proximity to our core market and the opportunity to assume what is essentially a banking franchise in markets where we have recently invested in human capital were the primary factors we considered in entering into the exchange agreement.

In March 2017, we acquired Carolina Bank Holdings, Inc., the parent company of Carolina Bank, headquartered in Greensboro, North Carolina, with approximately $682 million in assets. Carolina Bank operated eight branches located in Greensboro, High Point, Burlington, Winston-Salem, and Asheboro, North Carolina and also operates three mortgage offices in North Carolina. The acquisition was a natural extension of our recent expansion into these high-growth areas.

In September 2017, we acquired Bear Insurance Services, an insurance agency based in Albemarle, North Carolina. Although not material to the Company’s consolidated operations, this acquisition provides us a larger platform for leveraging insurance services throughout our bank branch network.

In October 2017, we acquired ASB Bancorp, Inc., the parent company of Asheville Savings Bank, headquartered in Asheville, North Carolina, with approximately $798 million in assets. Asheville Savings Bank operated 13 branches in the Asheville and surrounding areas. The acquisition complemented our existing presence in this attractive and high-growth market.

There are many factors that we consider when evaluating how much to offer for potential acquisition candidates, with a few of the more significant factors being projected impact on earnings per share, projected impact on capital, and projected impact on book value and tangible book value. Significant assumptions that affect this analysis include the estimated future earnings stream of the acquisition candidate, estimated credit and other losses to be incurred, the amount of cost efficiencies that can be realized, and the interest rate earned/lost on the cash received/paid. In addition to these primary factors, we also consider other factors including (but not limited to) marketplace acquisition statistics, location of the candidate in relation to our expansion strategy, market growth potential, management of the candidate, potential integration issues (including corporate culture), and the size of the acquisition candidate.

We plan to continue to evaluate acquisition opportunities that could potentially benefit the Company and its shareholders. These opportunities may include acquisitions that do not fit the categories discussed above.

Employees

As of December 31, 2017, we had 1,114 full-time and 52 part-time employees. We are not a party to any collective bargaining agreements, and we consider our employee relations to be good.

Supervision and Regulation

As a bank holding company, we are subject to supervision, examination and regulation by the Federal Reserve and the North Carolina Office of the Commissioner of Banks (the “Commissioner”). The Bank is also subject to supervision and examination by the Federal Reserve and the Commissioner. For additional information, see Note 16 to the consolidated financial statements.

Supervision and Regulation of the Company

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended. The Company is also regulated by the Commissioner under the North Carolina Bank Holding Company Act of 1984.

A bank holding company is required to file quarterly reports and other information regarding its business operations and those of its subsidiaries with the Federal Reserve. It is also subject to examination by the Federal Reserve and is required to obtain Federal Reserve approval prior to making certain acquisitions of other institutions or voting securities. The Federal Reserve requires the Company to maintain certain levels of capital - see “Capital Resources and Shareholders’ Equity” under Item 7 below. The Federal Reserve also has the authority to take enforcement action against any bank holding company that commits any unsafe or unsound practice, or violates certain laws, regulations or conditions imposed in writing by the Federal Reserve. The Federal Reserve generally prohibits a bank holding company from declaring or paying a cash dividend that would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements which might adversely affect a

bank holding company’s financial position. Under the Federal Reserve policy, a bank holding company is not permitted to continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition.

The Commissioner is empowered to regulate certain acquisitions of North Carolina banks and bank holding companies, issue cease and desist orders for violations of North Carolina banking laws, and promulgate rules necessary to effectuate the purposes of those banking laws.

Regulatory authorities have cease and desist powers over bank holding companies and their nonbank subsidiaries where their actions would constitute a serious threat to the safety, soundness or stability of a subsidiary bank. Those authorities may compel holding companies to invest additional capital into banking subsidiaries upon acquisitions or in the event of significant loan losses or rapid growth of loans or deposits.

The United States Congress and the North Carolina General Assembly have periodically considered and adopted legislation that has impacted the Company.

Supervision and Regulation of the Bank

Federal banking regulations applicable to all depository financial institutions, among other things: (i) provide federal bank regulatory agencies with powers to prevent unsafe and unsound banking practices; (ii) restrict preferential loans by banks to “insiders” of banks; (iii) require banks to keep information on loans to major shareholders and executive officers; and (iv) bar certain director and officer interlocks between financial institutions.

As a state-chartered bank, the Bank is subject to the provisions of the North Carolina banking statutes and to regulation by the Commissioner. The Commissioner has a wide range of regulatory authority over the activities and operations of the Bank, and the Commissioner’s staff conducts periodic examinations of the Bank and its affiliates to ensure compliance with state banking laws and regulations and to assess the safety and soundness of the Bank. Among other things, the Commissioner regulates the merger of state-chartered banks, the payment of dividends, loans to officers and directors, recordkeeping, types and amounts of loans and investments, and the establishment of branches. The Commissioner also has cease and desist powers over state-chartered banks for violations of state banking laws or regulations and for unsafe or unsound conduct that is likely to jeopardize the interest of depositors.

The dividends that may be paid by the Bank to the Company are subject to legal limitations under North Carolina law. In addition, under Federal Reserve regulations, a dividend cannot be paid by the Bank if it would be less than well-capitalized after the dividend. The Federal Reserve may also prevent the payment of a dividend by the Bank if it determines that the payment would be an unsafe and unsound banking practice. The ability of the Company to pay dividends to its shareholders is largely dependent on the dividends paid to the Company by the Bank.

The Federal Reserve is authorized to approve conversions, mergers, and assumptions of deposit liability transactions between insured banks and uninsured banks or institutions, and to prevent capital or surplus diminution in such transactions if the resulting, continuing, or assumed bank is an insured member bank. First Bank is a member of the Federal Reserve System, and accordingly the Federal Reserve also conducts periodic examinations of the Bank to assess its safety and soundness and its compliance with banking laws and regulations, and it has the power to implement changes to, or restrictions on, the Bank’s operations if it finds that a violation is occurring or is threatened. In addition, the Federal Reserve monitors the Bank’s compliance with several banking statutes, such as the Depository Institution Management Interlocks Act and the Community Reinvestment Act of 1977.

Small Business Lending Fund

In December 2010, the U.S. Treasury announced the creation of the Small Business Lending Fund (“SBLF”) program, which was established under the Small Business Jobs Act of 2010. The SBLF was created to encourage lending to small businesses by providing capital to qualified community banks at favorable rates.

Interested financial institutions were required to submit an application and a small business lending plan. Less than half of the financial institutions that applied for the SBLF were approved. We were one of the institutions approved, and on September 1, 2011, we completed the sale of $63.5 million of Series B Preferred Stock to the Treasury under the SBLF (“SBLF stock”). The initial dividend rate on SBLF stock was 5%. The terms of the stock provided that our dividend rate could decrease to as low as 1% for a period of time depending on our success in meeting certain loan growth targets to small businesses. Based on our increases in small business lending, we achieved the minimal dividend rate of 1% as of March 31, 2013. The increase in the amount of small business loans remained at a level corresponding to a 1% dividend rate at September 30, 2013, at which point the terms of the preferred stock provided that the dividend rate remained fixed until March 1, 2016. On March 1, 2016, the contractual dividend rate was set to increase to 9%. The Company redeemed $32 million of the SBLF stock in June 2015 and the remaining $31.5 million in October 2015, which ended our participation in the SBLF. See Note 19 to the consolidated financial statements for more information.

FDIC Insurance

As a member of the FDIC, the Bank’s deposits are insured by the FDIC up to a maximum amount, which is currently $250,000 per depositor. For this protection, each insured bank pays a quarterly statutory assessment (which is currently based on average total assets less average tangible equity) and is subject to the rules and regulations of the FDIC.

We recognized approximately $2.4 million, $2.0 million, and $2.4 million in FDIC insurance expense in 2017, 2016, and 2015, respectively. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments related to outstanding FICO bonds. As discussed in more detail below related to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), on April 26, 2016, the FDIC adopted a final rule that changed the way banks with less than $10 billion in assets would be assessed FDIC insurance once the Deposit Insurance Fund (“DIF”) reached a ratio of 1.15%. The DIF reached 1.15% at June 30, 2016 and thus the rule was triggered. Accordingly, the Bank’s FDIC insurance expense assessment methodology changed in the second half of 2016 and resulted in a decrease in the Bank’s FDIC insurance expense of approximately 25% compared to the prior rate, or $550,000 annually. In 2017, our FDIC insurance expense increased due to the acquisitions of Carolina Bank and Asheville Savings Bank.

Legislative and Regulatory Developments

The most significant recent legislative and regulatory developments impacting the Company are discussed below.

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

On July 21, 2010, the Dodd-Frank Act became law. The Dodd-Frank Act has had and will continue to have a broad impact on the financial services industry, including significant regulatory and compliance changes including, among other things,

In addition, the Dodd-Frank Act established a new framework for systemic risk oversight within the financial system that will be enforced by new and existing federal regulatory agencies, including the Financial Stability Oversight Council (“FSOC”), the Federal Reserve, the Office of Comptroller of the Currency, the FDIC, and the Consumer Financial Protection Bureau. The following description briefly summarizes aspects of the Dodd-Frank Act that could impact the Company, both currently and prospectively.

Deposit Insurance.  The Dodd-Frank Act made permanent the $250,000 deposit insurance limit for insured deposits, which was an increase from the previous limit of $100,000. Amendments to the Federal Deposit Insurance Act also revised the assessment base against which an insured depository institution’s deposit insurance premiums paid to the FDIC’s DIF will be calculated. Under the amendments, which became effective on April 1, 2011, the FDIC assessment base is no longer the institution’s deposit base, but rather its average consolidated total assets less its average tangible equity. The Dodd-Frank Act also changed the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15% to 1.35% of the estimated amount of total insured deposits, and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds by September 30, 2020. On April 26, 2016, the FDIC adopted a final rule that would change the way banks with less than $10 billion in assets are assessed FDIC insurance once the DIF reaches a ratio of 1.15%. It was estimated that the change would lower assessment rates for a significant majority of banks with less than $10 billion in total assets. The DIF reached 1.15% at June 30, 2016 and thus the rule was triggered. Accordingly, the Bank’s FDIC insurance expense assessment methodology changed in the second half of 2016. For the Bank, the changes resulted in a decrease in FDIC insurance expense of approximately 25% compared to the prior rate, or $550,000 annually.

Trust Preferred Securities.  The Dodd-Frank Act prohibits bank holding companies from including in their regulatory Tier I capital hybrid debt and equity securities issued on or after May 19, 2010. Among the hybrid debt and equity securities included in this prohibition are trust preferred securities, which we have issued in the past in order to raise additional Tier I capital and otherwise improve our regulatory capital ratios. Although we may continue to include our existing trust preferred securities as Tier I capital because they were issued prior to May 19, 2010, the prohibition on the use of these securities as Tier I capital may limit our ability to raise capital in the future.

The Consumer Financial Protection Bureau. The Dodd-Frank Act created a new, independent federal agency called the Consumer Financial Protection Bureau (“CFPB”), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Depository institutions with less than $10 billion in assets, such as the Bank, are subject to rules promulgated by the CFPB but are examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products.

The Dodd-Frank Act also authorized the CFPB to establish certain minimum standards for the origination of residential mortgages, including a determination of the borrower's ability to repay. Among other things, the rules adopted by the CFPB require banks to: (i) develop and implement procedures to ensure compliance with a “reasonable ability to repay” test and identify whether a loan meets a new definition for a “qualified mortgage,” in which case a rebuttable presumption exists that the creditor extending the loan has satisfied the reasonable ability to repay test; (ii) implement new or revised disclosures, policies and procedures for originating and servicing mortgages including, but not limited to, pre-loan counseling, early intervention with delinquent borrowers and specific loss mitigation procedures for loans secured by a borrower's principal residence; (iii) comply with additional restrictions on mortgage loan originator hiring and compensation; (iv) comply with new disclosure requirements and standards for appraisals and certain financial products; and (v) maintain escrow accounts for higher-priced mortgage loans for a longer period of time. It is our policy not to make predatory loans and to determine borrowers’ ability to repay, but the law and related rules create the potential for increased liability with respect to our lending and loan investment activities. They increase our cost of doing business and ultimately, may prevent us from making certain loans and cause us to reduce the average percentage rate or the points and fees on loans that we do make.

The Dodd-Frank Act also permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorney generals to enforce compliance with both the state and federal laws and regulations. Compliance with any such new regulations established by the CFPB and/or states could reduce our revenue, increase our cost of operations, and limit our ability to expand into certain products and services.

Debit Card Interchange Fees.  The Dodd-Frank Act gave the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer. Effective October 1, 2011, the Federal Reserve set new caps on interchange fees at $0.21 per transaction, plus an additional five basis-point charge per transaction to help cover fraud losses. An additional $0.01 per transaction is allowed if certain fraud-monitoring controls are in place. While we are not directly subject to these rules so long as our assets do not exceed $10 billion, our activities as a debit card issuer may nevertheless be indirectly impacted by the change in the applicable debit card market caused by these regulations, which may require us to match any new lower fee structure implemented by larger financial institutions in order to remain competitive in the future. Nevertheless, to date, the Company has not noted any significant indirect negative effects of the interchange fee caps that are applicable to the larger financial institutions.

Increased Capital Standards and Enhanced Supervision.  The Dodd-Frank Act required the federal banking agencies to establish minimum leverage and risk-based capital requirements for banks and bank holding companies. These new standards are to be no less strict than existing regulatory capital and leverage standards applicable to insured depository institutions and may, in fact, become higher once the agencies promulgate the new standards. Compliance with heightened capital standards may reduce our ability to generate or originate revenue-producing assets and thereby restrict revenue generation from banking and non-banking operations. See discussion of the new capital requirements established by the federal banking agencies under “Recent Amendments to Regulatory Capital Requirement under Basel III” below.

Transactions with Affiliates.  The Dodd-Frank Act enhances the requirements for certain transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions,” and an increase in the amount of time for which collateral requirements regarding covered transactions must be maintained.

Transactions with Insiders.  The Dodd-Frank Act expands insider transaction limitations through the strengthening of loan restrictions to insiders and the expansion of the types of transactions subject to the various limits, including derivative transactions, repurchase agreements, reverse repurchase agreements and securities lending and borrowing transactions. The Dodd-Frank Act also places restrictions on certain asset sales to and from an insider of an institution, including requirements that such sales be on market terms and, in certain circumstances, receive the approval of the institution’s board of directors.

Enhanced Lending Limits.  The Dodd-Frank Act strengthens the existing limits on a depository institution’s credit exposure to one borrower. Federal banking law limits a national bank’s ability to extend credit to one person or group of related persons to an amount that does not exceed certain thresholds. The Dodd-Frank Act expands the scope of these restrictions to include credit exposure arising from derivative transactions, repurchase agreements and securities lending and borrowing transactions. It also will eventually prohibit state-chartered banks, including the Bank, from engaging in derivative transactions unless the state lending limit laws take into account credit exposure to such transactions.

Corporate Governance.  The Dodd-Frank Act addresses many corporate governance and executive compensation matters that affects most U.S. publicly traded companies, including the Company. The Dodd-Frank Act:

The Volcker Rule. Section 619 of the Dodd-Frank Act, known as the “Volcker Rule,” prohibits any bank, bank holding company, or affiliate (referred to collectively as “banking entities”) from engaging in two types of activities: “proprietary trading” and the ownership or sponsorship of private equity or hedge funds that are referred to as “covered funds.” Proprietary trading is, in general, trading in securities on a short-term basis for a banking entity's own account. Funds subject to the ownership and sponsorship prohibition are those not required to register with the Securities and Exchange Commission because they have only accredited investors or no more than 100 investors. In December 2013, our primary federal regulator, the Federal Reserve, together with other federal banking agencies, the FDIC, the SEC and the Commodity Futures Trading Commission, finalized a regulation to implement the Volcker Rule. In January 2014, the same agencies adopted interim final regulations that permitted certain banking entities to retain several types of investment that were to otherwise be prohibited under the Volcker Rule. The Volcker Rule became effective in July 2015, with staggered dates in effect for banks to exit prohibited investments. The Company has evaluated our securities portfolio and has determined that we do not hold any covered funds.

Many of the requirements of the Dodd-Frank Act remain subject to implementation over the course of several years. While we do not currently expect the final requirements of the Dodd-Frank Act to have a material adverse impact on the Company, we do expect them to negatively impact our profitability, require changes to certain of our business practices, including limitations on fee income opportunities, and impose more stringent capital, liquidity and leverage requirements upon the Company. These changes may also require us to invest significant management attention and resources to evaluate and make any changes necessary to comply with the new statutory and regulatory requirements.

Incentive Compensation. The Dodd-Frank Act requires the federal bank regulators and the SEC to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities having at least $1 billion in total assets that encourage inappropriate risks by providing an executive officer, employee, director or principal stockholder with excessive compensation, fees, or benefits or that could lead to material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure to regulators of incentive-based compensation arrangements. The agencies proposed such regulations in April 2011. However, the 2011 proposal was replaced with a new proposal in May 2016, which makes explicit that the involvement of risk management and control personnel includes not only compliance, risk management and internal audit, but also legal, human resources, accounting, financial reporting and finance roles responsible for identifying, measuring, monitoring or controlling risk-taking. A final rule had not been adopted as of December 31, 2017.

In June 2010, the Federal Reserve, along with other bank regulatory agencies, issued a comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

Regulatory Capital Requirement under Basel III

In July 2013, the federal banking agencies approved amendments to their regulatory capital rules to conform U.S. regulatory capital rules with the international regulatory standards agreed to by the Basel Committee on Banking Supervision in the accord referred to as “Basel III.” The revisions established new higher capital ratio requirements, narrowed the definitions of capital, imposed new operating restrictions on banking organizations with insufficient capital buffers and increased the risk weighting of certain assets. The new capital requirements applied to all banks,

savings associations, bank holding companies with more than $1 billion in total consolidated assets, such as the Company and the Bank, and all savings and loan holding companies regardless of asset size. The rules became effective for institutions with assets over $250 billion and internationally active institutions in January 2014 and became effective for all other institutions in January 2015. The following discussion summarizes the changes that had the most effect on the Company and the Bank.

The regulations also increased the required ratio of Tier I Capital to risk-weighted assets from 4% to 6% effective January 1, 2015. Tier I Capital consists of Common Equity Tier I Capital plus Additional Tier I Capital which includes non-cumulative perpetual preferred stock. Cumulative preferred stock (other than cumulative preferred stock issued to the Treasury under the TARP Capital Purchase Program or the Small Business Lending Fund) no longer qualifies as Additional Tier I Capital. Trust preferred securities and other non-qualifying capital instruments issued prior to May 19, 2010 by bank and thrift holding companies with less than $15 billion in assets as of December 31, 2009, such as the Company, may continue to be included in Tier I Capital, but these instruments will be phased out over 10 years beginning in 2016 for all other banking organizations. These non-qualified capital instruments, however, may be included in Tier II Capital which could also include qualifying subordinated debt.

associated deferred tax liability, are now deducted from Common Equity Tier I Capital unless the banking organization has unrestricted and unfettered access to such assets. Reciprocal cross-holdings of capital instruments in any other financial institutions are now deducted from capital, not just holdings in other depository institutions.  For this purpose, financial institutions are broadly defined to include securities and commodities firms, hedge and private equity funds and non-depository lenders. Banking organizations are now also required to deduct non-significant investments (less than 10% of outstanding stock) in other financial institutions to the extent these exceed 10% of Common Equity Tier I Capital subject to a 15% of Common Equity Tier I Capital cap.  Greater than 10% investments must be deducted if they exceed 10% of Common Equity Tier I Capital.  If the aggregate amount of certain items excluded from capital deduction due to a 10% threshold exceeds 17.65% of Common Equity Tier I Capital, the excess must be deducted. 

The final rules became effective for the Company and the Bank on January 1, 2015.

We believe that both the Company and the Bank will continue to meet all capital adequacy requirements under the fully phased-in final rules.

See “Capital Resources and Shareholders’ Equity” under Item 7 below for further discussion of regulatory capital requirements.

Liquidity Requirements

Historically, the regulation and monitoring of bank and bank holding company liquidity has been addressed as a supervisory matter, without required formulaic measures. Liquidity risk management has become increasingly important since the 2008 financial crisis. The Basel III liquidity framework requires banks and bank holding companies to measure their liquidity against specific liquidity tests that, although similar in some respects to liquidity measures historically applied by banks and regulators for management and supervisory purposes, going forward would be required by regulation. One test, referred to as the liquidity coverage ratio (“LCR”), is designed to ensure that the banking entity maintains an adequate level of unencumbered high-quality liquid assets equal to the entity’s expected net cash outflow for a 30-day time horizon (or, if greater, 25% of its expected total cash outflow) under an acute liquidity stress scenario. The other test, referred to as the net stable funding ratio (“NSFR”), is designed to promote more medium- and long-term funding of the assets and activities of banking entities over a one-year time horizon. These requirements will incent banking entities to increase their holdings of Treasury securities and other sovereign debt as a component of assets and increase the use of long-term debt as a funding source.

In September 2014, the federal bank regulators approved final rules implementing the LCR for advanced approaches banking organizations (i.e., banking organizations with $250 billion or more in total consolidated assets or $10 billion or more in total on-balance sheet foreign exposure) and a modified version of the LCR for bank holding companies with at least $50 billion in total consolidated assets that are not advanced approach banking organizations, neither of

which would apply to the Company or the Bank. The federal bank regulators have not yet proposed rules to implement the NSFR or addressed the scope of bank organizations to which it will apply.

Financial Privacy and Cybersecurity

The federal banking regulators have adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to non-affiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a non-affiliated third party. These regulations affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. In addition, consumers may also prevent disclosure of certain information among affiliated companies that is assembled or used to determine eligibility for a product or service, such as that shown on consumer credit reports and asset and income information from applications. Consumers also have the option to direct banks and other financial institutions not to share information about transactions and experiences with affiliated companies for the purpose of marketing products or services.

In March 2015, federal regulators issued two related statements regarding cybersecurity. One statement indicates that financial institutions should design multiple layers of security controls to establish lines of defense and to ensure that their risk management processes also address the risk posed by compromised customer credentials, including security measures to reliably authenticate customers accessing Internet-based services of the financial institution. The other statement indicates that a financial institution’s management is expected to maintain sufficient business continuity planning processes to ensure the rapid recovery, resumption and maintenance of the institution’s operations after a cyber-attack involving destructive malware. A financial institution is also expected to develop appropriate processes to enable recovery of data and business operations and address rebuilding network capabilities and restoring data if the institution or its critical service providers fall victim to this type of cyber-attack. The Company has multiple Information Security Programs that reflect the requirements of this guidance. If, however, we fail to observe the regulatory guidance in the future, we could be subject to various regulatory sanctions, including financial penalties.

Anti-Money Laundering and the USA Patriot Act

A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations on financial institutions, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States.

On May 11, 2016, the Financial Crimes Enforcement Network (“FinCEN”) issued new anti-money laundering (“AML”) rules governing corporate entities doing business with banks and other financial institutions that are subject to the requirements of the USA Patriot Act. The AML rules impose significant due diligence obligations on financial institutions with respect to opening of new accounts and the monitoring of existing accounts. Under the AML rules, a financial institution must identify persons owning or controlling 25% or more of a “legal entity,” whenever the legal entity opens a new account at the bank. The financial institution must also identify an individual who has substantial management authority at the legal entity, such as a CEO, CFO, or managing partner. These new AML rules become effective in May 2018.

The AML rules codify within the FinCEN regulations the “pillars” that must be included in a financial institutions AML compliance program. Regulators previously communicated their expectations with respect to four of these pillars: (1) the development of internal policies, procedures, and control; (2) the designation of a compliance officer; (3) the establishment of an ongoing employee training program; and (4) the implementation of an independent audit function to test programs. The new beneficial ownership requirement establishes a fifth pillar. Among other things, this new pillar includes the necessity to monitor and update the beneficial ownership of a legal entity, including the need to subject corporate borrowers to due diligence requests from financial institutions for certifications with

respect to their beneficial owners. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution, including causing applicable bank regulatory authorities not to approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required.

Office of Foreign Assets Control Regulation

The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others which are administered by the U.S. Treasury Department Office of Foreign Assets Control (“OFAC”). Failure to comply with these sanctions could have serious legal and reputational consequences, including causing applicable bank regulatory authorities not to approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required.

Tax Cuts and Jobs Act

U.S. tax reform legislation was signed into law in December 2017 and made broad and complex changes to the U.S. Internal Revenue Code. The primary impact on our 2017 financial results was associated with the effect of reducing the U.S. statutory tax rate from 35% to 21% on our deferred tax balances as of December 31, 2017. We were in a net deferred tax liability position at December 31, 2017 and recorded a $1.3 million benefit in the fourth quarter by lowering the net deferred liability and reducing income tax expense by the $1.3 million amount in the fourth quarter of 2017.

Beginning January 1, 2018, we will apply a federal tax rate of 21% to our taxable earnings. Other provisions of U.S. tax reform not effective until January 1, 2018, include, but are not limited to: 1) provisions reducing the dividends received deduction; 2) essentially eliminating U.S. federal income taxes on dividends from foreign subsidiaries; 3) retaining an element of current inclusion of certain earnings of controlled foreign corporations; 4) eliminating the corporate alternative minimum tax ("AMT") and 5) changing how existing AMT credits will be realized. Although we continue to evaluate the impact of the tax reform, we don’t expect the changes, other than the change in the statutory tax rate, will significantly impact our Company.

Neither the Company nor the Bank can predict what other legislation might be enacted or what other regulations or assessments might be adopted.

Available Information

We maintain a corporate Internet site at www.LocalFirstBank.com, which contains a link within the “Investor Relations” section of the site to each of our filings with the Securities and Exchange Commission, including our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. These filings are available, free of charge, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. These filings can also be accessed at the Securities and Exchange Commission’s website located at www.sec.gov. Information included on our Internet site is not incorporated by reference into this annual report.

Item 1A. Risk Factors

An investment in our common stock involves certain risks. Before you invest in our common stock, you should be aware that there are various risks, including those described below, which could affect the value of your investment in the future. The trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment. The risk factors described in this section, as well as any cautionary language in this report, provide examples of risks, uncertainties and events that could have a material adverse effect on our business, including our operating results and financial condition. In addition to the risks and uncertainties described below, other risks and uncertainties not currently known to us, or that we currently deem to be immaterial, also may materially or adversely affect our business, financial condition, and results of operations. The value or market price of our common stock could decline due to any of these identified or other unidentified risks.

Unfavorable economic conditions could adversely affect our business.

Our business is subject to periodic fluctuations based on national, regional and local economic conditions. These fluctuations are not predictable, cannot be controlled, and may have a material adverse impact on our operations and financial condition. Our banking operations are primarily locally oriented and community-based. Our retail and commercial banking activities are primarily concentrated within the same geographic footprint. Our markets include most of North Carolina and parts of South Carolina. Worsening economic conditions within our markets could have a material adverse effect on our financial condition, results of operations and cash flows. Accordingly, we expect to continue to be dependent upon local business conditions as well as conditions in the local residential and commercial real estate markets we serve. Unfavorable changes in unemployment, real estate values, interest rates and other factors could weaken the economies of the communities we serve. In recent years, economic growth and business activity across a wide range of industries has been slow and uneven and there can be no assurance that economic conditions will continue to improve, and these conditions could worsen. In addition, oil price volatility, the level of U.S. debt and global economic conditions have had a destabilizing effect on financial markets. Weakness in any of our market areas could have an adverse impact on our earnings, and consequently our financial condition and capital adequacy.

If our goodwill becomes impaired, we may be required to record a significant charge to earnings.

We have goodwill recorded on our balance sheet as an asset with a carrying value as of December 31, 2017 of $233.1 million. Under generally accepted accounting principles, goodwill is required to be tested for impairment at least annually and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.  The test for goodwill impairment involves comparing the fair value of a company’s reporting units to their respective carrying values.  We have three reporting units – 1) First Bank with $221.4 million in goodwill, 2) First Bank Insurance with $7.4 million in goodwill, and 3) SBA activities, including SBA Complete and our SBA lending division, with $4.3 million in goodwill. The price of our common stock is one of several factors available for estimating the fair value of our reporting units and is most closely associated with our First Bank reporting unit. Subject to the results of other valuation techniques, if the price of our common stock falls below book value, it could indicate that a portion of our goodwill is impaired.  Accordingly, for this reason or other reasons that indicate that the goodwill at any of our reporting units is impaired, we may be required to record a significant charge to earnings in our financial statements during the period in which any impairment of our goodwill is determined, which could have a negative impact on our results of operations.

New capital rules that became effective in 2015 generally require insured depository institutions and their holding companies to hold more capital. The impact of the new rules on our financial condition and operations is uncertain but could be materially adverse.

On January 1, 2015, new rules under Basel III that substantially amended the regulatory risk-based capital rules applicable to the Company and the Bank became effective. These new rules will be fully phased in by January 1, 2019.

The rules include certain new and higher risk-based capital and leverage requirements than those previously in place. Specifically, the following minimum capital requirements apply to us at December 31, 2017:

In general, the rules have had the effect of increasing capital requirements by increasing the risk weights on certain assets, including high volatility commercial real estate, certain loans past due 90 days or more or in nonaccrual status, mortgage servicing rights not includable in common equity tier 1 capital, equity exposures, and claims on securities firms, that are used in the denominator of the three risk-based capital ratios.

In addition, in the current economic and regulatory environment, bank regulators may impose capital requirements that are more stringent than those required by applicable existing regulations. The application of more stringent capital requirements for us could, among other things, result in lower returns on equity, require the raising of additional capital, and result in regulatory actions if we were to be unable to comply with such requirements. Implementation of changes to asset risk weightings for risk-based capital calculations, items included or deducted in calculating regulatory capital or additional capital conservation buffers, could result in management modifying our business strategy and could limit our ability to make distributions, including paying dividends or buying back our shares.

We might be required to raise additional capital in the future, but that capital may not be available or may not be available on terms acceptable to us when it is needed.

We are required to maintain adequate capital levels to support our operations. In the future, we might need to raise additional capital to support growth, absorb loan losses, or meet more stringent capital requirements. Our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot be certain of our ability to raise additional capital in the future if needed or on terms acceptable to us. If we cannot raise additional capital when needed, our ability to conduct our business could be materially impaired.

We may issue additional shares of stock or equity derivative securities that will dilute the percentage ownership interest of existing shareholders and may dilute the book value per share of our common stock and adversely affect the terms on which we may obtain additional capital.

Our authorized capital includes 40,000,000 shares of common stock and 5,000,000 shares of preferred stock. As of December 31, 2017, we had 29,639,374 shares of common stock outstanding and had reserved for issuance 38,689 shares underlying options that are or may become exercisable at an average price of $16.09 per share. In addition, as of December 31, 2017, we had the ability to issue 809,690 shares of common stock pursuant to options and restricted stock under our existing equity compensation plans and 261,446 contingently issuable shares that are tied to performance goals associated with a corporate acquisition.

Subject to applicable NASDAQ rules, our board generally has the authority, without action by or vote of the shareholders, to issue all or part of any authorized but unissued shares of stock for any corporate purpose. Such corporate purposes could include, among other things, issuances of equity-based incentives under or outside of our equity compensation plans, issuances of equity in business combination transactions, and issuances of equity to raise additional capital to support growth or to otherwise strengthen our balance sheet. Any issuance of additional shares of stock or equity derivative securities will dilute the percentage ownership interest of our shareholders and may dilute the book value per share of our common stock. Shares we issue in connection with any such offering will increase the total number of outstanding shares and may dilute the economic and voting ownership interest of our existing shareholders.

The soundness of other financial institutions could adversely affect us.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services companies are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, and investment banks. Defaults by, or even rumors or questions about, one or more financial services companies, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. We can make no assurance that any such losses would not materially and adversely affect our business, financial condition or results of operations.

We are subject to extensive regulation, which could have an adverse effect on our operations.

We are subject to extensive regulation and supervision from the North Carolina Commissioner of Banks and the Federal Reserve. This regulation and supervision is intended primarily for the protection of the FDIC insurance fund and our depositors and borrowers, rather than for holders of our equity securities. In the past, our business has been materially affected by these regulations. This trend is likely to continue in the future.

Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on operations, the classification of our assets and the determination of the level of allowance for loan losses. Changes in the regulations that apply to us, or changes in our compliance with regulations, could have a material impact on our operations.

Financial reform legislation enacted by the U.S. Congress, and further changes in regulation to which we are exposed, will result in additional new laws and regulations that are expected to increase our costs of operations.

The Dodd-Frank Act has and will continue to significantly change bank regulatory structure and affect lending, deposit, investment, and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting and implementing the rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years. See “Legislative and Regulatory Developments – Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010” above for additional information regarding the Dodd-Frank Act.

The Dodd-Frank Act also created the CFPB and gave it broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. Additionally, the CFPB has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets.

Proposals for further regulation of the financial services industry are continually being introduced in the United States Congress. The agencies regulating the financial services industry also periodically adopt changes to their regulations. It is possible that additional legislative proposals may be adopted or regulatory changes may be made that would have an adverse effect on our business. In addition, it is expected that such regulatory changes will increase our operating and compliance cost. We can provide no assurance regarding the manner in which new laws and regulations will affect us.

We are subject to interest rate risk, which could negatively impact earnings.

Net interest income is the most significant component of our earnings. Our net interest income results from the difference between the yields we earn on our interest-earning assets, primarily loans and investments, and the rates that we pay on our interest-bearing liabilities, primarily deposits and borrowings. When interest rates change, the yields we earn on our interest-earning assets and the rates we pay on our interest-bearing liabilities do not necessarily move in tandem with each other because of the difference between their maturities and repricing

characteristics. This mismatch can negatively impact net interest income if the margin between yields earned and rates paid narrows. Interest rate environment changes can occur at any time and are affected by many factors that are outside our control, including inflation, recession, unemployment trends, the Federal Reserve’s monetary policy, domestic and international disorder and instability in domestic and foreign financial markets.

Our allowance for loan losses may not be adequate to cover actual losses.

Like all financial institutions, we maintain an allowance for loan losses to provide for probable losses caused by customer loan defaults. The allowance for loan losses may not be adequate to cover actual loan losses, and in this case additional and larger provisions for loan losses would be required to replenish the allowance. Provisions for loan losses are a direct charge against income.

We establish the amount of the allowance for loan losses based on historical loss rates, as well as estimates and assumptions about future events. Because of the extensive use of estimates and assumptions, our actual loan losses could differ, possibly significantly, from our estimate. We believe that our allowance for loan losses is adequate to provide for probable losses, but it is possible that the allowance for loan losses will need to be increased for credit reasons or that regulators will require us to increase this allowance. Either of these occurrences could materially and adversely affect our earnings and profitability.

In addition, the measure of our allowance for loan losses is dependent on the adoption of new accounting standards. The Financial Accounting Standards Board issued an Accounting Standards Update related to a new credit impairment model, the Current Expected Credit Loss ("CECL") model, which will become effective on January 1, 2020 for the Company. This new model requires financial institutions to estimate and develop a provision for credit losses at origination for the lifetime of the loan, as opposed to reserving for probable incurred losses up to the balance sheet date. Under the CECL model, credit deterioration will be reflected in the income statement in the period of origination or acquisition of the loan, with changes in expected credit losses due to further credit deterioration or improvement reflected in the periods in which the expectation changes. Accordingly, the CECL model will likely require financial institutions like the Company to increase their allowances for loan losses. Moreover, the CECL model will likely create more volatility in our level of allowance for loan losses.

We may make future acquisitions, which could dilute current shareholders’ stock ownership and expose us to additional risks.

In accordance with our strategic plan, we evaluate opportunities to acquire other banks and branch locations to expand the Company. As a result, we may engage in acquisitions and other transactions that could have a material effect on our operating results and financial condition, including short and long-term liquidity. Our acquisition activities could require us to issue a significant number of shares of common stock or other securities and/or to use a substantial amount of cash, other liquid assets, and/or incur debt. In addition, if goodwill recorded in connection with our potential future acquisitions were determined to be impaired, then we would be required to recognize a charge against our earnings, which could materially and adversely affect our results of operations during the period in which the impairment was recognized.

Our acquisition activities could involve a number of additional risks, some of which are described in more detail elsewhere in this report and include:

If we do not successfully manage these risks, our acquisition activities could have a material adverse effect on our operating results and financial condition, including short- and long-term liquidity.

Future acquisitions may be delayed, impeded, or prohibited due to regulatory issues.

Future acquisitions by the Company, particularly those of financial institutions, are subject to approval by a variety of federal and state regulatory agencies (collectively, “regulatory approvals”). The process for obtaining these required regulatory approvals has become substantially more difficult in recent years. Regulatory approvals could be delayed, impeded, restrictively conditioned or denied due to existing or new regulatory issues we have, or may have, with regulatory agencies, including, without limitation, issues related to anti-money laundering/Bank Secrecy Act compliance, fair lending laws, fair housing laws, consumer protection laws, unfair, deceptive, or abusive acts or practices regulations, Community Reinvestment Act issues, and other similar laws and regulations. We may fail to pursue, evaluate or complete strategic and competitively significant acquisition opportunities as a result of our inability, or perceived or anticipated inability, to obtain regulatory approvals in a timely manner, under reasonable conditions or at all. Difficulties associated with potential acquisitions that may result from these factors could have a material adverse effect on our business, and, in turn, our financial condition and results of operations.

We may be exposed to difficulties in combining the operations of acquired businesses into our own operations, which may prevent us from achieving the expected benefits from our acquisition activities.

We may not be able to fully achieve the strategic objectives and operating efficiencies that we anticipate in our acquisition activities. Inherent uncertainties exist in integrating the operations of an acquired business. In addition, the markets and industries in which the Company and our potential acquisition targets operate are highly competitive. We may lose customers or the customers of acquired entities as a result of an acquisition. We also may lose key personnel from the acquired entity as a result of an acquisition. We may not discover all known and unknown factors when examining a company for acquisition during the due diligence period. These factors could produce unintended and unexpected consequences for us. Undiscovered factors as a result of acquisition, pursued by non-related third party entities, could bring civil, criminal, and financial liabilities against us, our management, and the management of those entities acquired. These factors could contribute to the Company not achieving the expected benefits from its acquisitions within desired time frames.

In the normal course of business, we process large volumes of transactions involving millions of dollars. If our internal controls fail to work as expected, if our systems are used in an unauthorized manner, or if our employees subvert our internal controls, we could experience significant losses.

We process large volumes of transactions on a daily basis and are exposed to numerous types of operational risk. Operational risk includes the risk of fraud by persons inside or outside the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems and breaches of the internal control system and compliance requirements. This risk also includes potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards.

We establish and maintain systems of internal operational controls that provide us with timely and accurate information about our level of operational risk. Although not foolproof, these systems have been designed to manage operational risk at appropriate, cost-effective levels. Procedures exist that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. From time to time, losses from operational risk may occur, including the effects of operational errors. We continually monitor and improve our internal controls, data processing systems, and corporate-wide processes and procedures, but there can be no assurance that future losses will not occur.

We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.

The federal Bank Secrecy Act, the Patriot Act and other laws and regulations require financial institutions, among other duties, to institute and maintain effective anti-money laundering programs and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network, established by the Treasury to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration and Internal Revenue Service. There is also increased scrutiny of compliance with the rules enforced by the OFAC. Federal and state bank regulators also have begun to focus on compliance with Bank Secrecy Act and anti-money laundering regulations. If our policies, procedures and systems are deemed deficient or the policies, procedures and systems of the financial institutions that we have already acquired or may acquire in the future are deficient, we would be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plan, including our acquisition plans, which would negatively impact our business, financial condition and results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.

Federal, state and local consumer lending laws restrict our ability to originate certain mortgage loans and increase our risk of liability with respect to such loans and increase our cost of doing business.

Federal, state and local laws have been adopted that are intended to eliminate certain lending practices considered “predatory.” These laws prohibit practices such as steering borrowers away from more affordable products, selling unnecessary insurance to borrowers, repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans irrespective of the value of the underlying property. Over the past several years, the CFPB issued several rules on mortgage lending, notably a rule requiring all home mortgage lenders to determine a borrower’s ability to repay the loan. Loans with certain terms and conditions and that otherwise meet the definition of a “qualified mortgage” may be protected from liability to a borrower for failing to make the necessary determinations. We may find it necessary to tighten our mortgage loan underwriting standards in response to the CFPB rules, which may constrain our ability to make loans consistent with our business strategies. It is our policy not to make predatory loans and to determine borrowers’ ability to repay, but the law and related rules create the potential for increased liability with respect to our lending and loan investment activities. They increase our cost of doing business and, ultimately, may prevent us from making certain loans and cause us to reduce the average percentage rate or the points and fees on loans that we do make.

We are subject to federal and state fair lending laws, and failure to comply with these laws could lead to material penalties.

Federal and state fair lending laws and regulations, such as the Equal Credit Opportunity Act and the Fair Housing Act, impose nondiscriminatory lending requirements on financial institutions. The Department of Justice, CFPB and other federal and state agencies are responsible for enforcing these laws and regulations. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation. A successful challenge to our performance under the fair lending laws and regulations could adversely impact our rating under the Community Reinvestment Act and result in a wide variety of sanctions, including the required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on or delays in approving merger and acquisition activity and restrictions on expansion activity, which could negatively impact our reputation, business, financial condition and results of operations.

Negative public opinion regarding our Company and the financial services industry in general, could damage our reputation and adversely impact our earnings.

Reputation risk, or the risk to our business, earnings and capital from negative public opinion regarding our Company and the financial services industry in general, is inherent in our business. Negative public opinion can result from actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep and attract clients and employees and can expose us to litigation and regulatory action. Although we have taken steps to minimize reputation risk in dealing with our clients and communities, this risk will always be present given the nature of our business.

We could experience a loss due to competition with other financial institutions.

We face substantial competition in all areas of our operations from a variety of different competitors, both within and beyond our principal markets, many of which are larger and may have more financial resources. Such competitors primarily include national, regional and internet banks within the various markets in which we operate. We also face competition from many other types of financial institutions, including, without limitation, thrifts, credit unions, finance companies, brokerage firms, insurance companies and other financial intermediaries, such as online lenders and banks. The financial services industry could become even more competitive as a result of legislative and regulatory changes and continued consolidation. In addition, as customer preferences and expectations continue to evolve, technology has lowered barriers to entry and made it possible for nonbanks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can.

Our ability to compete successfully depends on a number of factors, including, among other things:

Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability, which, in turn, could have a material adverse effect on our financial condition and results of operations.

Failure to keep pace with technological change could adversely affect our business.

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.

New lines of business or new products and services may subject us to additional risk.

From time to time, we may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services, we may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business and/or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business and/or new products or services could have a material adverse effect on our business and, in turn, our financial condition and results of operations.

In May 2016, we completed the acquisition of SBA Complete. SBA Complete is a consulting firm that specializes in consulting with financial institutions across the country related to SBA loan origination and servicing. We leveraged the expertise assumed in the acquisition of SBA Complete to launch our own SBA lending division in the third quarter of 2016. These are both relatively new lines of business for the Bank with unique operational, control and accounting risks, which if not properly managed, could result in losses for our Company.

Consumers may decide not to use banks to complete their financial transactions.

Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

Our reported financial results are impacted by management’s selection of accounting methods and certain assumptions and estimates.

Our accounting policies and methods are fundamental to the way we record and report our financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s

judgment of the most appropriate manner to report our financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which may be reasonable under the circumstances, yet may result in reporting materially different results than would have been reported under a different alternative.

Certain accounting policies are critical to presenting our financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include: the allowance for loan losses; intangible assets; and the fair value and discount accretion of acquired loans.

There can be no assurance that we will continue to pay cash dividends.

Although we have historically paid cash dividends, there is no assurance that we will continue to pay cash dividends. Future payment of cash dividends, if any, will be at the discretion of our board of directors and will be dependent upon our financial condition, results of operations, capital requirements, economic conditions, and such other factors as the board may deem relevant.

Future sales of our stock by our shareholders or the perception that those sales could occur may cause our stock price to decline.

Although our common stock is listed for trading in The NASDAQ Global Select Market under the symbol FBNC, the trading volume in our common stock is lower than that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the relatively low trading volume of our common stock, significant sales of our common stock in the public market, or the perception that those sales may occur, could cause the trading price of our common stock to decline or to be lower than it otherwise might be in the absence of those sales or perceptions.

Our business continuity plans or data security systems could prove to be inadequate, resulting in a material interruption in, or disruption to, our business and a negative impact on our results of operations.

We rely heavily on communications and information systems to conduct our business. Our daily operations depend on the operational effectiveness of our technology. We rely on our systems to accurately track and record our assets and liabilities. Any failure, interruption or breach in security of our computer systems or outside technology, whether due to severe weather, natural disasters, acts of war or terrorism, criminal activity, cyber-attacks or other factors, could result in failures or disruptions in general ledger, deposit, loan, customer relationship management, and other systems leading to inaccurate financial records. This could materially affect our business operations and financial condition. While we have disaster recovery and other policies and procedures designed to prevent or limit the effect of any failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions, or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our results of operations.

In addition, the Bank provides its customers the ability to bank online and through mobile banking. The secure transmission of confidential information over the Internet is a critical element of online and mobile banking. While we use qualified third party vendors to test and audit our network, our network could become vulnerable to unauthorized access, computer viruses, phishing schemes and other security issues. The Bank may be required to spend significant capital and other resources to alleviate problems caused by security breaches or computer viruses. To the extent that the Bank’s activities or the activities of its customers involve the storage and transmission of confidential information, security breaches and viruses could expose the Bank to claims, litigation, and other potential

liabilities. Any inability to prevent security breaches or computer viruses could also cause existing customers to lose confidence in the Bank’s systems and could adversely affect its reputation and its ability to generate deposits.

Additionally, we outsource the processing of our core data system, as well as other systems such as online banking, to third party vendors. Prior to establishing an outsourcing relationship, and on an ongoing basis thereafter, management monitors key vendor controls and procedures related to information technology, which includes reviewing reports of service auditor’s examinations. If our third party provider encounters difficulties or if we have difficulty in communicating with such third party, it will significantly affect our ability to adequately process and account for customer transactions, which would significantly affect our business operations.

We rely on certain external vendors.

We are reliant upon certain external vendors to provide products and services necessary to maintain our day-to-day operations. Accordingly, our operations are exposed to risk that these vendors will not perform in accordance with applicable contractual arrangements or service level agreements. We maintain a system of policies and procedures designed to monitor vendor risks including, among other things, (i) changes in the vendor’s organizational structure, (ii) changes in the vendor’s financial condition and (iii) changes in the vendor’s support for existing products and services. While we believe these policies and procedures help to mitigate risk, and our vendors are not the sole source of service, the failure of an external vendor to perform in accordance with applicable contractual arrangements or the service level agreements could be disruptive to our operations, which could have a material adverse impact on our business and its financial condition and results of operations.

We are subject to losses due to errors, omissions or fraudulent behavior by our employees, clients, counterparties or other third parties.

We are exposed to many types of operational risk, including the risk of fraud by employees and third parties, clerical recordkeeping errors and transactional errors. Our business is dependent on our employees as well as third-party service providers to process a large number of increasingly complex transactions. We could be materially and adversely affected if employees, clients, counterparties or other third parties caused an operational breakdown or failure, either as a result of human error, fraudulent manipulation or purposeful damage to any of our operations or systems.

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

Item 1B. Unresolved Staff Comments

None

Item 2. Properties

The main offices of the Company and the Bank are located in a three-story building in the central business district of Southern Pines, North Carolina and is owned by the Bank. The building houses administrative facilities. The Bank’s Operations Division, including customer accounting functions, offices for information technology operations, and offices for loan operations, are housed in two one-story steel frame buildings in Troy, North Carolina. Both of these buildings are

owned by the Bank. At December 31, 2017, the Company operated 104 bank branches. The Company owned all of its bank branch premises except nine branch offices for which the land and buildings are leased and 12 branch offices for which the land is leased but the building is owned. The Bank also leases five mortgage loan production offices and five other office locations for administrative functions. There are no options to purchase or lease additional properties. The Company considers its facilities adequate to meet current needs and believes that lease renewals or replacement properties can be acquired as necessary to meet future needs.

Item 3. Legal Proceedings

Various legal proceedings may arise in the ordinary course of business and may be pending or threatened against the Company and its subsidiaries. Neither the Company nor any of its subsidiaries is involved in any pending legal proceedings that management believes are material to the Company or its consolidated financial position. If an exposure were to be identified, it is the Company’s policy to establish and accrue appropriate reserves during the accounting period in which a loss is deemed to be probable and the amount is determinable.

Item 4. Mine Safety Disclosure

Not applicable.

PART II

Item 5. Market for the Registrant’s Common Stock, Related Shareholder Matters, and Issuer Purchases of Equity Securities

Our common stock trades on The NASDAQ Global Select Market under the symbol FBNC. Table 22, included in “Management’s Discussion and Analysis” below, sets forth the high and low market prices of our common stock as traded by the brokerage firms that maintain a market in our common stock and the dividends declared for the periods indicated. We paid a cash dividend of $0.08 per share for each quarter of 2017. For the foreseeable future, it is our current intention to continue to pay regular cash dividends on a quarterly basis. See “Business - Supervision and Regulation” above and Note 16 to the consolidated financial statements for a discussion of other regulatory restrictions on the Company’s payment of dividends. As of December 31, 2017, there were approximately 2,000 shareholders of record and another 8,000 shareholders whose stock is held in “street name.”

Additional Information Regarding the Registrant’s Equity Compensation Plans

At December 31, 2017, the Company had two equity-based compensation plans. The Company’s 2014 Equity Plan is the only plan under which new grants of equity-based awards are possible.

The following table presents information as of December 31, 2017 regarding shares of the Company’s stock that may be issued pursuant to the Company’s equity-based compensation plans. At December 31, 2017, the Company had no warrants or stock appreciation rights outstanding under any compensation plans.

_________________

(1) Consists of (A) the Company’s 2014 Equity Plan, which is currently in effect; and (B) the Company’s 2007 Equity Plan, each of which was approved by our shareholders.

Performance Graph

The performance graph shown below compares the Company’s cumulative total return to shareholders for the five-year period commencing December 31, 2012 and ending December 31, 2017, with the cumulative total return of the Russell 2000 Index (reflecting overall stock market performance of small-capitalization companies), and an index of banks with between $1 billion and $5 billion in assets, as constructed by SNL Securities, LP (reflecting changes in banking industry stocks). The graph and table assume that $100 was invested on December 31, 2012 in each of the Company’s common stock, the Russell 2000 Index, and the SNL Bank Index, and that all dividends were reinvested.

First Bancorp

Comparison of Five-Year Total Return Performances (1)

Five Years Ending December 31, 2017

Notes:

Issuer Purchases of Equity Securities

Pursuant to authorizations by the Company’s board of directors, the Company has from time to time repurchased shares of common stock in private transactions and in open-market purchases. The most recent board authorization was announced on July 30, 2004 and authorized the repurchase of 375,000 shares of the Company’s stock. The Company did not repurchase any shares of its common stock during the quarter ended December 31, 2017.

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Item 6. Selected Consolidated Financial Data

Table 1 on page 68 of this report sets forth the selected consolidated financial data for the Company.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis is intended to assist readers in understanding our results of operations and changes in financial position for the past three years. This review should be read in conjunction with the consolidated financial statements and accompanying notes beginning on page 86 of this report and the supplemental financial data contained in Tables 1 through 22 included with this discussion and analysis beginning on page 68 of this report.

Overview - 2017 Compared to 2016

We reported net income per diluted common share of $1.82 in 2017, a 36.8% increase compared to 2016. The increased earnings were primarily due to the Company’s acquisitions of Carolina Bank and Asheville Savings Bank, with loans increasing 49.1% and deposits increasing 49.5% year over year.

n/m — not meaningful

The following is a more detailed discussion of our results for 2017 compared to 2016:

For the year ended December 31, 2017, we reported net income available to common shareholders of $46.0 million, or $1.82 per diluted common share, an increase of 36.8% in earnings per share from the $27.3 million, or $1.33 per diluted common share, in 2016. The higher earnings in 2017 were primarily the result of the growth of the Company, including two acquisitions completed in 2017, as well as other initiatives that increased profitability.

On March 3, 2017, we acquired Carolina Bank Holdings, Inc., the parent company of Carolina Bank, which operated eight branches and three mortgage loan offices, primarily in the Triad region of North Carolina. As of the acquisition date, Carolina Bank had total assets of $682 million, including $497 million in loans and $585 million in deposits.

On October 1, 2017, we acquired ASB Bancorp, Inc., the parent company of Asheville Savings Bank, SSB, headquartered in Asheville, North Carolina, which operated through 13 branches in the Asheville area. As of the acquisition date, Asheville Savings Bank reported total assets of approximately $798 million, including $606 million in loans and $679 million in deposits.

Net interest income for the year ended December 31, 2017 amounted to $164.7 million, a 33.5% increase from the $123.4 million recorded in 2016. The increase in net interest income was primarily due to the acquisitions of Carolina Bank and Asheville Savings Bank, as well as higher amounts of loans outstanding as a result of organic growth. Also, see the section entitled “Net Interest Income” for additional information.

Our net interest margin (tax-equivalent net interest income divided by average earning assets) was 4.08% for 2017 compared to 4.03% for 2016. Asset yields have increased primarily as a result of three Federal Reserve interest rate increases during the past year. Funding costs have also increased, but to a lesser degree.

We recorded a provision for loan losses of $0.7 million in 2017 compared to a negative provision for loan losses (reduction of the allowance for loan losses) of $23,000 in 2016. The low level of provision for loan losses in both years was primarily due to stable and improving loan quality. Our nonperforming assets to total assets ratio was 0.96% at December 31, 2017 compared to 1.64% at December 31, 2016. We experienced net loan charge-offs of $1.2 million in 2017, compared to $3.7 million in 2016. Annualized net charge-offs to average loans for the year ended December 31, 2017 amounted to 0.04%, compared to 0.14% for 2016.

For the year ended December 31, 2017, noninterest income amounted to $48.9 million compared to $25.6 million for 2016. The primary reason for the increase in core noninterest income in 2017 was the acquisition of Carolina Bank and Asheville Savings Bank, as well as income derived from the Company’s SBA consulting fees and SBA loan sale gains, which began during the middle of 2016. See the section entitled “Noninterest Income” for additional information.

Noninterest expenses for the year ended December 31, 2017 amounted to $145.2 million compared to $106.8 million in 2016. The increase in noninterest expenses in 2017 related primarily to the Company’s acquisition of Carolina Bank and Asheville Savings Bank. Also impacting expenses were other growth initiatives, including continued growth of the Company’s SBA consulting firm and SBA lending division, as well as the acquisition of an insurance agency during the third quarter of 2017. See the section entitled “Noninterest Expense” for additional information.

The Company’s effective tax rate for 2017 was 32.1% compared to 34.7% in 2016. The lower effective tax rate was due to the 2017 Tax Cuts and Jobs Act, which was signed into law in December 2017. The impact to the Company of revaluing its net deferred tax liability was to reduce income tax expense by approximately $1.3 million in the fourth quarter of 2017. The Company expects to be favorably impacted in 2018 by the reduction in the federal tax rate, with a projected effective tax rate of approximately 21%.

Total assets at December 31, 2017 amounted to $5.5 billion, a 53.5% increase from a year earlier. Total loans at December 31, 2017 amounted to $4.0 billion, a 49.1% increase from a year earlier, and total deposits amounted to $4.4 billion at December 31, 2017, a 49.5% increase from a year earlier.

In addition to the growth realized from the acquisitions of Carolina Bank in March 2017 and Asheville Savings Bank in October 2017, the Company experienced strong organic loan and deposit growth during 2017. For 2017, organic loan growth (i.e. excluding loan balances assumed from Carolina Bank and Asheville Savings Bank) amounted to $228.0 million, or 8.4%. For 2017, organic deposit growth amounted to $195.1 million, or 6.6%. The strong growth was a result of ongoing internal initiatives to enhance loan and deposit growth, including the Company’s recent expansion into higher growth markets. The organic loan growth noted above has been driven by the recently-entered North Carolina markets of Charlotte, Raleigh, and the Triad.

Overview - 2016 Compared to 2015

We reported net income per diluted common share of $1.33 in 2016, a 2.3% increase compared to 2015. The increased earnings were primarily due to the Company’s growth, with loans increasing 7.6% and deposits increasing 4.8% year over year.

The following is a more detailed discussion of our results for 2016 compared to 2015:

For the year ended December 31, 2016, we reported net income available to common shareholders of $27.3 million, or $1.33 per diluted common share, an increase of 3.4% compared to the $26.4 million, or $1.30 per diluted common share, for the year ended December 31, 2015. The higher earnings were primarily the result of loan and deposit growth, as well as other initiatives that increased profitability.

Net interest income for the year ended December 31, 2016 amounted to $123.4 million, a 3.0% increase from the $119.7 million recorded in 2015. The higher net interest income was primarily due to growth in our loans outstanding. Also, see the section entitled “Net Interest Income” for additional information.

Our net interest margin (tax-equivalent net interest income divided by average earning assets) was 4.03% for 2016 compared to 4.13% for 2015. The lower margin in 2016 compared to 2015 was primarily due to lower loan yields, which were impacted by the continued low interest rate environment.

We recorded a negative total provision for loan losses (reduction of the allowance for loan losses) on our covered and non-covered loans of $23,000 in 2016 compared to a negative provision for loan losses of $780,000 in 2015. For periods prior to the third quarter of 2016, our provision for loan losses was calculated separately between covered loans and non-covered loans, with covered loans being those loans subject to FDIC loss share agreements. Upon the termination of the FDIC loss share agreements on September 22, 2016, all loans became classified as non-covered. For the year 2016, the provision for loan losses on non-covered loans did not vary significantly from 2015, amounting

to $2.1 million in 2016 compared to $2.0 million for 2015. For the portion of the year our loss share agreements were in effect in 2016, we recorded a negative provision for loan losses on covered loans of $2.1 million compared to a $2.8 million negative provision for loan losses in 2015. The lower negative provision for loan losses on covered loans in 2016 was due to lower covered loan recoveries.

Our overall provision for loan loss levels were impacted by continued improvement in asset quality. Nonperforming assets amounted to $59.1 million at December 31, 2016, a decrease of 33.8% from the $89.3 million one year earlier. Our nonperforming assets to total assets ratio was 1.64% at December 31, 2016 compared to 2.66% at December 31, 2015. Annualized net charge-offs as a percentage of average loans for the twelve months ended December 31, 2016 was 0.14% compared to 0.46% for 2015.

For the year ended December 31, 2016, noninterest income amounted to $25.6 million compared to $18.8 million for the year ended December 31, 2015. The increases in noninterest income are primarily the result of the following strategic initiatives:

Partially offsetting the above-noted increases in noninterest income was higher indemnification asset expense in 2016 compared to 2015. Indemnification asset expense relates to write-offs of an indemnification asset associated with two FDIC loss share agreements. For 2016, the Company recorded $10.3 million in indemnification asset expense compared to $8.6 million in 2015. The 2016 amount includes a $5.7 million charge associated with the early termination of the loss share agreements that occurred in September 2016.

Noninterest expenses for the year ended December 31, 2016 amounted to $106.8 million compared to $98.1 million recorded in 2015. The primary reason for the increase was the costs associated with the growth initiatives previously discussed.

Total assets at December 31, 2016 amounted to $3.6 billion, a 7.5% increase from a year earlier. Total loans at December 31, 2016 amounted to $2.7 billion, a 7.6% increase from a year earlier, and total deposits amounted to $2.9 billion at December 31, 2016, a 4.8% increase from a year earlier.

The $192 million increase in our loans at December 31, 2016 compared to a year earlier is primarily related to ongoing internal initiatives to drive loan growth, including our expansion into higher growth markets.

Total deposits increased $136 million at December 31, 2016 compared to December 31, 2015, which was driven by a $175 million increase, or 8.3%, in checking, money market and savings accounts. Retail time deposits declined by $99 million, or 15.8%, over this same period, while deposits obtained from brokers increased $60 million, or 78.6%.

For the periods presented until the September 2016 termination of the FDIC loss share agreements, the Company’s results of operations were significantly affected by FDIC loss share agreements related to two FDIC-assisted failed

bank acquisitions. In the discussion above and in the accompanying tables, the term “covered” is used to describe assets that were included in FDIC loss share agreements, while the term “non-covered” refers to the assets not included in a loss share arrangement. As previously discussed, all loss share agreements were terminated in the third quarter of 2016 and thus the entire loan portfolio is now classified as non-covered. Certain prior period disclosures will continue to present the breakout of the loan portfolio between covered and non-covered.

Certain covered loans continued to have an unaccreted discount associated with them at the time of transfer to non-covered status. Such loans that experience favorable changes in credit quality compared to what was expected at the acquisition date, including loans that pay off, will continue to result in positive adjustments to interest income being recorded over the life of the respective loan – also referred to as loan discount accretion.

For periods prior to the termination, because favorable changes in covered assets resulted in lower expected FDIC claims, and unfavorable changes in covered assets resulted in higher expected FDIC claims, the FDIC indemnification asset was adjusted to reflect those expectations. The net increase or decrease in the indemnification asset was reflected within noninterest income, with the net impact being that pretax income was generally only impacted by 20% of the income or expense associated with provisions for loan losses on covered loans, discount accretion, and losses from covered foreclosed properties.

Outlook for 2018

We generally believe that the outlook for 2018 is favorable. We expect the national economy, as well as our local economies, to continue to improve, with unemployment rates remaining at low levels. We believe that the recent tax reform is likely to result in future economic growth, and the lower statutory tax rate will benefit our Company.

The Federal Reserve has increased short-term interest rates by 125 basis points since late 2015, with more increases projected. Longer-term interest rates, while still low, have begun to increase. Generally, higher interest rates can be favorable for banks like us. We are able to earn higher yields on our interest-earning assets, while our funding costs may reprice at a lag to the interest rate changes in the market, and potentially not to the full amount of the rate increases. However interest rates on loans continue to be impacted by intense competition, and we are beginning to experience pressure on the rates we pay on deposits. Thus the stability of our net interest margin is uncertain.

With several consecutive years of significantly improved trends of nonperforming assets and lower loan charge-offs compared to the recessionary years, we again recorded low levels of provisions for loan losses in 2017, which brought our overall allowance for loan loss level down significantly following the elevated amounts we maintained during and immediately following the recession. As stated in Note 20 to the consolidated financial statements, from January 1, 2018 through February 28, 2018, we have recorded net loan recoveries of $3.3 million. With other asset quality measures expected to remain stable, we currently expect our levels of provisions for loan losses to remain low in 2018.

Excluding our two whole-bank acquisitions in 2017, we experienced solid organic loan and deposit growth in 2017. Our local economies have continued to improve, and we experienced positive results from our recent expansion into the larger and higher growth markets in North Carolina. With our expanded market areas due to acquisitions and other strategic initiatives, we expect to experience continued loan and deposit growth in 2018.

Critical Accounting Policies

The accounting principles we follow and our methods of applying these principles conform with accounting principles generally accepted in the United States of America and with general practices followed by the banking industry. Certain of these principles involve a significant amount of judgment and may involve the use of estimates based on our best assumptions at the time of the estimation. The allowance for loan losses, intangible assets, and the fair value and discount accretion of acquired loans are three policies we have identified as being more sensitive in terms of judgments and estimates, taking into account their overall potential impact to our consolidated financial statements.

Allowance for Loan Losses

Due to the estimation process and the potential materiality of the amounts involved, we have identified the accounting for the allowance for loan losses and the related provision for loan losses as an accounting policy critical to our consolidated financial statements. The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered adequate to absorb losses inherent in the portfolio.

Our determination of the adequacy of the allowance is based primarily on a mathematical model that estimates the appropriate allowance for loan losses. This model has two components. The first component involves the estimation of losses on individually evaluated “impaired loans.” A loan is considered to be impaired when, based on current information and events, it is probable we will be unable to collect all amounts due according to the contractual terms of the original loan agreement. A loan is specifically evaluated for an appropriate valuation allowance if the loan balance is above a prescribed evaluation threshold (which varies based on credit quality, accruing status, troubled debt restructured status, purchased credit impaired status, and type of collateral) and the loan is determined to be impaired. The estimated valuation allowance is the difference, if any, between the loan balance outstanding and the value of the impaired loan as determined by either 1) an estimate of the cash flows that we expect to receive from the borrower discounted at the loan’s effective rate, or 2) in the case of a collateral-dependent loan, the fair value of the collateral.

The second component of the allowance model is an estimate of losses for all loans not considered to be impaired loans (“general reserve loans”). General reserve loans are segregated into pools by loan type and risk grade and estimated loss percentages are assigned to each loan pool based on historical losses.  The historical loss percentages are then adjusted for any environmental factors used to reflect changes in the collectability of the portfolio not captured by historical data.

The reserves estimated for individually evaluated impaired loans are then added to the reserve estimated for general reserve loans. This becomes our “allocated allowance.” The allocated allowance is compared to the actual allowance for loan losses recorded on our books and any adjustment necessary for the recorded allowance to absorb losses inherent in the portfolio is recorded as a provision for loan losses. The provision for loan losses is a direct charge to earnings in the period recorded. Any remaining difference between the allocated allowance and the actual allowance for loan losses recorded on our books is our “unallocated allowance.”

Purchased loans are recorded at fair value at the acquisition date. Therefore, amounts deemed uncollectible at the acquisition date represent a discount to the loan value and become a part of the fair value calculation. Subsequent decreases in the amount expected to be collected result in a provision for loan losses with a corresponding increase in the allowance for loan losses. Subsequent increases in the amount expected to be collected are accreted into income over the life of the loan and this accretion is referred to as “loan discount accretion.”

Within the purchased loan portfolio, loans are deemed purchased credit impaired at acquisition if the bank believes it will not be able to collect all contractual cash flows. Performing loans with an unamortized discount or premium that are not deemed purchased credit impaired are considered to be purchased performing loans. Purchased credit impaired loans are individually evaluated as impaired loans, as described above, while purchased performing loans are

evaluated as general reserve loans. For purchased performing loan pools, any computed allowance that is in excess of remaining net discounts is a component of the allocated allowance.

Although we use the best information available to make evaluations, future material adjustments may be necessary if economic, operational, or other conditions change. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may require us to recognize additions to the allowance based on the examiners’ judgment about information available to them at the time of their examinations.

For further discussion, see “Nonperforming Assets” and “Summary of Loan Loss Experience” below.

Intangible Assets

Due to the estimation process and the potential materiality of the amounts involved, we have also identified the accounting for intangible assets as an accounting policy critical to our consolidated financial statements.

When we complete an acquisition transaction, the excess of the purchase price over the amount by which the fair market value of assets acquired exceeds the fair market value of liabilities assumed represents an intangible asset. We must then determine the identifiable portions of the intangible asset, with any remaining amount classified as goodwill. Identifiable intangible assets associated with these acquisitions are generally amortized over the estimated life of the related asset, whereas goodwill is tested annually for impairment, but not systematically amortized. Assuming no goodwill impairment, it is beneficial to our future earnings to have a lower amount assigned to identifiable intangible assets and higher amount of goodwill as opposed to having a higher amount considered to be identifiable intangible assets and a lower amount classified as goodwill.

The primary identifiable intangible asset we typically record in connection with a whole bank or bank branch acquisition is the value of the core deposit intangible, whereas when we acquire an insurance agency or a consulting firm, as we did in 2016 and 2017, the primary identifiable intangible asset is the value of the acquired customer list. Determining the amount of identifiable intangible assets and their average lives involves multiple assumptions and estimates and is typically determined by performing a discounted cash flow analysis, which involves a combination of any or all of the following assumptions: customer attrition/runoff, alternative funding costs, deposit servicing costs, and discount rates. We typically engage a third party consultant to assist in each analysis. For the whole bank and bank branch transactions recorded to date, the core deposit intangibles have generally been estimated to have a life ranging from seven to ten years, with an accelerated rate of amortization. For insurance agency acquisitions, the identifiable intangible assets related to the customer lists were determined to have a life of ten to fifteen years, with amortization occurring on a straight-line basis. For the SBA consulting firm we acquired in 2016, the identifiable intangible asset related to the customer list was determined to have a life of approximately seven years, with amortization occurring on a straight-line basis.

Subsequent to the initial recording of the identifiable intangible assets and goodwill, we amortize the identifiable intangible assets over their estimated average lives, as discussed above. In addition, on at least an annual basis, goodwill is evaluated for impairment by comparing the fair value of our reporting units to their related carrying value, including goodwill. We have three reporting units – 1) First Bank with $221.4 million in goodwill, 2) First Bank Insurance with $7.4 million in goodwill, and 3) SBA activities, including SBA Complete and our SBA lending division, with $4.3 million in goodwill. If the carrying value of a reporting unit were ever to exceed its fair value, we would determine whether the implied fair value of the goodwill, using a discounted cash flow analysis, exceeded the carrying value of the goodwill. If the carrying value of the goodwill exceeded the implied fair value of the goodwill, an impairment loss would be recorded in an amount equal to that excess. Performing such a discounted cash flow analysis would involve the significant use of estimates and assumptions.

In our 2017 goodwill impairment evaluation, we concluded that the goodwill for each of our reporting units was not impaired.

We review identifiable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our policy is that an impairment loss is recognized, equal to the difference between the asset’s carrying amount and its fair value, if the sum of the expected undiscounted future cash flows is less than the carrying amount of the asset. Estimating future cash flows involves the use of multiple estimates and assumptions, such as those listed above.

Fair Value and Discount Accretion of Acquired Loans

We consider the determination of the initial fair value of acquired loans and the subsequent discount accretion of the purchased loans to involve a high degree of judgment and complexity.

We determine fair value accounting estimates of newly assumed assets and liabilities in accordance with relevant accounting guidance. However, the amount that we realize on these assets could differ materially from the carrying value reflected in our financial statements, based upon the timing of collections on the acquired loans in future periods. Because of inherent credit losses and interest rate marks associated with acquired loans, the amount that we record as the fair values for the loans is generally less than the contractual unpaid principal balance due from the borrowers, with the difference being referred to as the “discount” on the acquired loans. For non-impaired purchased loans, we accrete the discount over the lives of the loans in a manner consistent with the guidance for accounting for loan origination fees and costs.

For purchased credit-impaired (“PCI”) loans, the excess of the cash flows initially expected to be collected over the fair value of the loans at the acquisition date (i.e., the accretable yield) is accreted into interest income over the estimated remaining life of the loans using the effective yield method, provided that the timing and the amount of future cash flows is reasonably estimable. Accordingly, such loans are not classified as nonaccrual and they are considered to be accruing because their interest income relates to the accretable yield recognized under accounting for PCI loans and not to contractual interest payments. The difference between the contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference.

Subsequent to an acquisition, estimates of cash flows expected to be collected are updated periodically based on updated assumptions regarding default rates, loss severities, and other factors that are reflective of current market conditions. If there is a decrease in cash flows expected to be collected, the provision for loan losses is charged, resulting in an increase to the allowance for loan losses. If the Company has a probable increase in cash flows expected to be collected, we will first reverse any previously established allowance for loan losses and then increase interest income as a prospective yield adjustment over the remaining life of the loan. The impact of changes in variable interest rates is recognized prospectively as adjustments to interest income.

Merger and Acquisition Activity

As previously discussed, in January 2016, we acquired an insurance agency in Sanford, North Carolina, and in May 2016, we acquired a firm specializing in origination and servicing of SBA loans. In July 2016, we exchanged our seven bank branches located in Virginia to another community bank in return for six of their North Carolina branches. In 2017, we completed two full-bank acquisitions – Carolina Bank and Asheville Savings Bank. Also in 2017, we completed the acquisition of another insurance agency headquartered in Albemarle, North Carolina.

See Note 2 to the consolidated financial statements for additional information regarding these acquisitions.

FDIC Indemnification Asset

As previously discussed, in 2009 and 2011, we acquired substantially all of the assets and liabilities of two failed banks in FDIC-assisted transactions. For each transaction, we entered into two loss share agreements with the FDIC, which provided the Bank significant loss protection from losses experienced on the loans and foreclosed real estate. One of these loss share agreements expired in July 2014 and one agreement expired in April 2016. On September 22, 2016,

we reached a mutual agreement with the FDIC to terminate all loss share agreements, with all future losses and recoveries associated with these failed bank assets being fully borne by the Bank.

ANALYSIS OF RESULTS OF OPERATIONS

Net interest income, the “spread” between earnings on interest-earning assets and the interest paid on interest-bearing liabilities, constitutes the largest source of our earnings. Other factors that significantly affect operating results are the provision for loan losses, noninterest income such as service fees and noninterest expenses such as salaries, occupancy expense, equipment expense and other overhead costs, as well as the effects of income taxes.

Net Interest Income

Net interest income on a reported basis amounted to $164.7 million in 2017, $123.4 million in 2016, and $119.7 million in 2015. For internal purposes and in the discussion that follows, we evaluate our net interest income on a tax-equivalent basis by adding the tax benefit realized from tax-exempt securities to reported interest income. Net interest income on a tax-equivalent basis amounted to $167.3 million in 2017, $125.4 million in 2016, and $121.4 million in 2015. Management believes that analysis of net interest income on a tax-equivalent basis is useful and appropriate because it allows a comparison of net interest amounts in different periods without taking into account the different mix of taxable versus non-taxable investments that may have existed during those periods. The following is a reconciliation of reported net interest income to tax-equivalent net interest income.

Table 2 analyzes net interest income on a tax-equivalent basis. Our net interest income on a tax-equivalent basis increased by 33.4% in 2017 and increased by 3.3% in 2016. There are two primary factors that cause changes in the amount of net interest income we record – 1) changes in our loans and deposits balances and 2) our net interest margin. “Net interest margin” is a ratio we use to measure the spread between the yield on our earning assets and the cost of our funding and is calculated by dividing tax-equivalent net interest income by average earning assets.

The increase in net interest income in 2017 compared to 2016 was primarily due to growth in our loans outstanding (acquired and organic), with a five basis point increase in our net interest margin also contributing to the increase.

For 2017, average loans increased $817.6 million, or 31.4%, with interest income earned on loans increasing by $42.4 million over 2016. Average deposits also increased significantly at 30.7%, but interest expense on deposits only increased by $2.4 million over 2016.

Our net interest margin increased from 4.03% in 2016 to 4.08% in 2017. Asset yields increased primarily as a result of three Federal Reserve interest rate increases during the past year. Funding costs also increased, but to a lesser degree.

Increases in asset yields were partially offset by increased funding costs in 2017. The average interest rate paid on our interest bearing deposits increased from 0.24% in 2016 to 0.28% in 2017, which is mainly due to a higher level of brokered deposits over the past year, which are generally more expensive than retail deposits. Our average borrowings also increased in 2017 by $116.2 million, or 55.4%, with interest expense on borrowings increasing $2.7 million over 2016. The higher reliance on brokered deposits and borrowings was due primarily to strong loan growth that outpaced core funding growth.

The increase in net interest income in 2016 compared to 2015 was due to growth in our loans outstanding, the positive impact of which was partially offset by a 10 basis point decline in our net interest margin.

For 2016, average loans increased $168.7 million, or 6.9%, with interest income earned on loans increasing by $3.4 million over 2015, while average deposits also had good growth at 5.2%.

Our net interest margin declined from 4.13% in 2015 to 4.03% in 2016. Lower asset yields were the primary factor causing the decline in the net interest margin in 2016, as the yield we earned on our interest-earning assets declined from 4.37% in 2015 to 4.28% in 2016. Steadily declining loan yields caused by the continued low interest rate environment and competition for loans were the primary factors in this decline.

For 2016, the declines in asset yields were partially offset by lower liability costs, as we were able to progressively lower interest rates on maturing time deposits that were originated in prior periods. The average interest rate paid on our interest bearing deposits declined from 0.26% in 2015 to 0.24% in 2016. Also, for 2016, shifts in the funding mix of our liabilities have had a positive impact on our net interest margin. As calculated from Table 2, the average amount of our lower cost deposits, comprised of checking accounts (non-interest bearing and interest bearing), money market accounts and savings accounts, increased from $2.0 billion in 2015 to $2.2 billion in 2016, an increase of 10%, while the average amount of our higher cost funding, comprised of time deposits, remained stable at approximately $0.7 billion over that same period.

The net interest margin for all periods benefited, by varying amounts, from the net accretion of purchase accounting premiums/discounts associated with acquisitions. As can be seen in the table below, we recorded $7.3 million in 2017, $4.5 million in 2016, and $4.8 million in 2015, in net accretion of purchase accounting premiums/discounts that increased net interest income.

The biggest component of the purchase accounting adjustments in each year was loan discount accretion, which amounted to $7.1 million in 2017, $4.5 million in 2016, and $4.8 million in 2015. In 2017, the increase in loan discount accretion is primarily due to the loan discounts recorded in the acquisitions of Carolina Bank and Asheville Savings Bank. During 2017, we recorded an additional $20.7 million in loan discounts related to these acquisitions. Unaccreted loan discount increased from $12.7 million at December 31, 2016 to $26.9 million at December 31, 2017. Unaccreted loan discount declined from $20.8 million at January 1, 2015 to $12.7 million at December 31, 2016. We expect loan discount accretion to increase in 2018 as a result of the newly acquired loan portfolios being held by the Bank for a full-year.

Table 3 presents additional detail regarding the estimated impact that changes in loan and deposit volumes and changes in the interest rates we earned/paid had on our net interest income in 2016 and 2017. In 2017, we acquired Carolina Bank and Asheville Savings Bank, which significantly increased our volumes for loans and deposits. For 2017, higher loan volume positively impacted interest income by $38.6 million, and higher loan interest rates positively impacted interest income by $3.8 million, with the combined effect driving the total increase in interest income of $46.9 million. Higher volumes and higher rates paid on deposits drove an increase of $2.4 million in interest expense. A higher level of borrowings and higher rates paid on those borrowings in 2017 also contributed significantly to the $5.1 million increase in interest expense. The higher level of borrowings was necessary in 2017 in order to fund our organic loan growth, which outpaced deposit growth. Overall, as the table indicates, net interest income on a tax-equivalent basis grew $41.9 million in 2017.

For 2016, higher loan volume positively impacted interest income by $8.0 million, while lower loan interest rates negatively impacted interest income by $4.6 million, with the net effect driving the total increase in interest income of $4.8 million. A higher level of borrowings in 2016 was the primary factor causing the $0.7 million increase in

interest expense. The higher level of borrowings was necessary in 2016 in order to fund the loan growth, which outpaced deposit growth. Overall, as the table indicates, net interest income on a tax-equivalent basis grew $4.1 million in 2016.

See additional information regarding net interest income in the section entitled “Interest Rate Risk.”

Provision for Loan Losses

The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered appropriate to absorb probable losses inherent in our loan portfolio. Management’s determination of the adequacy of the allowance is based on our level of loan growth, an evaluation of the loan portfolio, current economic conditions, historical loan loss experience and other risk factors.

For 2017, we recorded total provision for loan losses of $723,000. In 2016, we recorded total negative provisions for loan losses (reduction of allowance for loan losses) of $23,000. For 2015, our total provisions for loan losses were $780,000.

For periods prior to the third quarter 2016 termination of our loss share agreements, we computed and presented the provision for loan losses related to covered loans separately from that of our non-covered loans. Generally, we had recorded provisions for loan losses on non-covered loans as a result of net charge-offs and loan growth, while significant recoveries in our previously covered loan portfolios resulted in negative provisions for loan losses. Upon the termination of the loss share agreements, all loans became classified as non-covered and the allowance for loan losses balances were combined into a single amount and no longer computed separately.

We recorded $0.7 million, $2.1 million, and $2.0 million in provisions for loan losses related to non-covered loans for the years ended December 31, 2017, 2016, and 2015, respectively. These relatively low amounts were the result of a prolonged period of stable and improving loan quality trends, which resulted in lower provisions for loan losses that were needed to adjust our allowance for loan losses to the appropriate amount. This was because our allowance for loan loss model utilizes the net charge-offs experienced in the most recent years as a significant component of estimating the current allowance for loan losses that is necessary. Thus, older years (and parts thereof) systematically age out and are excluded from the analysis as time goes on. In 2015, periods of high net charge-offs we experienced during the peak of the recession dropped out of the analysis and were replaced by the more modest levels of net charge-offs recently experienced. This had the impact of bringing our overall allowance for loan loss level down to a more normalized level following the elevated amounts we maintained during and immediately following the recession. This same situation continued in 2016 and 2017 and was further impacted by net charge-offs that declined significantly in 2016 and again in 2017. These factors combined to result in a provision for non-covered loan losses that only slightly increased to $2.1 million in 2016 and decreased to $0.7 million in 2017 despite higher loan growth in both periods. As stated in Note 20 to the consolidated financial statements, from January 1, 2018 through February 28, 2018, we have recorded net loan recoveries of $3.3 million. With other asset quality measures expected to remain stable, we currently expect our levels of provisions for loan losses to remain low in 2018.

As it relates to covered loans, we recorded a negative provision for loan losses (reduction of allowance for loan losses) of $2.1 million in 2016 and $2.8 million in 2015. The negative provisions in 2015 and 2016 resulted from lower levels of covered nonperforming loans, declining levels of total covered loans, and several large recoveries received that resulted in having net loan recoveries (recoveries, net of charge-offs) of $1.7 million in 2016 and $2.3 million in 2015.

Total net charge-offs (covered and non-covered) for the years ended December 31, 2017, 2016, and 2015, were $1.2 million, $3.7 million, and $11.3 million, respectively.

Net-charge offs of non-covered loans were $1.2 million, $5.4 million, and $13.6 million for 2017, 2016, and 2015, respectively. The declining amount of non-covered net-charge offs in recent years is reflective of improving economic conditions and lower levels of our highest-risk loans.

Net charge-offs (recoveries) of covered loans were ($1.7 million) and ($2.3 million) in 2016 and 2015, respectively, with several large recoveries significantly impacting 2015 and 2016.

As seen in Table 14, in 2017, 2016 and 2015, net charge-offs were highest in our residential first mortgages, which is reflective of the size of our residential first mortgage portfolio and continued challenging economic conditions in some of our more rural market areas. In 2013 and 2014, net charge-offs were highest in loans classified as “real estate – construction, land development & other land loans.”  This category of loans is primarily comprised of land acquisition and development loans and other types of lot loans.  These types of loans were particularly hard hit by the decline in real estate development and property values that occurred in the recession. 

See “Nonperforming Assets” below for further discussion of our asset quality, which impacts our provisions for loan losses.

See the section entitled “Allowance for Loan Losses and Loan Loss Experience” below for a more detailed discussion of the allowance for loan losses. The allowance is monitored and analyzed regularly in conjunction with our loan analysis and grading program, and adjustments are made to maintain an adequate allowance for loan losses.

Noninterest Income

Our noninterest income amounted to $48.9 million in 2017, $25.6 million in 2016, and $18.8 million in 2015.

As shown in Table 4, core noninterest income excludes gains from acquisitions, foreclosed property write-downs and losses, indemnification asset income (expense), securities gains or losses, and other miscellaneous gains and losses. Core noninterest income amounted to $49.3 million in 2017, a 40.9% increase from the $35.0 million recorded in 2016. The 2016 core noninterest income of $35.0 million was a 19.3% increase from the $29.3 million recorded in 2015.

See Table 4 and the following discussion for an understanding of the components of noninterest income.

For most categories of noninterest income, our acquisitions of Carolina Bank in March 2017 and Asheville Savings Bank in October 2017 had the effect of increasing noninterest income in 2017 in comparison to 2016.

Service charges on deposit accounts amounted to $11.9 million, $10.6 million, and $11.6 million in 2017, 2016 and 2015, respectively. In 2017, the increase is primarily due to the aforementioned acquisitions. In 2017, 2016 and 2015, fewer instances of fees earned from customers overdrawing their accounts negatively impacted this line item, as well as more customers meeting the requirements to have the monthly services charges waived on their checking accounts.

Other service charges, commissions and fees amounted to $14.6 million in 2017, a 22.6% increase from the $11.9 million earned in 2016. The 2016 amount of $11.9 million was 9.2% higher than the $10.9 million earned in 2015. This category of noninterest income includes items such as electronic payment processing revenue (which includes fees related to credit card transactions by merchants and customers and fees earned from debit card transactions), ATM charges, safety deposit box rentals, fees from sales of personalized checks, and check cashing fees. The increase in this line item in 2017 was due to a combination of the Carolina Bank and Asheville Savings Bank acquisitions, as well as growth in interchange fees from debit and credit cards. In both 2017 and 2016, increased debit card usage by our customers has increased income, as we earn a small fee each time our customers make a debit card transaction. Interchange income from credit cards has also increased due to growth in the number and usage of credit cards, which we believe is a result of increased promotion of this product.

Fees from presold mortgages amounted to $5.7 million in 2017, $2.0 million in 2016, and $2.5 million in 2015. In 2017, the increases were primarily due to the acquisition of Carolina Bank in March 2017, which had a significant mortgage loan operation. In 2016, fewer mortgage loan originations resulted in decreases in these fees. Also, fewer

mortgage loans were sold to the secondary market in 2016 compared to 2015 due to our decision to hold more loans for investment in order to offset declines in our residential mortgage loan portfolio.

Commissions from sales of insurance and financial products amounted to $5.3 million in 2017, $3.8 million in 2016, and $2.6 million in 2015. This line item includes commissions we receive from two primary sources - 1) commissions from the sales of investment, annuity, and long term care insurance products, and 2) commissions from the sale of property and casualty insurance. The following table presents the contribution of each source to the total amount recognized in this line item:

As can be seen in the above table, sales of property and casualty insurance increased significantly in 2016 and again in 2017, which is due to our January 1, 2016 acquisition of Bankingport, Inc., an insurance agency located in Sanford, North Carolina and our September 1, 2017 acquisition of Bear Insurance Services, an insurance agency headquartered in Albemarle, North Carolina (see Note 2 to the consolidated financial statements for additional information). Sales of investments, annuities and long term care insurance did not vary significantly among the years presented.

Another primary reason for the increases in core noninterest income in 2017 and 2016 was the addition of SBA consulting fees and SBA loan sale gains during the last half of 2016. As previously discussed, on May 5, 2016, we completed the acquisition of a firm that specializes in consulting with financial institutions across the country related to SBA loan origination and servicing (see Note 2 to the consolidated financial statements for additional information). We recorded $3.2 million in SBA consulting fees related to this business from the date of the acquisition through December 31, 2016. In the third quarter of 2016, we leveraged the expertise we gained from personnel assumed in the SBA Complete acquisition and launched a national SBA lending division offering SBA loans to small business owners throughout the United States. The SBA division originated $24.8 million in loans in 2016 and earned $1.4 million from gains on the sales of the guaranteed portions of these loans for 2016. In 2017, we recorded $4.0 million in SBA consulting fees and $5.5 million in gains on the sales of SBA loans. The SBA division originated $95.4 million in loans in 2017.

Table 4 shows earnings from bank-owned life insurance income were $2.3 million in 2017, $2.1 million in 2016, and $1.7 million in 2015. In 2017, we acquired approximately $23 million in bank-owned life insurance from Carolina Bank and Asheville Savings Bank, increasing our income for this line item. In the fourth quarter of 2015, we purchased $15.0 million in bank-owned life insurance on certain officers of our Company, which increased our income for this line item in 2016.

Noninterest income not considered to be “core” resulted in net reductions to total noninterest income of $0.4 million in 2017, $9.4 million in 2016, and $10.6 million in 2015. The components of non-core noninterest income are shown in Table 4 and the significant components thereof are discussed below.

We recorded net losses on non-covered foreclosed properties of $0.5 million in 2017, $1.5 million in 2016, and $2.5 million in 2015. These losses have resulted from ongoing declines in property values for certain types of properties.

Prior to the termination of the loss share agreements in September 2016, we recorded $0.9 million and $1.0 million of net gains on covered foreclosed properties in 2016 and 2015, respectively. Most of our covered foreclosed properties were along the coast of North Carolina. The market value for properties in that area recovered significantly following the recession and resulted in the gains experienced in 2015 and 2016.

For the years ended December 31, 2016 and 2015, indemnification asset expense amounted to $10.3 million and $8.6 million, respectively. Historically, indemnification asset income (expense) was recorded to reflect additional (or decreased) amounts that were expected to be received from the FDIC during the period related to covered assets. The three primary items that resulted in recording indemnification asset income (expense) were 1) loan discount accretion resulting from improved borrower repayment prospects, which generally resulted in indemnification expense, 2) provisions (reversals) for loan losses on covered loans, which resulted in indemnification income (expense) and 3) foreclosed property gains (losses) on covered assets, which resulted in indemnification expense (income). The higher indemnification asset expense in 2016 resulted from the write-off of the remaining indemnification asset of $5.7 million when we terminated the FDIC loss share agreements. The following table presents the sources of indemnification income (expense) for the periods noted.

In 2017, we recorded losses on sales of securities of $0.2 million. Securities gains (losses) were insignificant for 2016 and 2015.

“Other gains (losses), net” for the 2017, 2016 and 2015 periods presented represent the net effects of miscellaneous gains and losses that are non-routine in nature. In 2016, the Company recorded a net gain of $1.5 million as a result of a branch exchange transaction with First Community Bank (see Note 2 of the consolidated financial statements for additional discussion).

Noninterest Expenses

Total noninterest expenses totaled $145.2 million, $106.8 million, and $98.1 million for 2017, 2016 and 2015, respectively. Table 5 presents the components of our noninterest expense during the past three years. The primary reason for the growth in noninterest expense in 2017 and 2016 was associated with our growth initiatives, including several acquisitions, including Carolina Bank and Asheville Savings Bank, and market expansion. Line items with the largest fluctuations are further discussed below.

Total personnel expense increased from $62.1 million in 2016 to $81.2 million in 2017, an increase of $19.1 million, or 30.8%. Within personnel expense, salaries expense increased $15.5 million in 2017 and employee benefits expense increased by $3.6 million in 2017. The primary reason for these increases in personnel expense is due to the additional personnel assumed in the Carolina Bank and Asheville Savings Bank acquisitions. Also, in 2017, we have added personnel due to the continued growth of the SBA consulting firm and our SBA national lending division. Additionally, salary expense for the fourth quarter of 2017 was also impacted by approximately $1.1 million related to one-time bonuses granted to a majority of the Company’s employees. Effective January 1, 2018, the Company increased its 401k match from effectively a 100% match up to 4% of an employee’s salary contribution to a 100% match up to 6% of an employee’s salary contribution. The higher match is expected to have an approximately $0.8 million impact on employee benefits expense.

Total personnel expense increased from $56.8 million in 2015 to $62.1 million in 2016, an increase of $5.3 million, or 9.3%. Within personnel expense, salaries expense increased $3.6 million in 2016 and employee benefits expense increased by $1.7 million in 2016. The primary reason for these increases in 2016 in personnel expense was the aforementioned growth initiatives in 2016, including acquisitions of an insurance agency and an SBA consulting firm, as well as the creation of an SBA lending division and our expansion into the Triad region of North Carolina.

Net occupancy expenses amounted to $9.7 million in 2017, $7.8 million in 2016, and $7.4 million in 2015. The increases in 2017 and 2016 were related to the aforementioned acquisitions and expansion initiatives.

Equipment related expenses amounted to $4.5 million, $3.6 million, and $3.7 million, in 2017, 2016, and 2015, respectively, with the increase in 2017 being attributed to the 2017 acquisitions.

Merger and acquisition expenses amounted to $8.1 million in 2017 and $1.4 million in 2016 compared to none in 2015. The 2017 amount was primarily comprised of professional fees and severance costs incurred in our acquisitions of Carolina Bank and Asheville Savings Bank. In 2016, the amount was comprised of professional fees incurred for our various acquisitions, including Bankingport, SBA Complete, our branch exchange, and our agreement to acquire Carolina Bank that was announced in 2016.

Intangible amortization expense increased from $1.2 million in 2016 to $4.2 million in 2017 due to the addition of $22.5 million in amortizable intangible assets recorded in connection with the acquisitions of Carolina Bank, Asheville Savings Bank, and Bear Insurance Services. Intangible amortization expense increased from $0.7 million in 2015 to $1.2 million in 2016. The increase was due to the additional amortizable intangible assets recorded in connection with the acquisitions of Bankingport and SBA Complete and the branch exchange transaction with First Community Bank.

FDIC insurance expense amounted to $2.4 million in 2017, $2.0 million in 2016, and $2.4 million in 2015. The insurance premium rate charged by the FDIC is based on several variable factors that can result in fluctuations from year to year. As previously discussed, a change in the methodology for assessing banks with $10 billion or less in total assets was implemented as of July 1, 2016 due to the deposit insurance fund reaching a targeted minimum level. This change was the biggest factor in the lower expense in 2016. The increase in 2017 was due to the acquisitions of Carolina Bank and Asheville Savings Bank.

Outside consultant expense amounted to $2.5 million in 2017, and $1.7 million in both 2016 and 2015. The increase in 2017 related to various operational activities.

Data processing expenses amounted to $2.9 million, $2.0 million, and $1.9 million in 2017, 2016, and 2015, respectively. In 2017, our expense was higher due to the acquisitions of Carolina Bank and Asheville Savings Bank. For a period of time following each acquisition until a systems conversion, the Bank incurs the expense of running two data processing systems. For Carolina Bank, this period was from March 3, 2017 to August 4, 2017. For Asheville Savings Bank, this period is from October 1, 2017 to March 16, 2018.

Marketing expense increased to $2.5 million in 2017, from $2.0 million in 2016 and $1.7 million in 2015. In 2017, we increased our promotional efforts, primarily in our new and expanded market areas.

Non-credit losses amounted $0.9 million in 2017, $1.2 million in 2016, and $0.3 million in 2015. The increase in 2016 was primarily due to higher debit card and credit card fraud losses. In 2017, we incurred fewer losses as we rolled out new debit and credit cards in late 2016 and 2017, which had additional fraud-resistant security features.

Income Taxes

Table 6 presents the components of income tax expense and the related effective tax rates. We recorded income tax expense of $21.8 million in 2017, $14.6 million in 2016, and $14.1 million in 2015. Our effective tax rates were 32.1% for 2017, 34.7% for 2016, and 34.3% for 2015. Due to the 2017 Tax Cuts and Jobs Act that was signed into law on December 22, 2017, our federal statutory income tax rate was reduced from 35% to 21%. Accordingly, we revalued our net deferred tax liability and reduced income tax expense by $1.3 million, which reduced our effective tax rate for 2017.

The slight increase in effective tax rate in 2016 was due to nondeductible intangible and merger and acquisition expenses incurred related to corporate acquisitions and the branch exchange transaction in 2016.

Our effective tax rate has generally declined in recent years due to higher amounts of tax-exempt income, primarily bank-owned life insurance income, and lower statutory income tax rates in North Carolina. North Carolina

implemented decreases to its state income tax rate for corporations from 5.0% in 2015 to 4.0% in 2016 to 3.0% in 2017. We expect our effective tax rate to be approximately 21.0% in 2018.

Stock-Based Compensation

We recorded stock-based compensation expense of $1.1 million, $0.7 million, and $0.7 million, for the years ended December 31, 2017, 2016, and 2015, respectively. The increase in this expense from 2016 to 2017 was due to retention-based restricted stock grants made to certain officers during the year. See Note 15 to the consolidated financial statements for more information regarding stock-based compensation.

ANALYSIS OF FINANCIAL CONDITION AND CHANGES IN FINANCIAL CONDITION

Overview

At December 31, 2017, our total assets amounted to $5.5 billion, a 53.5% increase from 2016. As previously discussed, our significant growth is due to the acquisition of Carolina Bank and Asheville Savings Bank in 2017. The following table presents detailed information regarding the nature of changes in our loans and deposits in 2016 and 2017:

n/m – not meaningful

As derived from the table above, in 2017, our total loans outstanding increased $1.3 billion, or 49.1%. The loan growth from acquisitions is due to our acquisition of Carolina Bank in March 2017, which had $497.5 million in loans on the date of acquisition, and our acquisition of Asheville Savings Bank in October 2017, which had $606.2 million in loans on the date of acquisition. Carolina Bank operated through eight branches predominately in the Triad region of North Carolina, and Asheville Savings Bank operated through 13 branches in the Asheville area of North Carolina. We expect these acquisitions to complement our strategic initiatives in these attractive and high-growth markets. Internal growth in our loan portfolio amounted to $228.0 million, or 8.4%. Internal loan growth has been primarily

driven by our recent expansion into high-growth markets and the hiring of experienced bankers in these areas. We expect continued growth in our loan portfolio for 2018.

In 2016, our total loan growth was 7.6%. As derived from the table above, we experienced internal growth in our non-covered loan portfolio of $196.8 million, or 8.1%. We terminated our FDIC loss share agreements on September 22, 2016 and thus, all loans were transferred to non-covered status on that date.

During 2017, we experienced an increase in total deposits of $1.5 billion, or 49.5%. In 2017, we acquired $585.4 million in deposits from the Carolina Bank acquisition and $679.1 million in deposits from the Asheville Savings Bank acquisition. Net internal deposit growth amounted to $195.1 million, or 6.6%. We experienced internal growth of $191.2 million in our core deposit accounts, compared to net declines of $50.4 million in our retail time deposits, excluding brokered and internet deposits. Total brokered deposits amounted to $239.7 million at December 31, 2017, which is a 75.6% increase from the $136.5 million outstanding a year earlier. We increased our reliance of brokered deposits in 2017 to assist in funding the strong organic loan growth we experienced during 2017.

During 2016, we experienced a net increase in total deposits of $136.1 million, or 4.8%. Net internal deposit growth amounted to $159.0 million, or 5.7%, which was partially offset by the impact of our branch exchange in which we sold $23 million more in deposits than we purchased. Our internal growth arose from significant growth in our low-cost core deposit accounts (checking, money market and savings), which was partially offset by declines in our time deposit accounts. We experienced internal growth of $173.9 million in our core deposit accounts, compared to net declines of $74.9 million in retail time deposits, excluding brokered deposits. Total brokered deposits amounted to $136.5 million at December 31, 2016, which is a 78.6% increase from the $76.4 million outstanding a year earlier. We increased our holding of brokered deposits in 2016 in order to fund the strong loan growth experienced.

Our overall liquidity was substantially the same at December 31, 2017 compared to a year earlier. Our liquid assets (cash and securities) as a percentage of our total deposits and borrowings was 20.0% at December 31, 2017 compared to 19.8% at December 31, 2016.

At December 31, 2017, our nonperforming assets to total assets ratio was 0.96% compared to 1.64% at December 31, 2016. The decrease is primarily due to improved economic conditions, on-going resolution of nonperforming assets and improving credit quality.

Distribution of Assets and Liabilities

Table 7 sets forth the percentage relationships of significant components of our balance sheet at December 31, 2017, 2016, and 2015.

Our balance sheet mix has remained relatively stable over the past three years. On the asset side, there have been no significant changes, with net loans comprising 73%-74% of total assets and interest-earning assets ranging from 88%-91%. Intangible assets increased from 2% of total assets in 2015 and 2016 to 5% as of December 31, 2017, primarily as a result of our two whole-bank acquisitions in 2017, in which we recorded a total of $153.9 million in goodwill and $18.6 million in other intangible assets.

On the liability side, in 2016 and 2017, we obtained additional borrowings to help fund the loan growth that we experienced during those years that increased its percentage from 5% to 7%. Deposits decreased from 84% of total liabilities and shareholder’s equity at December 31, 2015 to 80% at December 31, 2017.

Shareholders’ equity increased from 10% of total liabilities and shareholders’ equity at December 31, 2015 and 2016 to 12% at December 31, 2017 due to the common stock issued in connection with our 2017 acquisitions.

Securities

Information regarding our securities portfolio as of December 31, 2017, 2016, and 2015 is presented in Tables 8 and 9.

The composition of the investment securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits. We obtain fair values for the vast majority of our investment securities from a third-party investment recordkeeper, who specializes in securities purchases and sales, recordkeeping, and valuation. This recordkeeper provides us with a third-party report that contains an evaluation of internal controls that includes testwork of securities valuation. We further test the values we receive by comparing the values for a significant sample of securities to another third-party valuation service on a quarterly basis.

Total securities amounted to $461.8 million, $329.0 million, and $320.2 million at December 31, 2017, 2016, and 2015, respectively. The increase in securities in 2017 was partially due to $49.4 million in securities acquired in the acquisition of Carolina Bank in March 2017. Also, we sold $95.0 million in securities that we acquired from Asheville Savings Bank in October 2017 and then subsequently purchased $150 million in mortgage-backed securities in the fourth quarter of 2017. The increase in securities in 2016 was primarily due to purchases of mortgage-backed securities.

The majority of our “government-sponsored enterprise” securities carry one maturity date, often with an issuer call feature. At December 31, 2017, of the $13.9 million (carrying value) in government-sponsored enterprise securities, $6.4 million were issued by the Federal Home Loan Bank system, $5.0 million were issued by Fannie Mae, and the remaining $2.5 million were issued by Freddie Mac.

Nearly all of our $359.0 million in total mortgage-backed securities have been issued by Freddie Mac, Fannie Mae, Ginnie Mae, or the Small Business Administration, each of which are government-sponsored corporations. Included in the mortgage-backed securities at December 31, 2017, were commercial mortgage-backed securities of $48.6 million that were issued by Ginnie Mae. We have one insignificant “private label” mortgage-backed security that was purchased for Community Reinvestment Act purposes. Mortgage-backed securities vary in their repayment in correlation with the underlying pools of mortgage loans.

At December 31, 2017, our $34.2 million investment in corporate bonds was comprised of the following:

We have concluded that any unrealized losses associated with our corporate bonds are due to interest rate considerations and not due to credit concerns.

We held $118.5 million in securities held to maturity at December 31, 2017, which had a fair value that exceeded their carrying value by $0.5 million. Approximately $63.8 million of the securities held to maturity are mortgage-backed securities that have been issued by either Freddie Mac or Fannie Mae. The remaining $54.7 million in securities held to maturity are comprised almost entirely of municipal bonds issued by state and local governments throughout our market area. We have only two municipal bonds with a denomination of $2 million or greater and we have no significant concentration of bond holdings from one government entity, with the single largest exposure to any one entity being $6.5 million. Management evaluated any unrealized losses on individual securities at each year end and determined them to be of a temporary nature and caused by fluctuations in market interest rates, not by concerns about the ability of the issuers to meet their obligations.

At December 31, 2017, 2016, and 2015, net unrealized losses of $2.2 million, $3.1 million and $1.2 million, respectively, were included in the carrying value of securities classified as available for sale. Management evaluated any unrealized losses on individual securities at each year end and determined them to be of a temporary nature and caused by fluctuations in market interest rates and the overall economic environment, not by concerns about the ability of the issuers to meet their obligations. Net unrealized losses (net of applicable deferred income taxes of $0.5 million, $1.1 million, and $0.5 million) have been reported as part of a separate component of shareholders’ equity (accumulated other comprehensive income) as of December 31, 2017, 2016, and 2015, respectively.

The weighted average taxable-equivalent yield for the securities available for sale portfolio was 2.63% at December 31, 2017. The expected weighted average life of the available for sale portfolio using the call date for above-market callable bonds, the maturity date for all other non-mortgage-backed securities, and the expected life for mortgage-backed securities, was 4.9 years.

The weighted average taxable-equivalent yield for the securities held to maturity portfolio was 2.98% at December 31, 2017. The expected weighted average life of the held to maturity portfolio using the call date for above-market callable bonds, the expected life for mortgage-backed securities, and the maturity date for all other securities, was 2.8 years.

The following table provides the names of issuers for which the Company has investment securities totaling in excess of 10% of shareholders’ equity and the fair value and amortized cost of these investments as of December 31, 2017. All of these securities are issued by government sponsored corporations.

Loans

Table 10 provides a summary of the loan portfolio composition of our total loans at each of the past five year ends.

The loan portfolio is the largest category of our earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans, and consumer loans. Substantially all of our entire current loan portfolio is within our 40 county market area, which is located in western, central and eastern North Carolina and three counties in northeastern South Carolina. The diversity of the region’s economic base has historically provided a stable lending environment.

As previously discussed, in our acquisitions of failed banks in 2009 and 2011, we entered into loss share agreements with the FDIC, which afforded us significant protection from losses on all loans and other real estate acquired in those acquisitions. Because of the loss protection provided by the FDIC, the financial risk of these loans became significantly different from assets not covered under the loss share agreements, and accordingly, they were presented

as “covered loans.” Loans that were not subject to the loss share agreements were presented as “non-covered loans.” All loss share agreements were terminated in 2016 and thus the entire loan portfolio is now classified as non-covered. Certain disclosures will continue to present the historical breakout of the loan portfolio between covered and non-covered.

In 2017, loans outstanding increased $1.33 billion, or 49.1% to $4.0 billion. The growth in 2017 can be attributed to the acquisitions of Carolina Bank and Asheville Savings Bank, as well as organic loan growth of $228.0 million. In 2016, loans outstanding increased $192.7 million, or 7.6% to $2.7 billion. The growth in 2016 can be attributed to the recent hiring of experienced lenders, our expansion into high-growth markets, and higher loan demand associated with a growing and recovering economy.

The majority of our loan portfolio over the years has been real estate mortgage loans, with loans secured by real estate consistently comprising 88% to 91% of our outstanding loan balances. Except for construction, land development and other land loans, the majority of our “real estate” loans are personal and commercial loans where cash flow from the borrower’s occupation or business is the primary repayment source, with the real estate pledged providing a secondary repayment source.

Table 10 presents a five-year history of loans outstanding by type. Residential real estate loans have declined from 34% of total loans at December 31, 2013 to 24% of total loans at December 31, 2017. This decline was due to a combination of factors including consumers refinancing their home loans held by the Bank with long term fixed rate loans, which we typically sell in the secondary market. Additionally, the Carolina Bank loan portfolio assumed during the year had only an 11% mix of residential real estate loans.

Commercial real estate loans as a percentage of total loans has increased steadily over the past five years and amounted to 42% of all loans at December 31, 2017. Consistent with our community banking strategy, we have placed emphases on this type of loan growth and hired a number of experienced community bankers, who have originated a significant amount of business loans secured by real estate.

Table 11 provides a summary of scheduled loan maturities over certain time periods, with fixed rate loans and adjustable rate loans shown separately. Approximately 15% of our accruing loans outstanding at December 31, 2017 mature within one year and 56% of total loans mature within five years. As of December 31, 2017, the percentages of variable rate loans and fixed rate loans as compared to total performing loans were 38% and 62%, respectively. We intentionally make a blend of fixed and variable rate loans so as to reduce interest rate risk. The mix of fixed rate loans has generally increased over the past several years because many borrowers desire to lock in an interest rate during the historically low interest rate environment that has been in effect. While this presents risk to our Company if interest rates rise, we measure our interest rate risk closely and, as discussed in the section “Interest Rate Risk” below, we do not believe that an increase in interest rates would materially negatively impact our net interest income.

Nonperforming Assets

Nonperforming assets include nonaccrual loans, troubled debt restructurings, loans past due 90 or more days and still accruing interest, and foreclosed real estate. As a matter of policy we place all loans that are past due 90 or more days on nonaccrual basis, and thus there were no loans at any of the past five year ends that were 90 days past due and still accruing interest.

Nonaccrual loans are loans on which interest income is no longer being recognized or accrued because management has determined that the collection of interest is doubtful. Placing loans on nonaccrual status negatively impacts earnings because (i) interest accrued but unpaid as of the date a loan is placed on nonaccrual status is reversed and deducted from interest income, (ii) future accruals of interest income are not recognized until it becomes probable that both principal and interest will be paid and (iii) principal charged-off, if appropriate, may necessitate additional provisions for loan losses that are charged against earnings. In some cases, where borrowers are experiencing

financial difficulties, loans may be restructured to provide terms significantly different from the originally contracted terms.

Table 12 summarizes our nonperforming assets at the dates indicated. Prior to September 2016, we presented nonperforming assets that were subject to the loss share agreements as “covered” and nonperforming assets that were not subject to the loss share agreements as “non-covered.” Our loss share agreements with the FDIC were terminated in 2016, and as such, all assets are now presented as a singled “non-covered” amount.

Due largely to the economic downturn that began in late 2007 and continued to worsen over succeeding years, we experienced significant increases in our non-covered nonperforming assets, with total non-covered nonperforming assets rising steadily from $11 million at December 31, 2007 to a peak of $146 million at September 30, 2012. Nonperforming covered assets assumed from two bank failures amounted to an additional $114 million at September 30, 2012, which resulted in a total of $260 million in nonperforming assets.

Since that time, we have benefited from improving economic conditions and also implemented a combination of strategies to reduce nonperforming assets including a 2013 loan sale, loan restructurings, discounted payoffs, and other collection strategies. As a result, we have steadily reduced our level of nonperforming assets over the years, with nonperforming assets amounting to $53.4 million at December 31, 2017. At December 31, 2017, the ratio of nonperforming assets to total assets was 0.96% compared to 1.64% and 2.66% at December 31, 2016 and 2015, respectively.

Table 12a presents our nonperforming assets at December 31, 2017 by general geographic region.

The following is the composition, by loan type, of all of our nonaccrual loans at each period end:

The nonaccrual table above generally indicates that we experienced decreases in almost all categories of nonaccrual loans, with the “real estate – mortgage – residential ( 1 - 4 family) first mortgages” category experiencing the largest decline. The decline in nonaccrual loans is due to our on-going focus to resolve our nonperforming loans and improving credit quality.

Management routinely monitors the status of certain large loans that, in management’s opinion, have credit weaknesses that could cause them to become nonperforming loans. In addition to the nonperforming loan amounts discussed above, management believes that an estimated $2.5 million of loans that were performing in accordance with their contractual terms at December 31, 2017 have the potential to develop problems depending upon the particular financial situations of the borrowers and economic conditions in general. Management has taken these potential problem loans into consideration when evaluating the adequacy of the allowance for loan losses at December 31, 2017 (see discussion below).

Loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been disclosed in the problem loan amounts and the potential problem loan amounts discussed above do not represent or result from trends or uncertainties that management reasonably expects will materially impact future operating results, liquidity, or capital resources, or represent material credits about which management is aware of any information that causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.

We provide additional information regarding the classification status of our loans in tables contained in Note 4 to our consolidated financial statements. Those tables indicate that from December 31, 2016 to December 31, 2017 our asset quality improved, with total classified and nonaccrual loans decreasing from $98.5 million at December 31, 2016 to $79.4 million at December 31, 2017. This is consistent with our generally improving asset quality trends.

Foreclosed real estate includes primarily foreclosed properties. Total foreclosed real estate amounted to $12.6 million, $9.5 million, and $10.0 million at December 31, 2017, 2016, and 2015, respectively. Generally, we have experienced decreases in foreclosed real estate over the past several years primarily due to increased property sales activity, particularly along the North Carolina coast, which is where a significant portion of our foreclosed properties are located, and the improvement in our overall asset quality. In 2017, we acquired $3.1 million and $3.9 million of foreclosed real estate in the acquisitions of Carolina Bank and Asheville Savings Bank, respectively.

The following table presents the detail of our foreclosed real estate at each of the past two year ends:

Allowance for Loan Losses and Loan Loss Experience

The allowance for loan losses is created by direct charges to operations (known as a “provision for loan losses” for the period in which the charge is taken). Losses on loans are charged against the allowance in the period in which such loans, in management’s opinion, become uncollectible. The recoveries realized during the period are credited to this allowance. We consider our procedures for recording the amount of the allowance for loan losses and the related provision for loan losses to be a critical accounting policy. See the heading “Critical Accounting Policies” above for further discussion.

The factors that influence management’s judgment in determining the amount charged to operating expense include recent loan loss experience, composition of the loan portfolio, evaluation of probable inherent losses and current economic conditions.

We use a loan analysis and grading program to facilitate our evaluation of probable inherent loan losses and the adequacy of our allowance for loan losses. In this program, credit risk grades are assigned by management and tested by an independent third-party consulting firm. The testing program includes an evaluation of a sample of new loans, loans we identify as having potential credit weaknesses, loans past due 90 days or more, loans originated by new loan officers, nonaccrual loans and any other loans identified during previous regulatory and other examinations.

We strive to maintain our loan portfolio in accordance with what management believes are conservative loan underwriting policies that result in loans specifically tailored to the needs of our market areas. Every effort is made to identify and minimize the credit risks associated with such lending strategies. We have no foreign loans, few agricultural loans and do not engage in significant lease financing or highly leveraged transactions. Commercial loans are diversified among a variety of industries. The majority of loans captioned in the tables discussed below as “real estate” loans are personal and commercial loans where real estate provides additional security for the loan. Collateral for virtually all of these loans is located within our principal market area.

The total allowance for loan losses amounted to $23.3 million at December 31, 2017 compared to $23.8 million at December 31, 2016 and $28.6 million at December 31, 2015.

Our allowance for loan loss is a mathematical model with the primary factors impacting this model being loan growth, net charge-off history, and asset quality trends. Our allowance for loan loss model utilizes the net charge-offs

experienced in the most recent years as a significant component of estimating the current allowance for loan losses that is necessary. Thus, older years (and parts thereof) systematically age out and are excluded from the analysis as time goes on. In 2015, a prolonged period of stable and improving loan quality trends following the recession resulted in generally lower provisions for loan losses that were needed to adjust our allowance for loan losses to the appropriate amount. This had the impact of bringing our overall allowance for loan loss level on non-covered loans down to a more normalized level, amounting to 1.11% at December 31, 2015, following the elevated amounts we maintained during and immediately following the recession. The impaired loan quality trends were also the primary reason for the provision for loan losses on non-covered loans declining from $7.1 million in 2014 to $2.0 million in 2015. These same factors continued in 2016 and 2017 and were further impacted by net charge-offs that declined significantly, amounting to only $3.7 million in 2016 and $1.2 million in 2017 compared to over $10 million in the immediately preceding years.

The ratio of our allowance to total loans was 0.58%, 0.88%, and 1.13% at December 31, 2017, 2016, and 2015, respectively. The decline in this ratio from December 31, 2015 to December 31, 2016 was a result of the factors discussed above that impacted our relatively low levels of provision for loan losses. The decline in 2017 was primarily due to the acquisitions of Carolina Bank and Asheville Savings Bank, which had over $1 billion in total loans. Applicable accounting guidance did not allow us to record an allowance for loan losses upon the acquisition of loans – instead the acquired loans were recorded at their discounted fair value, which included the consideration of any expected losses. No allowance for loan losses will be recorded for the acquired loans until the expected credit losses exceed the remaining unamortized discounts – based on an individual basis for purchased credit impaired loans and on a pooled basis for performing acquired loans. See Critical Accounting Policies above for further discussion. Unaccreted discount, which is available to absorb loan losses, amounted to $26.9 million, $12.7 million, and $15.3 million at December 31, 2017, December 31, 2016, and December 31, 2015, respectively. The ratios of allowance for loan losses plus unaccreted discount were 1.24%, 1.35%, and 1.74% at December 31, 2017, December 31, 2016, and December 31, 2015, respectively.

Table 13 sets forth the allocation of the allowance for loan losses at the dates indicated. The amount of the unallocated portion of the allowance for loan losses increased in 2017 due to a higher level of allowance resulting from management qualitative analysis. The allowance for loan losses is available to absorb losses in all categories.

Management considers the allowance for loan losses adequate to cover probable loan losses on the loans outstanding as of each reporting date. It must be emphasized, however, that the determination of the allowance using our procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that we will not in any particular period sustain loan losses that are sizable in relation to the amount reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and losses on foreclosed real estate. Such agencies may require us to recognize additions to the allowance based on the examiners’ judgments about information available to them at the time of their examinations.

For the years indicated, Table 14 summarizes our balances of loans outstanding, average loans outstanding, and a detailed rollforward of the allowance for loan losses.

Net loan charge-offs of total loans amounted to $1.2 million in 2017, $3.7 million in 2016, and $11.3 million in 2015. Net loan charge-offs of non-covered loans amounted to $1.2 million in 2017, $5.4 million in 2016, and $13.6 million in 2015. The trend of lower net charge-offs is associated with lower levels of nonperforming loans that have been impacted with improvements in the economy and real estate prices.

We recorded ($1.7 million), and ($2.3 million) in net charge-offs (recoveries) of covered loans during 2016 and 2015, respectively.

Deposits

At December 31, 2017, deposits outstanding amounted to $4.41 billion, an increase of $1.46 billion from the $2.95 billion at December 31, 2016. During 2017, we acquired Carolina Bank with $585.4 million in deposits and Asheville Savings Bank with $679.1 million in deposits. We also experienced organic growth totaling $195.1 million in 2017, with the majority of our growth occurring in noninterest-bearing checking accounts. Our higher cost retail time deposits declined by $50.4 million in 2017. Total brokered deposits amounted to $239.7 million at December 31, 2017, which is a 75.6% increase from the $136.5 million outstanding a year earlier. The increased usage of brokered deposits was necessary because of organic loan growth that exceeded deposit growth. This imbalance of growth is largely associated with our recent growth and expansion into the larger markets of North Carolina – Charlotte, Greensboro and Raleigh. When initially entering markets such as these, our experience has been that we are able to capture loan market share faster than deposit market share.

At December 31, 2016, deposits outstanding amounted to $2.95 billion, an increase of $136 million from the $2.81 billion at December 31, 2015. Similar to 2017, during 2016 we experienced strong growth in our noninterest-bearing and interest-bearing checking accounts, and declines in our higher cost time deposits.

The nature of our deposit growth is illustrated in the table on page 52. The following table reflects the mix of our deposits at each of the past three year ends:

Our deposit mix has shifted over the past few years to a heavier concentration in transaction accounts and less concentration in time deposits. The percentages for retail time deposits have declined because of a combination of 1) customers shifting their matured time deposits into checking accounts because of a steadily shrinking gap between the interest rates that the two products pay and 2) because of satisfactory levels of liquidity and the availability of brokered deposits and borrowings, we chose not to match certain promotional time deposit interest rates being offered by local competitors.

We routinely engage in activities designed to grow and retain deposits, such as (1) emphasizing relationship banking to new and existing customers, where borrowers are encouraged and normally expected to maintain deposit accounts with us, (2) pricing deposits at rate levels that will attract and/or retain deposits, and (3) continually working to identify and introduce new products that will attract customers or enhance our appeal as a primary provider of financial services.

Table 15 presents the average amounts of our deposits and the average yield paid for those deposits for the years ended December 31, 2017, 2016, and 2015.

As of December 31, 2017, we held approximately $593.1 million in time deposits of $100,000 or more. Table 16 is a maturity schedule of time deposits of $100,000 or more as of December 31, 2017. This table shows that 70% of our time deposits greater than $100,000 mature within one year.

At each of the past three year ends, we have no deposits issued through foreign offices, nor do we believe that we held any deposits by foreign depositors.

Borrowings

Our borrowings outstanding totaled $407.5 million at December 31, 2017, $271.4 million at December 31, 2016, and $186.4 million at December 31, 2015. In 2017, 2016 and 2015, we obtained net new borrowings of $87 million, $85 million and $70 million, respectively, from a low cost funding source to help support our loan growth experienced during the years. Also, during 2017, we acquired Carolina Bank and Asheville Savings Bank. Carolina Bank had $11.5 million in low-cost borrowings, with a fair value of $11.3 million at acquisition date, and $10.3 million in trust preferred security debt, with a fair value of $7.2 million at acquisition date. Asheville Savings Bank had $20.0 million in low-cost borrowings, with a fair value of $20.0 million at acquisition date.

Table 2 shows that average borrowings were $325.9 million in 2017, $209.7 million in 2016, and $149.8 million in 2015.

At December 31, 2017, the Company had three sources of readily available borrowing capacity – 1) an approximately $936 million line of credit with the FHLB, of which $354 million and $225 million was outstanding at December 31, 2017 and 2016, respectively, 2) a $35 million federal funds line of credit with a correspondent bank, of which none was outstanding at December 31, 2017 or 2016, and 3) an approximately $109 million line of credit through the Federal Reserve Bank of Richmond’s (“FRB”) discount window, of which none was outstanding at December 31, 2017 or 2016.

Our line of credit with the FHLB can be structured as either short-term or long-term borrowings, depending on the particular funding or liquidity need, and is secured by our FHLB stock and a blanket lien on most of our real estate loan portfolio. For the year ended December 31, 2017, the average amount of FHLB borrowings outstanding was approximately $273.8 million with a weighted average interest rate for the year of 1.19%. The maximum amount of short-term FHLB borrowings outstanding at any month-end during 2017 was $354 million. For the year ended December 31, 2016, the average amount of FHLB borrowings outstanding was approximately $163 million with a weighted average interest rate for the year of 0.75%. The maximum amount of short-term FHLB borrowings outstanding at any month-end during 2016 was $225 million.

In addition to any outstanding borrowings from the FHLB that reduce the available borrowing capacity of the line of credit, our borrowing capacity was further reduced by $198 million and $193 million at December 31, 2017 and 2016, respectively, as a result of our pledging letters of credit backed by the FHLB for public deposits at each of those dates.

Our correspondent bank relationship allows us to purchase up to $35 million in federal funds on an overnight, unsecured basis (federal funds purchased). We had no borrowings under this line at December 31, 2017 or 2016. There were no federal funds purchased outstanding at any month-end during 2017 or 2016.

We also have a line of credit with the FRB discount window. This line is secured by a blanket lien on a portion of our commercial and consumer loan portfolio (excluding real estate loans). Based on the collateral that we owned as of December 31, 2017, the available line of credit was approximately $109 million. At December 31, 2017 and 2016, we had no borrowings outstanding under this line.

In addition to the lines of credit described above, we also had a total of $56.7 million in trust preferred security debt outstanding at December 31, 2017 and 2016. We have initiated three trust preferred security issuances since 2002 totaling $67.0 million, with one of those issuances for $20.6 million being redeemed in 2007. These borrowings each have 30 year final maturities and were structured in a manner that allows them to qualify as capital for regulatory capital adequacy requirements. We may call these debt securities at par on any quarterly interest payment date five years after their issue date. We issued $20.6 million of this debt on October 29, 2002 (which we called in 2007), an additional $20.6 million on December 19, 2003, and $25.8 million on April 13, 2006. The interest rate on these debt securities adjusts on a quarterly basis at a rate of three-month LIBOR plus 2.70% for the securities issued in 2003, and three-month LIBOR plus 1.39% for the securities issued in 2006.

In 2017, we assumed $10.3 million in trust preferred security debt in our acquisition of Carolina Bank. This borrowing has a 30 year final maturity and was structured in a manner that allows them to qualify for regulatory capital adequacy requirements. These debt securities are currently callable by the Company at par on any quarterly interest payment date. The interest rate on these debt securities adjusts on a quarterly basis of three-month LIBOR plus 2.00%.

Liquidity, Commitments, and Contingencies

Our liquidity is determined by our ability to convert assets to cash or to acquire alternative sources of funds to meet the needs of our customers who are withdrawing or borrowing funds, and our ability to maintain required reserve levels, pay expenses and operate the Company on an ongoing basis. Our primary liquidity sources are net income from operations, cash and due from banks, federal funds sold and other short-term investments. Our securities portfolio is comprised almost entirely of readily marketable securities which could also be sold to provide cash.

As noted above, in addition to internally generated liquidity sources, at December 31, 2017, we had the ability to obtain borrowings from the following three sources – 1) an approximately $936 million line of credit with the FHLB, 2) a $35 million federal funds line with a correspondent bank, and 3) an approximately $109 million line of credit through the FRB’s discount window.

Our overall liquidity increased in 2017 compared to 2016. Our liquid assets (cash and securities) as a percentage of our total deposits and borrowings amounted to 19.8% at December 31, 2016 to 20.0% at December 31, 2017.

We continue to believe our liquidity sources, including unused lines of credit, are at an acceptable level and remain adequate to meet our operating needs in the foreseeable future. We will continue to monitor our liquidity position carefully and will explore and implement strategies to increase liquidity if deemed appropriate.

In the normal course of business we have various outstanding contractual obligations that will require future cash outflows. In addition, there are commitments and contingent liabilities, such as commitments to extend credit, that may or may not require future cash outflows.

Table 18 reflects our contractual obligations and other commercial commitments outstanding as of December 31, 2017. Any of our $354 million in outstanding borrowings with the FHLB may be accelerated immediately by the FHLB in certain circumstances, including material adverse changes in our condition or if our qualifying collateral is less than the amount required under the terms of the borrowing agreement.

In the normal course of business there are various outstanding commitments and contingent liabilities such as commitments to extend credit, which are not reflected in the financial statements. The following table presents a summary of our outstanding loan commitments as of December 31, 2017:

At December 31, 2017 and 2016, we also had $15.2 million and $12.7 million, respectively, in standby letters of credit outstanding. We had no carrying amount for these standby letters of credit at either of those dates. The nature of the standby letters of credit is that of a guarantee made on behalf of our customers to suppliers of the customers to guarantee payments owed to the supplier by the customer. The standby letters of credit are generally for terms of one year, at which time they may be renewed for another year if both parties agree. The payment of the guarantees would generally be triggered by a continued nonpayment of an obligation owed by the customer to the supplier. The maximum potential amount of future payments (undiscounted) we could be required to make under the guarantees

in the event of nonperformance by the parties to whom credit or financial guarantees have been extended is represented by the contractual amount of the financial instruments discussed above. In the event that we are required to honor a standby letter of credit, a note, already executed by the customer, becomes effective providing repayment terms and any collateral. Over the past two years, we have had to honor only a few standby letters of credit, none of which resulted in any loss to the Company. We expect any draws under existing commitments to be funded through normal operations.

It has been our experience that deposit withdrawals are generally able to be replaced with new deposits when needed. Based on that assumption, management believes that it can meet its contractual cash obligations and existing commitments from normal operations.

We are not involved in any legal proceedings that, in management’s opinion, are likely to have a material effect on the consolidated financial position of the Company.

Capital Resources and Shareholders’ Equity

Shareholders’ equity at December 31, 2017 amounted to $693.0 million compared to $368.1 million at December 31, 2016 and $342.2 million at December 31, 2015. The two basic components that typically have the largest impact on our shareholders’ equity are net income, which increases shareholders’ equity, and dividends declared, which decrease shareholders’ equity. Additionally, any stock issuances (redemptions) can significantly increase (decrease) shareholders’ equity.

In 2017, the most significant factors that impacted our equity were 1) the issuances of $284.2 million of common stock in connection with two bank acquisitions, which increased equity, 2) the $46.0 million net income reported for 2017, which increased equity, and 3) common stock dividends declared of $8.3 million, which reduced equity. With the acquisition of Carolina Bank in March 2017, we assumed a deferred compensation plan for certain members of Carolina Bank’s board of directors that is fully funded by underlying Company stock, which was valued at $7.7 million on the date of acquisition. Subsequent to the acquisition in 2017, approximately $4.1 million of the deferred compensation was paid to the plan participants. See the Consolidated Statements of Shareholders’ Equity within the consolidated financial statements for disclosure of other less significant items affecting shareholders’ equity.

In 2016, the most significant factors that impacted our equity were 1) the $27.5 million net income reported for 2016, which increased equity, 2) common stock dividends declared of $6.5 million, which reduced equity, and 3) issuances of $5.5 million of common stock in connection with two acquisitions, which increased equity.

Also, on December 22, 2016, we exchanged 728,706 shares of preferred stock for the same number of shares of our common stock, which resulted in $7.3 million in shareholders’ equity shifting from preferred stock to common stock, but did not affect our total amount of equity. At December 31, 2017 and 2016, we have no shares of preferred stock outstanding.

In 2015, the most significant factors that impacted our equity were 1) the $63.5 million redemption of our Series B Preferred Stock issued to the U.S. Treasury in 2011 under the Small Business Lending Fund, which reduced equity (see Note 19 to our consolidated financial statements), 2) the $27.0 million net income reported for 2015, which increased equity, and 3) common stock dividends declared of $6.3 million, which reduced equity. Another factor negatively impacting equity in 2015 was a $2.7 million decrease in accumulated other comprehensive income that was caused primarily by an increase in our pension liability. The increase in the pension liability was primarily due to underperformance of our pension plan assets during 2015.

In addition to shareholders’ equity, we have supplemented our capital in past years with trust preferred security debt issuances, which because of their structure qualify as regulatory capital. This was necessary in past years because our balance sheet growth outpaced the growth rate of our capital. Additionally, we have purchased several bank branches over the years that resulted in our recording intangible assets, which negatively impacted regulatory capital

ratios. As discussed in “Borrowings” above, we currently have $56.7 million in trust preferred securities outstanding, all of which qualify as Tier I capital under both current and forthcoming regulatory standards.

We are not aware of any recommendations of regulatory authorities or otherwise which, if they were to be implemented, would have a material effect on our liquidity, capital resources, or operations.

The Company and the Bank must comply with regulatory capital requirements established by the Federal Reserve. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements.

Common Equity Tier I capital (“CET1”) is comprised of common stock and related surplus, plus retained earnings, and is reduced by goodwill and other intangible assets, net of associated deferred tax liabilities. Tier I capital is comprised of CET1 capital plus Additional Tier I capital, which for the Company includes non-cumulative perpetual preferred stock and trust preferred securities. Total capital is comprised of Tier I capital plus certain adjustments, the largest of which for the Company and the Bank is the allowance for loan losses. Risk-weighted assets refer to the on- and off-balance sheet exposures of the Company and the Bank, adjusted for their related risk levels using formulas set forth in Federal Reserve regulations.

Under the Basel III Capital Rules, the following were the initial minimum capital ratios applicable to the Company and the Bank as of January 1, 2015:

The Basel III Capital Rules include a “capital conservation buffer,” composed entirely of CET1, on top of these minimum risk-weighted asset ratios. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the capital conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. The implementation of the capital conservation buffer began on January 1, 2016 at 0.625% and will be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019). Thus, when fully phased-in on January 1, 2019, the Company and the Bank will be required to maintain this additional capital conservation buffer of 2.5% of CET1, resulting in the following minimum capital ratios:

In addition to the minimum capital requirements described above, the regulatory framework for prompt corrective action also contains specific capital guidelines for a bank’s classification as “well capitalized.” The current specific guidelines are as follows:

If a bank falls below “well capitalized” status in any of these three ratios, it must ask for FDIC permission to originate or renew brokered deposits. The Bank’s regulatory ratios exceeded the threshold for “well-capitalized” status at December 31, 2017, 2016, and 2015 – see Note 16 to the consolidated financial statements for a table that presents the Bank’s regulatory ratios.

Table 21 presents our regulatory capital ratios as of December 31, 2017, 2016, and 2015. All of our capital ratios have significantly exceeded the minimum regulatory thresholds for all periods covered by this report.

In this economic environment, our goal is to maintain our capital ratios at levels at least 200 basis points higher than the “well capitalized” thresholds set for banks. At December 31, 2017, our total risk-based capital ratio was 12.50% compared to the 10.00% “well capitalized” threshold.

In addition to regulatory capital ratios, we also closely monitor our ratio of tangible common equity to tangible assets (“TCE Ratio”). Our TCE Ratio was 8.23% at December 31, 2017 compared to 8.16% at December 31, 2016.

See “Supervision and Regulation” under “Business” above and Note 16 to the consolidated financial statements for discussion of other matters that may affect our capital resources.

Off-Balance Sheet Arrangements and Derivative Financial Instruments

Off-balance sheet arrangements include transactions, agreements, or other contractual arrangements pursuant to which we have obligations or provide guarantees on behalf of an unconsolidated entity. We have no off-balance sheet arrangements of this kind other than letters of credit and repayment guarantees associated with our trust preferred securities.

Derivative financial instruments include futures, forwards, interest rate swaps, options contracts, and other financial instruments with similar characteristics. We have not engaged in significant derivatives activities through December 31, 2017 and have no current plans to do so.

Return on Assets and Equity

Table 20 shows return on average assets (net income available to common shareholders divided by average total assets), return on average common equity (net income available to common shareholders divided by average common shareholders’ equity), dividend payout ratio (dividends per share divided by net income per common share) and shareholders’ equity to assets ratio (average total shareholders’ equity divided by average total assets) for each of the years in the three-year period ended December 31, 2017.

Interest Rate Risk (Including Quantitative and Qualitative Disclosures About Market Risk – Item 7A.)

Net interest income is our most significant component of earnings. Notwithstanding changes in volumes of loans and deposits, our level of net interest income is continually at risk due to the effect that changes in general market interest rate trends have on interest yields earned and paid with respect to our various categories of earning assets and interest-bearing liabilities. It is our policy to maintain portfolios of earning assets and interest-bearing liabilities with maturities and repricing opportunities that will afford protection, to the extent practical, against wide interest rate fluctuations. Our exposure to interest rate risk is analyzed on a regular basis by management using standard GAP reports, maturity reports, and an asset/liability software model that simulates future levels of interest income and expense based on current interest rates, expected future interest rates, and various intervals of “shock” interest rates. Over the years, we have been able to maintain a fairly consistent yield on average earning assets (net interest margin). Over the past five calendar years, our net interest margin has ranged from a low of 4.03% (realized in 2016) to a high of 4.92% (realized in 2013). Up until the end of 2015, the prime rate of interest had remained at 3.25% since 2008. In response to Federal Reserve actions, the prime rate increased to 3.50% on December 17, 2015 and to 3.75% on December 15, 2016. In 2017, the Federal Reserve steadily increased the prime rate three additional times, up to 4.50% (the rate at December 31, 2017). The consistency of the net interest margin is aided by the relatively low level

of long-term interest rate exposure that we maintain. At December 31, 2017, approximately 78% of our interest-earning assets are subject to repricing within five years (because they are either adjustable rate assets or they are fixed rate assets that mature) and substantially all of our interest-bearing liabilities reprice within five years.

Table 17 sets forth our interest rate sensitivity analysis as of December 31, 2017, using stated maturities for all fixed rate instruments except mortgage-backed securities (which are allocated in the periods of their expected payback) and securities and borrowings with call features that are expected to be called (which are shown in the period of their expected call). As illustrated by this table, at December 31, 2017, we had $1.3 billion more in interest-bearing liabilities that are subject to interest rate changes within one year than earning assets. This generally would indicate that net interest income would experience downward pressure in a rising interest rate environment and would benefit from a declining interest rate environment. However, this method of analyzing interest sensitivity only measures the magnitude of the timing differences and does not address earnings, market value, or management actions. Also, interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. In addition to the effects of “when” various rate-sensitive products reprice, market rate changes may not result in uniform changes in rates among all products. For example, included in interest-bearing liabilities subject to interest rate changes within one year at December 31, 2017 are deposits totaling $2.3 billion comprised of checking, savings, and certain types of money market deposits with interest rates set by management. These types of deposits historically have not repriced with, or in the same proportion, as general market indicators.

Overall, we believe that in the near term (twelve months), net interest income will not likely experience significant downward pressure from rising interest rates. Similarly, we would not expect a significant increase in near term net interest income from falling interest rates. Generally, when rates change, our interest-sensitive assets that are subject to adjustment reprice immediately at the full amount of the change, while our interest-sensitive liabilities that are subject to adjustment reprice at a lag to the rate change and typically not to the full extent of the rate change. In the short-term (less than six months), this results in us being asset-sensitive, meaning that our net interest income benefits from an increase in interest rates and is negatively impacted by a decrease in interest rates. However, in the twelve-month horizon, the impact of having a higher level of interest-sensitive liabilities lessens the short-term effects of changes in interest rates.

The general discussion in the foregoing paragraph applies most directly in a “normal” interest rate environment in which longer-term maturity instruments carry higher interest rates than short-term maturity instruments, and is less applicable in periods in which there is a “flat” interest rate curve. A “flat yield curve” means that short-term interest rates are substantially the same as long-term interest rates. As a result of the prolonged negative/fragile economic environment, the Federal Reserve took steps to suppress long-term interest rates in an effort to boost the housing market, increase employment, and stimulate the economy, which resulted in a flat interest rate curve. A flat interest rate curve is an unfavorable interest rate environment for many banks, including the Company, as short-term interest rates generally drive our deposit pricing and longer-term interest rates generally drive loan pricing. When these rates converge, the profit spread we realize between loan yields and deposit rates narrows, which pressures our net interest margin.

While there have been periods in the last few years that the yield curve has steepened somewhat, it currently remains relatively flat. This flat yield curve and the intense competition for high-quality loans in our market areas have limited our ability to charge higher rates on loans, and thus we continue to experience challenges to increasing our loan yields and net interest margin.

As it relates to deposits, the Federal Reserve made no changes to the short term interest rates it sets directly from 2008 until mid-December 2015, and since that time we have been able to reprice many of our maturing time deposits at lower interest rates. We were also able to generally decrease the rates we paid on other categories of deposits as a result of declining short-term interest rates in the marketplace and an increase in liquidity that lessened our need to offer premium interest rates. However, as our average funding rate approached zero several years ago, meaningful further declines were not possible. Thus far, the five interest rate increases initiated by the Federal Reserve over the

past two years have not resulted in significant competitive pressure to increase deposit rates, but we expect the competitive pressures to increase.

As previously discussed in the section “Net Interest Income,” our net interest income has been impacted by certain purchase accounting adjustments related to the acquired banks. The purchase accounting adjustments related to the premium amortization on loans, deposits and borrowings are based on amortization schedules and are thus systematic and predictable. The accretion of the loan discount on acquired loans, which amounted to $7.1 million, $4.5 million, and $4.8 million in 2017, 2016, and 2015, respectively, is less predictable and could be materially different among periods. This is because of the magnitude of the discounts that are initially recorded and the fact that the accretion being recorded is dependent on both the credit quality of the acquired loans and the impact of any accelerated loan repayments, including payoffs. If the credit quality of the loans declines, some, or all, of the remaining discount will cease to be accreted into income. If the underlying loans experience accelerated paydowns or improved performance expectations, the remaining discount will be accreted into income on an accelerated basis. In the event of total payoff, the remaining discount will be entirely accreted into income in the period of the payoff. Each of these factors is difficult to predict and susceptible to volatility. The remaining loan discount on acquired loans amounted to $26.9 million at December 31, 2017 compared to $12.7 million at December 31, 2016.

Based on our most recent interest rate modeling, which assumes two interest rate increases for 2018 (federal funds rate = 2.00%, prime = 5.00%), we project that our net interest margin for 2018 will remain fairly stable. We expect asset yields to increase, and we also expect that we will experience pressure to increase our deposit rates.

We have no market risk sensitive instruments held for trading purposes, nor do we maintain any foreign currency positions. Table 19 presents the expected maturities of our other than trading market risk sensitive financial instruments. Table 19 also presents the estimated fair values of market risk sensitive instruments as estimated in accordance with relevant accounting guidance. Our assets and liabilities have estimated fair values that do not materially differ from their carrying amounts.

See additional discussion regarding net interest income, as well as discussion of the changes in the annual net interest margin, in the section entitled “Net Interest Income” above.

Inflation

Because the assets and liabilities of a bank are primarily monetary in nature (payable in fixed determinable amounts), the performance of a bank is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same. The effect of inflation on banks is normally not as significant as its influence on those businesses that have large investments in plant and inventories. During periods of high inflation, there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans and deposits. Also, general increases in the price of goods and services will result in increased operating expenses.

Current Accounting Matters

We prepare our consolidated financial statements and related disclosures in conformity with standards established by, among others, the Financial Accounting Standards Board (the “FASB”). Because the information needed by users of financial reports is dynamic, the FASB frequently issues new rules and proposes new rules for companies to apply in reporting their activities. See Note 1(v) to our consolidated financial statements for a discussion of recent rule proposals and changes.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

The information responsive to this Item is found in Item 7 under the caption “Interest Rate Risk.”

Table 1 Selected Consolidated Financial Data

Table 2 Average Balances and Net Interest Income Analysis