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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2020

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

For the transition period from__________ to___________

Commission file number 001-38884

FRANKLIN FINANCIAL SERVICES CORPORATION

(Exact name of registrant as specified in its charter)


Pennsylvania	25-1440803
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)


20 South Main Street, Chambersburg, PA	17201-0819
(Address of principal executive offices)	(Zip Code)

(717) 264-6116

(Registrant's telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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



Title of class	Symbol	Name of exchange on which registered
Common stock	FRAF	Nasdaq Capital Market

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨

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

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

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

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act) Yes ¨ No x

There were 4,352,944 outstanding shares of the Registrant’s common stock as of July 31, 2020.

‎

INDEX


Part I - FINANCIAL INFORMATION

Item 1	Financial Statements
	Consolidated Balance Sheets as of June 30, 2020 and December 31, 2019 (unaudited)	1
	Consolidated Statements of Income for the Three and Six Months ended June 30, 2020	2
	and 2019 (unaudited)
	Consolidated Statements of Comprehensive Income for the Three and Six Months ended	3
	June 30, 2020 and 2019 (unaudited)
	Consolidated Statements of Changes in Shareholders’ Equity for the Three and Six Months	3
	ended June 30, 2020 and 2019 (unaudited)
	Consolidated Statements of Cash Flows for the Six Months ended June 30, 2020	5
	and 2019 (unaudited)
	Notes to Consolidated Financial Statements (unaudited)	6

Item 2	Management’s Discussion and Analysis ofResults of Operations and Financial Condition	28
Item 3	Quantitative and Qualitative Disclosures about Market Risk	50
Item 4	Controls and Procedures	50

Part II - OTHER INFORMATION

Item 1	Legal Proceedings	52
Item 1A	Risk Factors	52
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	53
Item 3	Defaults Upon Senior Securities	53
Item 4	Mine Safety Disclosures	53
Item 5	Other Information	54
Item 6	Exhibits	54
SIGNATURE PAGE		55

Part I FINANCIAL INFORMATION

Item 1. Financial Statements

Consolidated Balance Sheets



(Dollars in thousands, except share and per share data) (unaudited)	June 30,		December 31,
	2020		2019
Assets
Cash and due from banks	$	17,752	$	15,336
Short-term interest-bearing deposits in other banks		40,847		68,492
Total cash and cash equivalents		58,599		83,828
Long-term interest-bearing deposits in other banks		13,985		8,746
Debt securities available for sale, at fair value		286,217		187,433
Equity securities		340		440
Restricted stock		468		465
Loans held for sale		5,255		2,040
Loans		1,012,138		934,575
Allowance for loan losses		(16,555)		(11,966)
Net Loans		995,583		922,609
Premises and equipment, net		13,552		13,851
Right of use asset		5,005		5,126
Bank owned life insurance		21,067		23,748
Goodwill		9,016		9,016
Deferred tax asset, net		4,076		4,003
Other assets		9,948		7,852
Total assets	$	1,423,111	$	1,269,157

Liabilities
Deposits
Noninterest-bearing checking	$	248,851	$	192,108
Money management, savings, and interest checking		944,792		843,936
Time		79,710		89,348
Total deposits		1,273,353		1,125,392
Lease liability		5,052		5,161
Other liabilities		9,866		11,076
Total liabilities		1,288,271		1,141,629

Commitments and contingent liabilities (Note 14)

Shareholders' equity
Common stock, $1 par value per share,15,000,000 shares authorized with
4,710,822 shares issued and 4,352,484 shares outstanding at June 30, 2020 and
4,709,849 shares issued and 4,352,753 shares outstanding at December 31, 2019		4,711		4,710
Capital stock no par value, 5,000,000 shares authorized with no
shares issued and outstanding		—		—
Additional paid-in capital		42,461		42,268
Retained earnings		97,124		94,946
Accumulated other comprehensive loss		(725)		(5,986)
Treasury stock, 358,338 shares at June 30, 2020 and 357,096 shares at
December 31, 2019, at cost		(8,731)		(8,410)
Total shareholders' equity		134,840		127,528
Total liabilities and shareholders' equity	$	1,423,111	$	1,269,157

The accompanying notes are an integral part of these unaudited financial statements.

Consolidated Statements of Income


	For the Three Months Ended				For the Six Months Ended
(Dollars in thousands, except per share data) (unaudited)	June 30,				June 30,
	2020		2019		2020		2019
Interest income
Loans, including fees	$	9,680	$	11,125	$	19,848	$	22,134
Interest and dividends on investments:
Taxable interest		1,048		575		2,110		1,114
Tax exempt interest		352		281		524		620
Dividend income		3		12		9		16
Interesting-bearing deposits in other banks		82		403		340		499
Total interest income		11,165		12,396		22,831		24,383
Interest expense
Deposits		833		1,833		2,246		3,457
Short-term borrowings		—		—		—		36
Total interest expense		833		1,833		2,246		3,493
Net interest income		10,332		10,563		20,585		20,890
Provision for loan losses		1,975		—		4,975		399
Net interest income after provision for loan losses		8,357		10,563		15,610		20,491
Noninterest income
Investment and trust services fees		1,590		1,647		3,035		3,099
Loan service charges		502		228		786		431
Deposit service charges and fees		397		603		962		1,149
Other service charges and fees		336		381		683		734
Debit card income		438		464		857		866
Increase in cash surrender value of Bank owned life insurance		112		128		236		255
Bank owned life insurance gain		—		—		812		—
Net gains/(losses) on sales of debt securities		—		229		(10)		253
Change in fair value of equity securities		27		13		(100)		16
Other		10		3		40		59
Total noninterest income		3,412		3,696		7,301		6,862
Noninterest Expense
Salaries and employee benefits		5,382		5,355		10,916		10,797
Net occupancy		865		858		1,695		1,715
Marketing and advertising		464		481		919		883
Legal and professional		430		471		825		901
Data processing		834		738		1,641		1,443
Pennsylvania bank shares tax		263		243		438		486
FDIC Insurance		88		115		148		180
ATM/debit card processing		279		247		543		505
Telecommunications		108		107		213		211
Other		931		991		1,835		1,896
Total noninterest expense		9,644		9,606		19,173		19,017
Income before federal income taxes		2,125		4,653		3,738		8,336
Federal income tax (benefit) expense		(942)		669		(1,048)		1,115
Net income	$	3,067	$	3,984	$	4,786	$	7,221
Per share
Basic earnings per share	$	0.71	$	0.91	$	1.10	$	1.64
Diluted earnings per share	$	0.71	$	0.90	$	1.10	$	1.63

The accompanying notes are an integral part of these unaudited financial statements.

Consolidated Statements of Comprehensive Income


	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
(Dollars in thousands) (unaudited)	2020		2019		2020		2019
Net Income	$	3,067	$	3,984	$	4,786	$	7,221

Debt Securities:
Unrealized gains arising during the period		4,602		1,220		6,650		2,634
Reclassification adjustment for (gains) losses included in net income (1) (2)		—		(229)		10		(253)
Net unrealized gains		4,602		991		6,660		2,381
Tax effect		(967)		(208)		(1,399)		(499)
Net of tax amount		3,635		783		5,261		1,882

Total other comprehensive income		3,635		783		5,261		1,882

Total Comprehensive Income	$	6,702	$	4,767	$	10,047	$	9,103

(1) Reclassified to net gains on sales of debt securities
(2) Net of the reclassification of $0, $48, ($2) and $53 to Federal income tax expense (benefit)

The accompanying notes are an integral part of these unaudited financial statements.

‎

Consolidated Statements of Changes in Shareholders’ Equity

For the three and six months ended June 30, 2020 and 2019


							Accumulated
			Additional				Other
	Common		Paid-in		Retained		Comprehensive		Treasury
(Dollars in thousands, except per share data) (unaudited)	Stock		Capital		Earnings		Loss		Stock		Total
Balance at April 1, 2020	$	4,711	$	42,390	$	95,359	$	(4,360)	$	(9,095)	$	129,005
Net income		—		—		3,067		—		—		3,067
Other comprehensive income		—		—		—		3,635		—		3,635
Cash dividends declared, $0.30 per share		—		—		(1,302)		—		—		(1,302)
Treasury shares issued under dividend reinvestment plan, 14,964 shares		—		16		—		—		364		380
Stock Compensation Plans:
Compensation expense		—		55		—		—		—		55
Balance at June 30, 2020	$	4,711	$	42,461	$	97,124	$	(725)	$	(8,731)	$	134,840

Balance at January 1, 2020	$	4,710	$	42,268	$	94,946	$	(5,986)	$	(8,410)	$	127,528
Net income		—		—		4,786		—		—		4,786
Other comprehensive income		—		—		—		5,261		—		5,261
Cash dividends declared, $0.60 per share		—		—		(2,608)		—		—		(2,608)
Acquisition of 36,401 shares of treasury stock		—		—		—		—		(1,172)		(1,172)
Treasury shares issued under dividend reinvestment plan, 35,088 shares		—		91		—		—		849		940
Stock Compensation Plans:
Treasury shares issued (71 shares)		—		1		—		—		2		3
Common shares issued (973 shares)		1		15		—		—		—		16
Compensation expense		—		86		—		—		—		86
Balance at June 30, 2020	$	4,711	$	42,461	$	97,124	$	(725)	$	(8,731)	$	134,840


Balance at April 1, 2019	$	4,708	$	41,841	$	85,991	$	(5,281)	$	(5,768)	$	121,491
Net income		—		—		3,984		—		—		3,984
Other comprehensive income		—		—		—		783		—		783
Cash dividends declared, $0.30 per share		—		—		(1,317)		—		—		(1,317)
Acquisition of 39,600 shares of treasury stock		—		—		—		—		(1,467)		(1,467)
Treasury shares issued under employee stock purchase plan, 2,110 shares		—		25		—		—		44		69
Treasury shares issued under dividend reinvestment plan, 9,554 shares		—		174		—		—		197		371
Balance at June 30, 2019	$	4,708	$	42,040	$	88,658	$	(4,498)	$	(6,994)	$	123,914

Balance at January 1, 2019	$	4,701	$	41,530	$	83,946	$	(6,380)	$	(5,401)	$	118,396
Net income		—		—		7,221		—		—		7,221
Other comprehensive income		—		—		—		1,882		—		1,882
Cash dividends declared, $0.57 per share		—		—		(2,509)		—		—		(2,509)
Acquisition of 54,763 shares of treasury stock		—		—		—		—		(2,027)		(2,027)
Treasury shares issued under employee stock purchase plan, 2,260 shares		—		27		—		—		47		74
Treasury shares issued under dividend reinvestment plan, 19,704 shares		—		335		—		—		387		722
Incentive stock options exercised, 6,982 shares		7		148		—		—		—		155
Balance at June 30, 2019	$	4,708	$	42,040	$	88,658	$	(4,498)	$	(6,994)	$	123,914

The accompanying notes are an integral part of these unaudited financial statements.

Consolidated Statements of Cash Flows


	Six Months Ended ‎June 30,
	2020		2019
(Dollars in thousands) (unaudited)
Cash flows from operating activities
Net income	$	4,786	$	7,221
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		663		681
Net amortization of loans and investment securities		867		733
Provision for loan losses		4,975		399
Decrease (increase) in fair value of equity securities		100		(16)
Debt securities losses (gains), net		10		(253)
Loans originated for sale		(28,817)		(16,892)
Proceeds from sale of loans		25,602		16,318
Increase in cash surrender value of bank owned life insurance		(236)		(255)
Gains from claim on bank owned life insurance policies		(812)		—
Income tax benefit of statutory treatment of net operating loss carryback		(1,112)		—
Stock option compensation		86		—
Decrease in other assets		(2,459)		(70)
(Decrease) increase in other liabilities		(1,081)		643
Net cash provided by operating activities		2,572		8,509
Cash flows from investing activities
Net increase in long-term interest-bearing deposits in other banks		(5,239)		—
Proceeds from sales and calls of investment securities available for sale		165		16,955
Proceeds from maturities and pay-downs of securities available for sale		21,049		13,318
Purchase of investment securities available for sale		(114,107)		(26,319)
Net increase in restricted stock		(3)		(13)
Net increase in loans		(78,056)		(9,362)
Proceeds from surrender of bank owned life insurance policy		3,623		—
Capital expenditures		(373)		(433)
Net cash used in investing activities		(172,941)		(5,854)
Cash flows from financing activities
Net increase in demand deposits, interest-bearing checking, and savings accounts		157,599		5,996
Net (decrease) increase in time deposits		(9,638)		24,424
Dividends paid		(2,608)		(2,509)
Purchase of Treasury shares		(1,172)		(2,004)
Cash received from option exercises		19		206
Treasury shares issued under dividend reinvestment plan		940		722
Net cash provided by financing activities		145,140		26,835
(Decrease) increase in cash and cash equivalents		(25,229)		29,490
Cash and cash equivalents at the beginning of the period		83,828		52,957
Cash and cash equivalents at the end of the period	$	58,599	$	82,447
Supplemental Disclosures of Cash Flow Information
Cash paid during the year for:
Interest on deposits and other borrowed funds	$	2,424	$	3,275
Income taxes	$	567	$	—
Noncash Activities
Lease liabilities arising from obtaining right-of-use assets	$	105	$	22

The accompanying notes are an integral part of these unaudited financial statements.

FRANKLIN FINANCIAL SERVICES CORPORATION and SUBSIDIARIES

UNAUDITED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation

The consolidated financial statements include the accounts of Franklin Financial Services Corporation (the Corporation), and its wholly owned subsidiaries, Farmers and Merchants Trust Company of Chambersburg (the Bank) and Franklin Future Fund Inc. Farmers and Merchants Trust Company of Chambersburg is a commercial bank that has one wholly owned subsidiary, Franklin Financial Properties Corp. Franklin Financial Properties Corp. holds real estate assets that are leased by the Bank. Franklin Future Fund Inc. is a non-bank investment company. The activities of non-bank entities are not significant to the consolidated totals. All significant intercompany transactions and account balances have been eliminated.

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the consolidated financial position, results of operations, and cash flows as of June 30, 2020, and for all other periods presented have been made.

Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the audited consolidated financial statements and notes thereto included in the Corporation’s 2019 Annual Report on Form 10-K. The consolidated results of operations for the three-month and six-month period ended June 30, 2020 are not necessarily indicative of the operating results for the full year. Management has evaluated subsequent events for potential recognition and/or disclosure through the date these consolidated financial statements were issued.

The consolidated balance sheet at December 31, 2019 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by GAAP for complete consolidated financial statements.

For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, interest-bearing deposits in other banks and cash items with original maturities less than 90 days.

Earnings per share are computed based on the weighted average number of shares outstanding during each period end. A reconciliation of the weighted average shares outstanding used to calculate basic earnings per share and diluted earnings per share follows:


	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
(Dollars and shares in thousands, except per share data)	2020		2019		2020		2019
Weighted average shares outstanding (basic)		4,345		4,396		4,346		4,404
Impact of common stock equivalents		5		25		8		23
Weighted average shares outstanding (diluted)		4,350		4,421		4,354		4,427
Anti-dilutive options excluded from calculation		80		—		80		—
Net income	$	3,067	$	3,984	$	4,786	$	7,221
Basic earnings per share	$	0.71	$	0.91	$	1.10	$	1.64
Diluted earnings per share	$	0.71	$	0.90	$	1.10	$	1.63

‎

Note 2. Recent Accounting Pronouncements


ASU 2017-04, Goodwill (Topic 350)
Description		This guidance, among other things, removes step 2 of the goodwill impairment test thus eliminating the need to determine the fair value of individual assets and liabilities of the reporting unit. Upon adoption of this standard, goodwill impairment will be the amount by which a reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. This may result in more or less impairment being recognized than under the current guidance. Early adoption is permitted for any impairment tests performed after January 1, 2017, applied prospectively.
Effective Date		January 1, 2020
Effect on the Consolidated Financial Statements		The Corporation early adopted the ASU in the fourth quarter of 2018 with the completion of the 2018 impairment analysis. The ASU did not have a material effect on the consolidated financial statements.

ASU 2018-14, Disclosure Framework (Topic 715): Changes to the Disclosure Requirements for Defined Benefit Plans
Description		This ASU makes minor changes to the disclosure requirements for employers that sponsor defined benefit pension and/or other postretirement benefit plans. ASU 2018-14 is effective for fiscal years ending after December 15, 2020; early adoption is permitted.
Effective Date		January 1, 2020
Effect on the Consolidated Financial Statements		The Corporation adopted the provisions of the ASU on January 1, 2020. As the ASU only revised disclosure requirements, it did not have a material effect on the consolidated financial statements.

Recently issued but not yet effective accounting standards

ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments
Description		This standard requires credit losses on most financial assets measured at amortized cost and certain other instruments to be measured using an expected credit loss model (referred to as the current expected credit loss (CECL) model). Under this model, entities will estimate credit losses over the entire contractual term of the instrument (considering estimated prepayments, but not expected extensions or modifications unless reasonable expectation of a troubled debt restructuring exists) from the date of initial recognition of that instrument. The ASU replaces the current accounting model for purchased credit impaired loans and debt securities. The allowance for credit losses for purchased financial assets with a more-than insignificant amount of credit deterioration since origination (“PCD assets”), should be determined in a similar manner to other financial assets measured on an amortized cost basis. However, upon initial recognition, the allowance for credit losses is added to the purchase price to determine the initial amortized cost basis. The subsequent accounting for PCD financial assets is the same expected loss model described above.
Effective Date		January 1, 2023
Effect on the Consolidated Financial Statements		We have formed an implementation team led by the Corporation's Risk Management function. The team is reviewing the requirements of the ASU and evaluating methods and models for implementation. The new standard will result in earlier recognition of additions to the allowance for loan losses and possibly a larger allowance for loan loss balance with a corresponding increase in the provision for loan losses in results of operations; however, the Corporation is continuing to evaluate the impact of the pending adoption of the new standard on its consolidated financial statements. A third-party vendor has been selected to assist with the CECL calculations and the implementation process has started. The Corporation expects to be able to run the CECL model in test mode in 2020.

ASU 2019-05, Financial Instruments - Credit Losses (Topic 326):Targeted Transition Relief
Description		This ASU allows entities to irrevocably elect, upon adoption of ASU 2016-13, the fair value option on financial instruments that (1) were previously recorded at amortized cost and (2) are within the scope of ASC 326-20 if the instruments are eligible for the fair value option under ASC 825-10. The fair value option election does not apply to held-to-maturity debt securities. Entities are required to make this election on an instrument-by-instrument basis. ASU 2019-05 has the same effective date as ASU 2016-13. On October 16,2019, FASB approved its August 2019 proposal to grant certain small public companies a delay in the effective date of ASU 2016-13. For the Corporation, the delay makes the ASU effective January 2023. Since the Corporation currently meets the SEC definition of a small reporting company, the delay will be application to the Corporation. Early adoption is permitted.
Effective Date		January 1, 2023
Effect on the Consolidated Financial Statements		The Corporation will continue to review the ASU as part of its adoption of ASU 2016-13.

Note 3. Accumulated Other Comprehensive Loss

The components of accumulated other comprehensive losses, net of income tax effects, included in shareholders' equity are as follows:


		Unrealized
		Gains and Losses on
		Available-for-sale		Defined Benefit
(Dollars in thousands)		Securities		Pension Items		Total
June 30, 2020
Beginning Balance	$	185	$	(6,171)	$	(5,986)
Other comprehensive income before reclassification		5,253		—		5,253
Amounts reclassified from accumulated other comprehensive income		8		—		8
Current period other comprehensive income		5,261		—		5,261
Ending balance	$	5,446	$	(6,171)	$	(725)

June 30, 2019
Beginning Balance	$	(870)	$	(5,510)	$	(6,380)
Other comprehensive income before reclassification		2,082		—		2,082
Amounts reclassified from accumulated other comprehensive income		(200)		—		(200)
Current period other comprehensive income		1,882		—		1,882
Ending balance	$	1,012	$	(5,510)	$	(4,498)

Note 4. Investments

Available for Sale (AFS) Securities

The amortized cost and estimated fair value of AFS securities as of June 30, 2020 and December 31, 2019 are as follows:



(Dollars in thousands)			Gross		Gross
	Amortized		unrealized		unrealized		Fair
June 30, 2020	cost		gains		losses		value
U.S. Government and Agency securities	$	12,240	$	41	$	(65)	$	12,216
Municipal securities		168,929		6,463		(177)		175,215
Trust preferred and Corporate securities		5,258		—		(411)		4,847
Agency mortgage-backed securities		63,800		1,925		(59)		65,666
Private-label mortgage-backed securities		4,223		18		(33)		4,208
Asset-backed securities		24,872		42		(849)		24,065
	$	279,322	$	8,489	$	(1,594)	$	286,217



(Dollars in thousands)			Gross		Gross
	Amortized		unrealized		unrealized		Fair
December 31, 2019	cost		gains		losses		value
U.S. Government and Agency securities	$	8,418	$	30	$	(20)	$	8,428
Municipal securities		90,865		1,418		(997)		91,286
Trust preferred and Corporate securities		4,097		—		(130)		3,967
Agency mortgage-backed securities		58,503		435		(234)		58,704
Private-label mortgage-backed securities		398		31		—		429
Asset-backed securities		24,918		6		(305)		24,619
	$	187,199	$	1,920	$	(1,686)	$	187,433

At June 30, 2020 and December 31, 2019, the fair value of AFS securities pledged to secure public funds and trust deposits totaled $91.8 million and $107.1 million, respectively.

The amortized cost and estimated fair value of debt securities at June 30, 2020, by contractual maturity are shown below. Actual maturities may differ from contractual maturities because of prepayment or call options embedded in the securities. Securities not due at a single maturity date are presented separately.



(Dollars in thousands)	Amortized ‎cost		Fair ‎value
Due in one year or less	$	8,777	$	8,829
Due after one year through five years		21,363		21,739
Due after five years through ten years		117,891		122,307
Due after ten years		38,396		39,403
		186,427		192,278
Mortgage-backed and asset-backed securities		92,895		93,939
	$	279,322	$	286,217

The composition of the net realized gains on AFS securities for the three and six months ended are as follows:


	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2020		2019		2020		2019
Proceeds	$	—	$	14,906	$	165	$	18,781
Gross gains realized		—		248		—		281
Gross losses realized		—		(19)		(10)		(28)
Net gains (losses) realized	$	—	$	229	$	(10)	$	253

Tax (provision) benefit on net gains (losses) realized	$	—	$	(48)	$	2	$	(53)

Impairment:

The AFS securities portfolio contained 85 securities with $73.4 million of temporarily impaired fair value and $1.6 million in unrealized losses at June 30, 2020. The total unrealized loss position has decreased $92 thousand since year-end 2019.

For securities with an unrealized loss, Management applies a systematic methodology in order to perform an assessment of the potential for other-than-temporary impairment. In the case of debt securities, investments considered for other-than-temporary impairment: (1) had a specified maturity or repricing date; (2) were generally expected to be redeemed at par, and (3) were expected to achieve a recovery in market value within a reasonable period of time. In addition, the Bank considers whether it intends to sell these securities or whether it will be forced to sell these securities before the earlier of amortized cost recovery or maturity. The impairment identified on debt securities and subject to assessment at June 30, 2020, was deemed to be temporary and required no further adjustments to the financial statements, unless otherwise noted.

The following table reflects temporary impairment in the AFS portfolio, aggregated by investment category, length of time that individual securities have been in a continuous unrealized loss position and the number of securities in each category as of June 30, 2020 and December 31, 2019:



	June 30, 2020
	Less than 12 months					12 months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses		Count	Value		Losses		Count	Value		Losses		Count

U.S. Government and Agency ‎ securities	$	6,792	$	(47)	9	$	1,983	$	(18)	8	$	8,775	$	(65)	17
Municipal securities		20,183		(150)	19		773		(27)	1		20,956		(177)	20
Trust preferred and Corporate securities		865		(95)	1		2,832		(316)	4		3,697		(411)	5
Agency mortgage-backed securities		11,872		(47)	12		2,759		(12)	4		14,631		(59)	16
Private-label mortgage-backed securities		3,881		(33)	1		—		—	—		3,881		(33)	1
Asset-backed securities		14,113		(529)	15		7,335		(320)	11		21,448		(849)	26
Total temporarily impaired ‎ securities	$	57,706	$	(901)	57	$	15,682	$	(693)	28	$	73,388	$	(1,594)	85



	December 31, 2019
	Less than 12 months					12 months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses		Count	Value		Losses		Count	Value		Losses		Count

U.S. Government and Agency ‎ securities	$	2,559	$	(12)	6	$	1,335	$	(8)	7	$	3,894	$	(20)	13
Municipal securities		38,874		(966)	40		2,655		(31)	4		41,529		(997)	44
Trust preferred and Corporate securities		—		—	—		3,967		(130)	5		3,967		(130)	5
Agency mortgage-backed securities		21,185		(185)	32		6,555		(49)	22		27,740		(234)	54
Asset-backed securities		17,644		(128)	19		5,669		(177)	9		23,313		(305)	28
Total temporarily impaired ‎ securities	$	80,262	$	(1,291)	97	$	20,181	$	(395)	47	$	100,443	$	(1,686)	144

The following table represents the cumulative credit losses on AFS securities recognized in earnings for:



	Six Months Ended
(Dollars in thousands)	June 30,
	2020		2019
Balance of cumulative credit-related OTTI at January 1	$	272	$	272
Additions for credit-related OTTI not previously recognized		—		—
Additional increases for credit-related OTTI previously recognized when there is
no intent to sell and no requirement to sell before recovery of amortized cost basis		—		—
Decreases for previously recognized credit-related OTTI because there was an intent to sell		—		—
Reduction for increases in cash flows expected to be collected		—		—
Balance of credit-related OTTI at June 30	$	272	$	272

Equity Securities at Fair Value

The Corporation owns one equity investment. At June 30, 2020 and December 31, 2019, this investment was reported at fair value of $340 thousand and $440 thousand, respectively, with changes in value reported through income.

Note 5. Loans

The Bank reports its loan portfolio based on the primary collateral of the loan. It further classifies these loans by the primary purpose, either consumer or commercial. The Bank’s residential real estate loans include long-term loans to individuals and businesses secured by mortgages on the borrower’s real property and include home equity loans. Construction loans are made to finance the purchase of land and the construction of residential and commercial buildings thereon and are secured by mortgages on real estate. Commercial real estate loans include construction, owner and non-owner occupied properties and farm real estate. Commercial loans are made to businesses of various sizes for a variety of purposes including property, plant and equipment, working capital and loans to government municipalities. Commercial lending is concentrated in the Bank’s primary market, but also includes purchased loan participations. Consumer loans are comprised of installment loans and unsecured personal lines of credit.

Each class of loans involves a different kind of risk. However, risk factors such as changes in interest rates, general economic conditions and changes in collateral values are common across all classes. The risk of each loan class is presented below.

Residential Real Estate 1-4 family

The largest risk in residential real estate loans to retail customers is the borrower’s inability to repay the loan due to the loss of the primary source of income. The Bank attempts to mitigate this risk through prudent underwriting standards including employment history, current financial condition and credit history. These loans are generally owner occupied and serve as the borrower’s primary residence. Commercial purpose loans, secured by residential real estate, are usually dependent upon repayment from the rental income or other business purposes. These loans are generally non-owner occupied. In addition to the real estate collateral, these loans may have personal guarantees or UCC filings on other business assets. If a payment default occurs on a 1-4 family residential real estate loan, the collateral serves as a source of repayment, but may be subject to a change in value due to economic conditions.

Residential Real Estate Construction

This class includes loans to individuals for construction of a primary residence and tocontractors and developers to improve real estate and construct residential properties. Construction loans to individuals generally bear the same risk as 1-4 family residential loans. Additional risks may include cost overruns, delays in construction or contractor problems.

Loans to contractors and developers are primarily dependent on the sale of improved lots or finished homes for repayment. Risks associated with these loans include the borrower’s character and capacity to complete a development, the effect of economic conditions on the valuation of lots or homes, cost overruns, delays in construction or contractor problems. In addition to real estate collateral, these loans may have personal guarantees or UCC filings on other business assets, depending on the financial strength and experience of the developer. Real estate construction loans are monitored on a regular basis by either an independent third party or the responsible loan officer, depending on the size and complexity of the project. This monitoring process includes at a minimum, the submission of invoices or AIA documents detailing the cost incurred by the borrower, on-site inspections, and an authorizing signature for disbursement of funds.

Commercial Real Estate

Commercial real estate loans may be secured by various types of commercial property including retail space, office buildings, warehouses, hotels and motel, manufacturing facilities and, agricultural land.

Commercial real estate loans present a higher level of risk than residential real estate loans. Repayment of these loans is normally dependent on cash-flow generated by the operation of a business that utilizes the real estate. The successful operation of the business, and therefore repayment ability, may be affected by general economic conditions outside of the control of the operator. On most commercial real estate loans ongoing monitoring of cash flow and other financial performance indictors is completed annually through financial statement analysis. In addition, the value of the collateral may be negatively affected by economic conditions and may be insufficient to repay the loan in the event of default. In the event of foreclosure, commercial real estate may be more difficult to liquidate than residential real estate.

Commercial

Commercial loans are made for various business purposes to finance equipment, inventory, accounts receivables, and operating liquidity. These loans are generally secured by business assets or equipment, non-real estate collateral and/or personal guarantees.

Commercial loans present a higher level of credit risk than other loans because repayment ability is usually dependent on cash-flow from a business operation that can be affected by general economic conditions. On most Commercial loans ongoing monitoring of cash flow and other financial performance indictors at least annually through financial statement analysis. In the event of a default, collateral for these loans may be more difficult to liquidate, and the valuation of the collateral may decline more quickly than loans secured by other types of collateral.

Loans to governmental municipalities are also included in the Commercial class. These loans generally have less risk than C&I loans due to the taxing authority of the municipality and its ability to assess fees on services.

Consumer

These loans are made for a variety of reasons to consumers and include term loans and personal lines-of credit. The loans may be secured or unsecured. Repayment is primarily dependent on the income of the borrower and to a lesser extent the sale of collateral. The underwriting of these loans is based on the consumer’s ability and willingness to repay and is determined by the borrower’s employment history, current financial condition and credit background. Collateral for these loans, if any, usually depreciates quickly and therefore, may not be adequate to repay the loan if it is repossessed. Therefore, the overall health of the economy, including unemployment rates and wages, will have an effect on the credit quality in this loan class.

‎

A summary of loans outstanding, by class, at the end of the reporting periods is as follows:



	June 30,		December 31,
(Dollars in thousands)	2020		2019
Residential Real Estate 1-4 Family
Consumer first liens	$	80,774	$	85,319
Commercial first lien		62,158		57,627
Total first liens		142,932		142,946

Consumer junior liens and lines of credit		49,741		42,715
Commercial junior liens and lines of credit		5,092		4,882
Total junior liens and lines of credit		54,833		47,597
Total residential real estate 1-4 family		197,765		190,543

Residential real estate - construction
Consumer		4,314		4,107
Commercial		9,263		9,216
Total residential real estate construction		13,577		13,323

Commercial real estate		497,682		494,262
Commercial		296,432		230,007
Total commercial		794,114		724,269

Consumer		6,682		6,440
		1,012,138		934,575
Less: Allowance for loan losses		(16,555)		(11,966)
Net Loans	$	995,583	$	922,609

Included in the loan balances are the following:
Net unamortized deferred loan (fees) costs	$	(1,199)	$	178

Paycheck Protection Program (PPP) loans (included in Commercial loans above)
Two-year loans	$	62,080	$	—
Five-year loans		433		—
Total Paycheck Protection Program loans	$	62,513	$	—

Unamortized deferred PPP loan fees (included in Net unamortized deferred loan fees above)
Two-year loans	$	(2,120)	$	—
Five-year loans		(22)		—
Total unamortized deferred loan fees	$	(2,142)	$	—

Loans pledged as collateral for borrowings and commitments from:
FHLB	$	831,810	$	764,340
Federal Reserve Bank		49,815		32,155
	$	881,625	$	796,495

Note 6. Loan Quality and Allowance for Loan Losses

The following table presents, by class, the activity in the Allowance for Loan Losses (ALL) for the periods shown:


	Residential Real Estate 1-4 Family
	First		Junior Liens &				Commercial
(Dollars in thousands)	Liens		Lines of Credit		Construction		Real Estate		Commercial		Consumer		Unallocated		Total


ALL at March 31, 2020	$	563	$	178	$	269	$	8,249	$	4,713	$	98	$	660	$	14,730
Charge-offs		—		—		—		—		(145)		(29)		—		(174)
Recoveries		1		—		—		—		19		4		—		24
Provision		16		19		(27)		588		1,258		32		89		1,975
ALL at June 30, 2020	$	580	$	197	$	242	$	8,837	$	5,845	$	105	$	749	$	16,555

ALL at December 31, 2019	$	416	$	119	$	187	$	6,607	$	4,021	$	84	$	532	$	11,966
Charge-offs		—		—		—		—		(365)		(59)		—		(424)
Recoveries		4		—		—		—		24		10		—		38
Provision		160		78		55		2,230		2,165		70		217		4,975
ALL at June 30, 2020	$	580	$	197	$	242	$	8,837	$	5,845	$	105	$	749	$	16,555

ALL at March 31, 2019	$	487	$	132	$	154	$	6,470	$	4,801	$	72	$	565	$	12,681
Charge-offs		(1)		—		—		(123)		(14)		(25)		—		(163)
Recoveries		2		1		—		20		9		3		—		35
Provision		(51)		(20)		10		85		(63)		45		(6)		-
ALL at June 30, 2019	$	437	$	113	$	164	$	6,452	$	4,733	$	95	$	559	$	12,553

ALL at December 31, 2018	$	491	$	133	$	110	$	6,278	$	4,783	$	70	$	550	$	12,415
Charge-offs		(34)		(1)		(3)		(186)		(75)		(51)		—		(350)
Recoveries		3		1		—		21		51		13		—		89
Provision		(23)		(20)		57		339		(26)		63		9		399
ALL at June 30, 2019	$	437	$	113	$	164	$	6,452	$	4,733	$	95	$	559	$	12,553

The following table presents, by class, loans that were evaluated for the ALL under the specific reserve (individually) and those that were evaluated under the general reserve (collectively) and the amount of the ALL established in each class as of June 30, 2020 and December 31, 2019:



	Residential Real Estate 1-4 Family
	First		Junior Liens &				Commercial
(Dollars in thousands)	Liens		Lines of Credit		Construction		Real Estate		Commercial		Consumer		Unallocated		Total

June 30, 2020
Loans evaluated for ALL:
Individually	$	648	$	—	$	518	$	11,127	$	—	$	—	$	—	$	12,293
Collectively		142,284		54,833		13,059		486,555		296,432		6,682		—		999,845
Total	$	142,932	$	54,833	$	13,577	$	497,682	$	296,432	$	6,682	$	—	$	1,012,138

ALL established for ‎ loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		580		197		242		8,837		5,845		105		749		16,555
ALL at June 30, 2020	$	580	$	197	$	242	$	8,837	$	5,845	$	105	$	749	$	16,555

December 31, 2019
Loans evaluated for ALL:
Individually	$	659	$	—	$	523	$	10,994	$	—	$	—	$	—	$	12,176
Collectively		142,287		47,597		12,800		483,268		230,007		6,440		—		922,399
Total	$	142,946	$	47,597	$	13,323	$	494,262	$	230,007	$	6,440	$	—	$	934,575

ALL established for ‎ loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		416		119		187		6,607		4,021		84		532		11,966
ALL at December 31, 2019	$	416	$	119	$	187	$	6,607	$	4,021	$	84	$	532	$	11,966

‎

The following table shows additional information about those loans considered to be impaired at June 30, 2020 and December 31, 2019:


	Impaired Loans
	With No Allowance				With Allowance
(Dollars in thousands)			Unpaid				Unpaid
	Recorded		Principal		Recorded		Principal		Related
June 30, 2020	Investment		Balance		Investment		Balance		Allowance
Residential Real Estate 1-4 Family
First liens	$	648	$	648	$	—	$	—	$	—
Junior liens and lines of credit		—		—		—		—		—
Total		648		648		—		—		—
Residential real estate - construction		518		729		—		—		—
Commercial real estate		11,127		12,259		—		—		—
Commercial		—		—		—		—		—
Total	$	12,293	$	13,636	$	—	$	—	$	—


December 31, 2019
Residential Real Estate 1-4 Family
First liens	$	659	$	659	$	—	$	—	$	—
Junior liens and lines of credit		—		—		—		—		—
Total		659		659		—		—		—
Residential real estate - construction		523		729		—		—		—
Commercial real estate		10,994		12,096		—		—		—
Commercial		—		—		—		—		—
Total	$	12,176	$	13,484	$	—	$	—	$	—

The following table shows the average of impaired loans and related interest income for the three and six months ended June 30, 2020 and 2019:


	Three Months Ended				Six Months Ended
	June 30, 2020				June 30, 2020
	Average		Interest		Average		Interest
(Dollars in thousands)	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
Residential Real Estate 1-4 Family
First liens	$	651	$	8	$	653	$	19
Junior liens and lines of credit		—		—		—		—
Total		651		8		653		19
Residential real estate - construction		520		—		521		—
Commercial real estate		11,179		93		11,039		187
Commercial		—		—		—		—
Total	$	12,350	$	101	$	12,213	$	206

	Three Months Ended				Six Months Ended
	June 30, 2019				June 30, 2019
	Average		Interest		Average		Interest
(Dollars in thousands)	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
Residential Real Estate 1-4 Family
First liens	$	779	$	11	$	813	$	21
Junior liens and lines of credit		26		1		35		1
Total		805		12		848		22
Residential real estate - construction		651		—		652		—
Commercial real estate		13,242		102		13,368		204
Commercial		147		—		138		—
Total	$	14,845	$	114	$	15,006	$	226

‎

The following table presents the aging of payments of the loan portfolio:



(Dollars in thousands)			Loans Past Due and Still Accruing										Total
	Current		30-59 Days		60-89 Days		90 Days+		Total		Non-Accrual		Loans
June 30, 2020
Residential Real Estate 1-4 Family
First liens	$	142,822	$	42	$	27	$	—	$	69	$	41	$	142,932
Junior liens and lines of credit		54,660		119		28		12		159		14		54,833
Total		197,482		161		55		12		228		55		197,765
Residential real estate - construction		13,059		—		—		—		—		518		13,577
Commercial real estate		493,923		392		—		—		392		3,367		497,682
Commercial		296,208		17		—		—		17		207		296,432
Consumer		6,661		15		4		2		21		—		6,682
Total	$	1,007,333	$	585	$	59	$	14	$	658	$	4,147	$	1,012,138



December 31, 2019
Residential Real Estate 1-4 Family
First liens	$	141,843	$	646	$	358	$	31	$	1,035	$	68	$	142,946
Junior liens and lines of credit		47,420		70		30		46		146		31		47,597
Total		189,263		716		388		77		1,181		99		190,543
Residential real estate - construction		12,800		—		—		—		—		523		13,323
Commercial real estate		490,114		813		326		—		1,139		3,009		494,262
Commercial		229,659		31		120		—		151		197		230,007
Consumer		6,397		25		18		—		43		—		6,440
Total	$	928,233	$	1,585	$	852	$	77	$	2,514	$	3,828	$	934,575

‎

The following table reports the risk rating for those loans in the portfolio that are assigned an individual risk rating. Consumer purpose loans are assigned a rating of either pass or substandard based on the performance status of the loans. Substandard consumer loans are comprised of loans 90 days or more past due and still accruing, and nonaccrual loans. Commercial purpose loans may be assigned any rating in accordance with the Bank’s internal risk rating system. Approximately $57 million of hotel portfolio loans were moved to Pass-watch (5) rating at June 30, 2020. The entire hotel portfolio of approximately $70 million at June 30, 2020 is now rated no better than Pass-watch (5).



	Pass		OAEM		Substandard		Doubtful
(Dollars in thousands)	(1-5)		(6)		(7)		(8)		Total

June 30, 2020
Residential Real Estate 1-4 Family
First liens	$	142,891	$	—	$	41	$	—	$	142,932
Junior liens and lines of credit		54,807		—		26		—		54,833
Total		197,698		—		67		—		197,765
Residential real estate - construction		13,059		—		518		—		13,577
Commercial real estate		487,112		5,983		4,587		—		497,682
Commercial		296,055		—		377		—		296,432
Consumer		6,679		—		3		—		6,682
Total	$	1,000,603	$	5,983	$	5,552	$	—	$	1,012,138



December 31, 2019
Residential Real Estate 1-4 Family
First liens	$	142,847	$	—	$	99	$	—	$	142,946
Junior liens and lines of credit		47,520		—		77		—		47,597
Total		190,367		—		176		—		190,543
Residential real estate - construction		12,800		—		523		—		13,323
Commercial real estate		483,878		5,875		4,509		—		494,262
Commercial		229,465		4		538		—		230,007
Consumer		6,440		—		—		—		6,440
Total	$	922,950	$	5,879	$	5,746	$	—	$	934,575

The following table presents information on the Bank’s Troubled Debt Restructuring (TDR) loans as of:


								Troubled Debt Restructurings
								Within the Last 12 Months
								That Have Defaulted
(Dollars in thousands)	Troubled Debt Restructurings							On Modified Terms
	Number of	Recorded						Number of	Recorded
	Contracts	Investment		Performing*		Nonperforming*		Contracts	Investment
June 30, 2020
Residential real estate - construction	1	$	440	$	440	$	—	—	$	—
Residential real estate	4		648		648		—	—		—
Commercial real estate	11		9,089		8,771		318	—		—
Total	16	$	10,177	$	9,859	$	318	—	$	—


December 31, 2019
Residential real estate - construction	1	$	444	$	444	$	—	—	$	—
Residential real estate	4		659		659		—	—		—
Commercial real estate	11		9,343		9,343		—	—		—
Total	16	$	10,446	$	10,446	$	—	—	$	—

*The performing status is determined by the loan’s compliance with the modified terms.

There were no new TDR loans during 2020 or 2019. Loans that have been modified on a good-faith basis in response to COVID-19 to borrowers who were classified as current prior to any relief are not TDRs as outlined in the March 22, 2020 Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus. Such short-term modifications (e.g., six months) may include payment deferrals, fee

waivers, extension of payment terms or other delays in payment that are insignificant. As of June 30, 2020, the Bank has granted approximately $196 million loan deferrals or modifications (approximately 19% of gross loans).

Note 7. Leases

The Corporation leases various assets in the course of its operations that are subject to recognition on the balance sheet. The Corporation considers all of its leases to be operating leases and it has no finance leases. The leased assets are comprised of equipment, and buildings and land (collectively real estate). The equipment leases are shorter-term than the real estate leases, and generally have a fixed payment over a defined term without renewal options. Certain equipment leases have purchase options and it was determined the option was not reasonably certain to be exercised. The real estate leases are longer-term and may contain renewal options after the initial term, but none of the real estate leases contain a purchase option. The renewal options on real estate leases were reviewed and if it was determined the option was reasonably certain to be renewed, the option term was considered in the determination of the lease liability. There is only one real estate lease with a variable payment based on an index included in the lease liability. None of the leases contain any restrictive covenants and there are no significant leases that have not yet commenced. The discount rate used to determine the lease liability is based on the Bank’s fully secured borrowing rate from the Federal Home Loan Bank for a term similar to the lease term. Operating lease expense is included in net occupancy expense in the consolidated statements of income.

Lease costs:

The components of total lease cost were as follows:


	Three Months Ended		Three Months Ended		Six Months Ended		Six Months Ended
(Dollars in thousands)	June 30, 2020		June 30, 2019		June 30, 2020		June 30, 2019
Operating lease cost	$	159	$	184	$	317	$	372
Short-term lease cost		1		3		3		9
Variable lease cost		14		12		28		23
Total lease cost	$	174	$	199	$	348	$	404

Supplemental Lease Information:


	Six Months Ended		Six Months Ended
(Dollars in thousands)	June 30, 2020		June 30, 2019
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases	$	304	$	249

Weighted-average remaining lease term (years)		12.7		13.0
Weighted-average discount rate		3.54%		3.51%

Lease Obligations:

Future undiscounted lease payments for operating leases with initial terms of one year or more as of June 30, 2020 are as follows:


(Dollars in thousands)

2020	$	286
2021		558
2022		546
2023		551
2024		525
2025 and beyond		3,876
Undiscounted cash flow		6,342
Imputed Interest		(1,290)
Total lease liability	$	5,052

Note 8. Other Real Estate Owned

Changes in other real estate owned were as follows:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2020		2019		2020		2019
Balance at beginning of the period	$	—	$	2,684	$	—	$	2,684
Additions		—		—		—		—
Proceeds from dispositions		—		—		—		—
Gains on sales, net		—		—		—		—
Valuation adjustment		—		—		—		—
Balance at the end of the period	$	—	$	2,684	$	—	$	2,684

Note 9. Derivatives

The Corporation is exposed to certain risks arising from both its business operations and economic conditions. The Corporation principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Corporation manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities.

The Corporation’s existing credit derivatives result from participations in interest rate swaps provided by external lenders as part of loan participation arrangements, therefore, are not used to manage interest rate risk in the Corporation’s assets or liabilities. Derivatives not designated as hedges are not speculative and result from a service the Corporation provides to certain lenders which participate in loans.

The table below presents the fair value of the Corporation’s derivative financial instruments as well as their classification on the Balance Sheet.

Fair Value of Derivative Instruments

Derivative Liabilities

(Dollars in thousands)

June 30, 2020

June 30, 2019

Notional amount

Balance Sheet Location

Fair Value

Notional amount

Balance Sheet Location

Fair Value

Derivatives not designated as hedging instruments

Other Contracts

6,924

Other Liabilities

—

Other Liabilities

—

Total derivatives not designated as hedging instruments

—

The table below presents the effect of the Corporation’s derivative financial instruments that are not designated as hedging instruments on the Income Statement.

Effect of Derivatives Not Designated as Hedging Instruments on the Statement of Financial Performance

Derivatives Not Designated as Hedging Instruments under Subtopic 815-20

Location of Gain or (Loss) Recognized in Income on Derivative

Amount of Gain or (Loss) Recognized in Income on Derivatives

(Dollars in thousands)

Three Months Ended

Six Months Ended

June 30, 2020

June 30, 2019

June 30, 2020

June 30, 2019

Other Contracts

Other income/(expense)

(36)

As of June 30, 2020, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was $55 thousand.

Note 10. Pension

The components of pension expense for the periods presented are as follows:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2020		2019		2020		2019
Components of net periodic cost:
Service cost	$	83	$	82	$	166	$	161
Interest cost		131		157		262		315
Expected return on plan assets		(269)		(272)		(539)		(542)
Recognized net actuarial loss		226		133		452		286
Total pension expense	$	171	$	100	$	341	$	220

The Bank expects its pension expense to increase to approximately $680 thousand in 2020 compared to $421 thousand in 2019, due primarily to increases in recognized net actuarial losses. The service cost component of pension expense is in the salaries and employee benefits line on the income statement. All other cost components are in the other expense line on the income statement.

Note 11. Fair Value Measurements and Fair Values of Financial Instruments

Management uses its best judgment in estimating the fair value of the Corporation’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Corporation could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of their respective period-ends and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates maybe different than the amounts reported at each year-end. The Corporation uses the exit price notion to measure the fair value of financial instruments.

FASB ASC Topic 820, “Financial Instruments”, requires disclosure of the fair value of financial assets and liabilities, including those financial assets and liabilities that are not measured and reported at fair value on a recurring and nonrecurring basis. The Corporation does not report any nonfinancial assets at fair value. FASB ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under FASB ASC Topic 820 are as follows:

Level 1: Valuation is based on unadjusted, quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. There may be substantial differences in the assumptions used for securities within the same level. For example, prices for U.S. Agency securities have fewer assumptions and are closer to level 1 valuations than the private label mortgage backed securities that require more assumptions and are closer to level 3 valuations.

Level 3: Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Corporation’s assumptions regarding what market participants would assume when pricing a financial instrument.

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The following information regarding the fair value of the Corporation’s financial instruments should not be interpreted as an estimate of the fair value of the entire Corporation since a fair value calculation is only provided for a limited portion of the Corporation’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Corporation’s disclosures and those of other companies may not be meaningful.

The following methods and assumptions were used to estimate the fair values of the Corporation’s financial instruments measured at fair value on a recurring and nonrecurring basis.

Equity Securities: Equity securities are valued using quoted market prices from nationally recognized markets (Level 1). Equity securities are measured at fair value on a recurring basis.

Investment securities: Fair values of investment securities available-for-sale were primarily measured using information from a third-party pricing service. This service provides pricing information by utilizing evaluated pricing models supported with market data information. Standard inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data from market research publications. Level 2 investment securities are primarily comprised of debt securities issued by states and municipalities, corporations, mortgage-backed securities issued by government agencies, and government-sponsored enterprises. Fair values were estimated primarily by obtaining quoted prices for similar assets in active markets or through the use of pricing models. Investment securities are measured at fair value on a recurring basis.

Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals conducted by an independent, licensed appraiser, less cost to sell. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach (Level 2). If the appraiser makes an adjustment to account for differences between the comparable sales and income data available for similar loans, or if management adjusts the appraised value, then the fair value is considered Level 3. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted in accordance with the allowance policy. No partial charge-offs on impaired loans were taken in the second quarter of 2020. Impaired loans are measured at fair value on a nonrecurring basis.

‎

Recurring Fair Value Measurements

For financial assets and liabilities measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at June 30, 2020 and December 31, 2019 are as follows:



(Dollars in thousands)	Fair Value at June 30, 2020
Asset Description	Level 1		Level 2		Level 3		Total
Equity securities, at fair value	$	340	$	—	$	—	$	340

Available for sale:
U.S. Government and Agency securities		—		12,216		—		12,216
Municipal securities		—		175,215		—		175,215
Trust preferred and Corporate securities		—		4,847		—		4,847
Agency mortgage-backed securities		—		65,666		—		65,666
Private-label mortgage-backed securities		—		4,208		—		4,208
Asset-backed securities		—		24,065		—		24,065
Total assets	$	340	$	286,217	$	—	$	286,557



(Dollars in thousands)	Fair Value at December 31, 2019
Asset Description	Level 1		Level 2		Level 3		Total
Equity securities, at fair value	$	440	$	—	$	—	$	440

Available for sale:
U.S. Government and Agency securities		—		8,428		—		8,428
Municipal securities		—		91,286		—		91,286
Trust preferred and Corporate securities		—		3,967		—		3,967
Agency mortgage-backed securities		—		58,704		—		58,704
Private-label mortgage-backed securities		—		429		—		429
Asset-backed securities		—		24,619		—		24,619
Total assets	$	440	$	187,433	$	—	$	187,873

Nonrecurring Fair Value Measurements

There were no assets measured at fair value on a nonrecurring basis as June 30, 2020 and the following table presents the fair value measurement by level within the fair value hierarchy used at December 31, 2019:



(Dollars in Thousands)	Fair Value at December 31, 2019
Asset Description	Level 1		Level 2		Level 3		Total
Impaired loans (1)	$	—	$	—	$	1,080	$	1,080
Total assets	$	—	$	—	$	1,080	$	1,080

(1)Includes assets directly charged-down to fair value during the year-to-date period.

The Corporation did not record any liabilities at fair value for which measurement of the fair value was made on a nonrecurring basis at June 30, 2020. For financial assets and liabilities measured at fair value on a recurring basis, there were no transfers of financial assets or liabilities between Level 1 and Level 2 during the period ending June 30, 2020.

There were no assets measured at fair value on a nonrecurring basis at June 30, 2020 and the following table presents additional quantitative information about Level 3 assets measured at fair value on a nonrecurring basis at December 31, 2019:



(Dollars in thousands)					Range
December 31, 2019		Fair Value	Valuation Technique	Unobservable Input	Weighted Average
Impaired loans	$	1,080	Appraisal	Appraisal Adjustments	0% - 100% (48%)

(1) Includes assets directly charged-down to fair value during the year-to-date period.

The carrying amounts and estimated fair value of financial instruments not carried at fair value are as follows:



	June 30, 2020
	Carrying		Fair
(Dollars in thousands)	Amount		Value		Level 1		Level 2		Level 3
Financial assets, carried at cost:
Cash and cash equivalents	$	58,599	$	58,599	$	58,599	$	—	$	—
Long-term interest-bearing deposits in other banks		13,985		13,985		13,985		—		—
Loans held for sale		5,255		5,255		—		5,255		—
Net loans		995,583		999,734		—		—		999,734
Accrued interest receivable		5,707		5,707		—		—		5,707

Financial liabilities:
Deposits	$	1,273,353	$	1,274,134	$	—	$	1,274,134	$	—
Accrued interest payable		258		258		—		258		—

	December 31, 2019
	Carrying		Fair
(Dollars in thousands)	Amount		Value		Level 1		Level 2		Level 3
Financial assets, carried at cost:
Cash and cash equivalents	$	83,828	$	83,828	$	83,828	$	—	$	—
Long-term interest-bearing deposits in other banks		8,746		8,746		8,746		—		—
Loans held for sale		2,040		2,040		—		2,040		—
Net loans		922,609		918,640		—		—		918,640
Accrued interest receivable		3,845		3,845		—		—		3,845

Financial liabilities:
Deposits	$	1,125,392	$	1,125,877	$	—	$	1,125,877	$	—
Accrued interest payable		436		436		—		436		—

Note 12. Capital Ratios

Capital adequacy is currently defined by regulatory agencies through the use of several minimum required ratios. The capital ratios to be considered “well capitalized” are: (1) Common Equity Tier 1 (CET1) of 6.5%, (2) Tier 1 Leverage of 5%, (3) Tier 1 Risk-Based Capital of 8%, and (4) Total Risk-Based Capital of 10%. In addition, a capital conservation buffer of 2.50% is applicable to all of the capital ratios except for the Tier 1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum for each respective capital measurement. The Bank’s capital conservation buffer at June 30, 2020 was 7.64% (total risk-based capital 15.64% less 8.00%) compared to the 2020 regulatory buffer of 2.50%. Compliance with the capital conservation buffer is required in order to avoid limitations to certain capital distributions and is in addition to the minimum required capital requirements. As of June 30, 2020, the Bank was “well capitalized”.

In 2019, the Community Bank Leverage Ratio (CBLR) was approved by federal banking agencies as an optional capital measure available to Qualifying Community Banking Organizations (QCBO). If a bank qualifies as a QCBR and maintains a CBLR of 9% or greater, the bank would be considered “well-capitalized” for regulatory capital purposes and exempt from complying with the risk-based capital rule described above. The CBLR rule took effect January 1, 2020 and banks could opt-in through an election in the first quarter 2020 regulatory filing. The Bank met the criteria of a QCBR but did not opt-in to the CBLR.

The Bank is participating in the Paycheck Protection Program (PPP) and the Paycheck Protection Program Liquidity Facility (PPPLF) to fund PPP Loans. In accordance with regulatory guidance, PPP loans pledged as collateral for PPPLF, and PPPLF advances, are excluded from leverage capital ratios. PPP loans will also carry a 0% risk-weight for risk-based capital rules.

The consolidated asset limit on small bank holding companies is $3 billion and a company with assets under that limit is not subject to the consolidated capital rules but may file reports that include capital amounts and ratios. The Corporation has elected to file those reports.

The following table summarizes the regulatory capital requirements and results as of June 30, 2020 and December 31, 2019 for the Corporation and the Bank:


			Regulatory Ratios
			Adequately	Well
	June 30,	December 31,	Capitalized	Capitalized
(Dollars in thousands)	2020	2019	Minimum	Minimum

Common Equity Tier 1 Risk-based Capital Ratio (1)
Franklin Financial Services Corporation	14.66%	14.82%	N/A	N/A
Farmers & Merchants Trust Company	14.38%	14.62%	4.500%	6.50%

Tier 1 Risk-based Capital Ratio (2)
Franklin Financial Services Corporation	14.66%	14.82%	N/A	N/A
Farmers & Merchants Trust Company	14.38%	14.62%	6.000%	8.00%

Total Risk-based Capital Ratio (3)
Franklin Financial Services Corporation	15.93%	16.08%	N/A	N/A
Farmers & Merchants Trust Company	15.64%	15.87%	8.000%	10.00%

Tier 1 Leverage Ratio (4)
Franklin Financial Services Corporation	9.22%	9.72%	N/A	N/A
Farmers & Merchants Trust Company	9.05%	9.59%	4.000%	5.00%

(1) Common equity Tier 1 capital/ total risk-weighted assets (2) Tier 1 capital / total risk-weighted assets
(3) Total risk-based capital / total risk-weighted assets, (4) Tier 1 capital / average quarterly assets

Note 13. Revenue Recognition

All of the Corporation’s revenue from contracts with customers within the scope of ASC 606 is recognized in non-interest income as presented in our consolidated statements of income. Revenue generating activities that fall within the scope of ASC 606 are described as follows:

Investment and Trust Service Fees - these represent fees from wealth management (assets under management), fees from the management and settlement of estates and commissions from the sale of investment and insurance products.

Asset management fees are generally assessed based on a tiered fee schedule, based on the value of assets under management, and are recognized monthly when the service obligation is completed. Fees recognized were $1.5 million for the second quarter of 2020 and 2019 and $2.8 million year-to-date for 2020 and 2019.

Fees for estate management services are based on the estimated fair value of the estate. These fees are generally recognized monthly over an 18-month period that Management has determined to represent the average time to fulfill the performance obligations of the contract. Management has the discretion to adjust this time period as needed based upon the nature and complexity of an individual estate. Fees recognized were $40 thousand for the second quarter of 2020, compared to $84 thousand for the second quarter of 2019 and $73 thousand year-to-date in 2020, compared to $154 thousand year-to-date in 2019.

Commissions from the sale of investment and insurance products are recognized upon the completion of the transaction. Commissions recognized were $49 thousand for the second quarter of 2020, compared to $68 thousand for the second quarter 2019 and $123 thousand year-to-date for 2020, compared to $135 year-to-date in 2019.

Loan Service Charges – these represent fees on loans for services or charges that occur after the loan has been booked, for example, late payment fees. These also include fees for mortgages settled for third-party mortgage companies. All of these fees are transactional in nature and are recognized upon completion of the transaction which represents the performance obligation.

Deposit Service Charges and Fees – these represent fees from deposit customers for transaction based, account maintenance, and overdraft services. Transaction based fees include, but are not limited to, stop payment fees and overdraft fees. These fees are recognized at the time of the transaction when the performance obligation has been fulfilled. Account maintenance fees and account analysis fee are earned over the course of a month, representing the period of the performance obligation, and are recognized monthly.

Debit Card Income – this represents interchange fees from cardholder transactions conducted through the card payment network. Cardholders use the debit card to conduct point-of-sale transactions that produce interchange fees. The fees are transaction based and the fee is recognized with the processing of the transaction. These fees are reported net of cardholder rewards.

Other Service Charges and Fees – these are comprised primarily of merchant card fees, credit card fees, ATM surcharges and interchange fees and wire transfer fees. Merchant card fees represent fees the Bank earns from a third party for enrolling a customer in the processor’s program. Credit card fees represent a fee earned by the Bank for a successful referral to a card-issuing company. ATM surcharges and interchange fees are the result of Bank customers conducting ATM transactions that generate fee income and are processed through multiple card networks. All of these fees are transaction based and are recognized at the time of the transaction.

Gains/Losses on the Sale of Other Real Estate – these are recognized when control of the property transfers to the buyer.

Increases in the cash surrender value of life insurance and security transactions are not within the scope of ASC 606.

Contract Balances

A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity’s obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. The Company’s noninterest revenue streams are largely based on transactional activity, or standard month-end revenue accruals such as asset management fees based on month-end market values. Consideration is often received immediately or shortly after the Company satisfies its performance obligation and revenue is recognized. The Company does not typically enter into longer-term revenue contracts with customers, and therefore, does not experience significant contract balances.

Contract Acquisition Costs

The Corporation expenses all contract acquisition costs as costs are incurred.

1Note 14. Commitments and Contingencies

In the normal course of business, the Bank is a party to financial instruments that are not reflected in the accompanying financial statements and are commonly referred to as off-balance-sheet instruments. These financial instruments are entered into primarily to meet the financing needs of the Bank’s customers and include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk not recognized in the consolidated balance sheet.

The Corporation’s exposure to credit loss in the event of nonperformance by other parties to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contract or notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments.

The Bank had the following outstanding commitments for the periods presented:


	June 30,		December 31,
(Dollars in thousands)	2020		2019
Financial instruments whose contract amounts represent credit risk
Commercial commitments to extend credit	$	253,981	$	248,251
Consumer commitments to extend credit (secured)		61,545		56,898
Consumer commitments to extend credit (unsecured)		5,330		5,088
	$	320,856	$	310,237
Standby letters of credit	$	22,081	$	26,382

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses with the exception of home equity lines and personal lines of credit and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank, is based on Management’s credit evaluation of the counterparty. Collateral for most commercial commitments varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties. Collateral for secured consumer commitments consists of liens on residential real estate.

Standby letters of credit are instruments issued by the Bank, which guarantee the beneficiary payment by the Bank in the event of default by the Bank’s customer in the nonperformance of an obligation or service. Most standby letters of

credit are extended for one-year periods. Generally, the credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds collateral supporting those commitments for which collateral is deemed necessary primarily in the form of certificates of deposit and liens on real estate. Management believes that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. As of June 30, 2018, the Bank established a $2.4 million allowance against letters of credit issued in connection with a commercial borrower that declared bankruptcy. In the first quarter of 2020, the Bank reversed $250 thousand of this reserve as one letter of credit was cancelled. At June 30, 2020 this reserve was $2.1 million. Except for the liability recorded for standby letters of credit, liabilities for credit loss associated with off-balance sheet commitments were not material at June 30, 2020 and December 31, 2019.

Most of the Bank’s business activity is with customers located within its primary market and does not involve any significant concentrations of credit to any one entity or industry.

Legal Proceedings

The nature of the Corporation’s business generates a certain amount of litigation.

We establish accruals for legal proceedings when information related to the loss contingencies represented by those matters indicates both that a loss is probable, and the amount of the loss can be reasonably estimated. When we are able to do so, we also determine estimates of possible losses, whether in excess of any accrued liability or where there is no accrued liability.

These assessments are based on our analysis of currently available information and are subject to significant judgment and a variety of assumptions and uncertainties. As new information is obtained, we may change our assessments and, as a result, take or adjust the amounts of our accruals and change our estimates of possible losses or ranges of possible losses. Due to the inherent subjectivity of the assessments and the unpredictability of outcomes of legal proceedings, any amounts that may be accrued or included in estimates of possible losses or ranges of possible losses may not represent the actual loss to the Corporation from any legal proceeding. Our exposure and ultimate losses may be higher, possibly significantly higher, than amounts we may accrue or amounts we may estimate.

In management’s opinion, we do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of all litigation to which the Corporation is a party at this time will have a material adverse effect on our financial position. We cannot now determine, however, whether or not any claim asserted against us will have a material adverse effect on our results of operations in any future reporting period, which will depend on, amount other things, the amount of loss resulting from the claim and the amount of income otherwise reported for the reporting period. Thus, at June 30, 2020, we are unable to provide an evaluation of the likelihood of an unfavorable outcome or an estimate of the amount or range of potential loss with respect to such other matters and, accordingly, have not yet established any specific accrual for such other matters.

No material proceedings are pending or are known to be threatened or contemplated against us by governmental authorities.

Note 15. Risk Factors

In December 2019, a novel strain of coronavirus surfaced in Wuhan, China, and has spread around the world, with resulting business and social disruption. The coronavirus was declared a Pandemic by the World Health Organization on March 11, 2020. The operations and business results of the Corporation could be materially adversely affected. The ability of our customers to make payments on loans could be adversely impacted, resulting in elevated loan losses and an increase in the Corporation’s allowance for loan losses. Additionally, it is reasonably possible future evaluations of the carrying amount of goodwill could result in a conclusion that goodwill is impaired. The extent to which the coronavirus may impact business activity or investment results will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of the coronavirus and the actions required to contain the coronavirus or treat its impact, among others.

Note 16. Subsequent Event

On August 4, 2020 the Corporation completed the sale of a subordinated debt note offering. The Corporation sold $15.0 million of subordinated debt notes with a maturity date of September 1, 2030. These notes are noncallable for 5 years and carry a fixed interest rate of 5% per year for 5 years and then convert to floating rate of Secured Overnight Financing Rate (SOFR) plus 4.93% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The Corporation also sold $5.0 million of subordinated debt notes with a maturity date of September 1, 2035. These notes are noncallable for 10 years and carry a fixed interest rate of 5.25% per year for 10 years and then convert to floating rate of SOFR plus 4.92% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The notes are structured to qualify as Tier 2 capital for the Corporation and any

funds it invests in the Bank qualify as Tier 1 capital at the Bank. The Corporation paid an issuance fee of 2% of the total issue that will be amortized to the call date of each issue on a pro-rata basis. The proceeds are intended to be used for general corporate purposes.

Note 17. Reclassification

Certain prior period amounts may have been reclassified to conform to the current year presentation. Such reclassifications did not affect reported net income.

‎

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

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

For the Three and Six Months Ended June 30, 2020 and 2019

Forward Looking Statements

Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements refer to a future period or periods, reflecting management’s current views as to likely future developments, and use words such as “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” or similar terms. Because forward-looking statements involve certain risks, uncertainties and other factors over which the Corporation has no direct control, actual results could differ materially from those contemplated in such statements. These factors include (but are not limited to) the following: general economic conditions, particularly with regard to the negative impact of severe, wide-ranging and continuing disruptions caused by, and resulting from, the spread of the coronavirus COVID-19 pandemic and affects thereof, changes in interest rates, changes in the Corporation’s cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, changes in the rate of inflation, changes in technology, the intensification of competition within the Corporation’s market area, and other similar factors. We caution readers not to place undue reliance on these forward-looking statements. They only reflect management’s analysis as of this date. The Corporation does not revise or update these forward-looking statements to reflect events or changed circumstances.

Critical Accounting Policies

Management has identified critical accounting policies for the Corporation. These policies are particularly sensitive, requiring significant judgements, estimates and assumptions to be made by Management. There were no changes to the critical accounting policies disclosed in the 2019 Annual Report on Form 10-K in regards to application or related judgments and estimates used. Please refer to Item 7 of the Corporation’s 2019 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.

Results of Operations

Summary

The Corporation reported net income of $3.1 million ($.71 per diluted share) for the second quarter of June 30, 2020, and $4.7 million ($1.10 per diluted share) year-to-date as of June 30, 2020. This compares to $4.0 million ($.90 per diluted share) net income in the second quarter of 2019 and $7.2 million ($1.63 per diluted share) year-to-date at June 30, 2019.

Net interest income was $10.3 million for the second quarter of 2020, compared to $10.6 million for the second quarter of 2019. Net interest margin was 3.26% for second quarter of 2020, compared to 3.74% for second quarter of 2019. Year-to-date net interest income was $20.6 million in 2020, compared to $20.9 million in 2019. However, the net interest margin fell from 3.80% in 2019 to 3.39% in 2020.

Earning assets for year-to-date 2020 averaged $1.3 billion compared to $1.2 billion for the same period in 2019. The year-to-date average balance of the loan portfolio decreased from $977.8 million in 2019 to $962.3 million in 2020. The average balance of the commercial loan portfolio decreased $17.4 million from 2019 due to participation payoffs. The average balance of the investment portfolio increased $89.8 million as the Bank invested excess funds to counter the reduction in loans. The yield on earning assets fell by .66% from 4.41% in 2019 to 3.75% in 2020 as market rates decreased during the year. The decrease in the yield was the primary reason for the decline in interest income. Average interest-bearing deposits increased $69.0 million from 2019 to 2020. The cost of interest-bearing deposits fell from .78% in 2019 to .47% in 2020 as the Bank reduced deposit rates. The overall cost of funds fell from .65% in 2019 to .38% in 2020. As a result, interest expense on deposits declined $1.2 million helping to stabilize net interest income year over year.

A provision for loan loss expense of $2.0 million was recorded for the second quarter of 2020 and $5.0 million year-to-date, as the economic effects and impact of the COVID-19 pandemic caused several qualitative factors in the allowance for loan loss calculation to increase. With this provision expense, the allowance for loan loss ratio was 1.64% of gross loans. The provision expense for the second quarter of 2019

was $0 and was $399 thousand year-to-date 2019 with an allowance ratio of 1.28% of gross loans. The allowance for loan loss ratio was 1.28% of gross loans at December 31, 2019. See the Allowance for Loan Loss discussion for more information.

Noninterest income decreased $284 thousand in the second quarter of 2020 over the same quarter of 2019. Fees on the sale of mortgages increased $147 thousand over the quarter but was more than offset by a decrease in deposit fees and security gains recognized in 2019, but not in 2020. Year-to-date, noninterest income increased $439 thousand over the same period in 2019, due to an $812 thousand gain on a bank owned life insurance policy and increased mortgage fees but was partially offset by a decrease in deposit fees. Fees related to transactional activity (e.g. ATM, debit card) were negatively affected by stay-at-home orders and business shutdowns related to the pandemic.

Noninterest expense for both the second quarter of 2020 and 2019 was $9.6 million. Year-to-date, noninterest expense increased $156 thousand over the same quarter of 2019. There were no significant changes in any expense category quarter over quarter or year over year. The pandemic held many expense items in check, such as business travel, education and community activities, but the Bank made a $100 thousand contribution to various social service and first responder organizations in our community during the second quarter.

The Corporation recorded an income tax benefit of $1.1 million in the second quarter of 2020. This benefit was available due to the passage of the Coronavirus Aid, Relief and Economic Security Act (the CARES Act) in March 2020. The CARES Act allows for net operating losses (NOL) incurred in 2018, 2019 and 2020 to be carried back to offset taxable income earned during the five-year period prior to the year in which the NOL was incurred. The Corporation incurred an NOL in 2018 that it is able to carryback to prior periods when the statutory rate for the Corporation was 34% as compared to the current rate of 21%.

Total assets at June 30, 2020 were $1.423 billion compared $1.269 billion at December 31, 2019.

Short-term interest-bearing deposits in other banks decreased $27.6 million since year-end as cash was reinvested into the investment portfolio, which increased $98.8 million.

The loan portfolio increased $77.6 million during 2020 over year-end 2019. The portfolio increased in junior liens and lines of credit and commercial loans (primarily from the Paycheck Protection Program (PPP) lending), partially offset by a decline in residential first lien mortgages. The Bank held $62.5 million of PPP loans at June 30, 2020.

Deposits increased $148.0 million from 2019, primarily in checking and money management accounts. Of this increase, approximately $36.0 million are remaining PPP loan proceeds. These deposits are expected to be short-term in nature.

Shareholders’ equity increased $7.3 million, from the end of 2019, due primarily to an increase in accumulated other comprehensive income. Retained earnings increased only $2.2 million, from the end of 2019, due to the lower earnings. The book value of the Corporation’s common stock increased from $29.30 to $30.98 per share since year-end. The Corporation suspended activity in its stock repurchase plan on March 19, 2020.

Management believes current asset quality is stable with a nonperforming loan ratio of .41% of total gross loans and the allowance for loan loss ratio has been increased to 1.64% higher than at any time during the great recession. As the Corporation faces the unprecedented circumstances of the COVID-19 pandemic, it believes its current balance sheet and capital position will allow it to meet the challenge. As of July 31, 2020, the Bank funded 732 loans for $62.8 million (6.2% of gross loans as of June 30, 2020) through the Paycheck Protection Program administered by the Small Business Administration (SBA) which started April 3, 2020. The Bank recorded $233 thousand in interest income from PPP loan origination fees during the second quarter of 2020. The Bank expects to recognize additional processing fees of approximately $2.1 million over the contractual life of the PPP loans (two years or five years). As PPP loans are granted forgiveness by the SBA, fee recognition will accelerate. Liquidity has been strengthened by access to the Paycheck Protection Program Liquidity Facility, but the Bank has no borrowings outstanding. The Corporation’s capital position is strong with total risk-based capital ratio of 15.93% and a leverage ratio of 9.22%.

Key performance ratios as of, or for the six months ended June 30, 2020 and 2019 and the year ended December 31, 2019 are listed below:


	June 30,		December 31,		June 30,
(Dollars in thousands, except per share)	2020		2019		2019

Balance Sheet Highlights
Total assets	$	1,423,111	$	1,269,157	$	1,252,141
Investment and equity securities		286,557		187,873		129,812
Loans, net		995,583		922,609		969,904
Deposits		1,273,353		1,125,392		1,113,049
Shareholders' equity		134,840		127,528		123,914

Summary of Operations
Interest income	$	22,831	$	49,235	$	24,383
Interest expense		2,246		7,113		3,493
Net interest income		20,585		42,122		20,890
Provision for loan losses		4,975		237		399
Net interest income after provision for loan losses		15,610		41,885		20,491
Noninterest income		7,301		15,424		6,862
Noninterest expense		19,173		38,314		19,017
Income before income taxes		3,738		18,995		8,336
Federal income tax (benefit) expense		(1,048)		2,880		1,115
Net income	$	4,786	$	16,115	$	7,221

Performance Measurements
Return on average assets*		0.73%		1.29%		1.18%
Return on average equity*		7.37%		13.17%		12.02%
Return on average tangible equity (1)*		7.92%		14.22%		13.00%
Efficiency ratio (1)		66.95%		65.36%		67.34%
Net interest margin*		3.39%		3.68%		3.80%

Shareholders' Value (per common share)
Diluted earnings per share	$	1.10	$	3.67	$	1.63
Basic earnings per share		1.10		3.68		1.64
Regular cash dividends declared		0.60		1.17		0.57
Book value		30.98		29.30		28.21
Tangible book value (1)		28.91		27.23		26.21
Market value		25.90		38.69		38.24
Market value/book value ratio		83.60%		132.05%		135.55%
Market value/tangible book value ratio		89.58%		142.11%		145.90%
Price/earnings multiple*		11.77		10.54		11.73
Current quarter dividend yield		4.63%		3.10%		3.14%
Dividend payout ratio year-to-date		54.49%		31.74%		34.75%

Safety and Soundness
Average equity/average assets		9.83%		9.78%		9.85%
Risk-based capital ratio (Total)		15.93%		16.08%		15.19%
Leverage ratio (Tier 1)		9.22%		9.72%		9.63%
Common equity ratio (Tier 1)		14.66%		14.82%		13.93%
Nonperforming loans/gross loans		0.41%		0.42%		0.59%
Nonperforming assets/total assets		0.29%		0.31%		0.68%
Allowance for loan losses as a % of loans		1.64%		1.28%		1.28%
Net loans charged-off/average loans*		0.08%		0.07%		0.05%

Assets under Management
Trust assets under management (fair value)	$	743,381	$	790,949	$	763,237
Held at third-party brokers (fair value)		121,781		127,976		125,448

*Year-to-date annualized

(1) See the section titled “GAAP versus Non-GAAP Presentation” that follows.

GAAP versus non-GAAP Presentations – The Corporation supplements its traditional GAAP measurements with certain non-GAAP measurements to evaluate its performance and to eliminate the effect of intangible assets. By eliminating intangible assets (Goodwill), the Corporation believes it presents a measurement that is comparable to companies that have no intangible assets or to companies that have eliminated intangible assets in similar calculations. However, not all companies may use the same calculation method for each measurement. The non-GAAP measurements are not intended to be used as a substitute for the related GAAP measurements. Non-GAAP financial measures should be viewed in addition to, and not as an alternative for, our reported results prepared in accordance with GAAP. In the event of such a disclosure or release, the Securities and Exchange Commission’s Regulation G requires: (i) the presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP and (ii) a reconciliation of the differences between the non-GAAP financial measure presented and the most directly comparable financial measure calculated and presented in accordance with GAAP. The following table shows the calculation of the non-GAAP measurements.


(Dollars in thousands, except per share)	Six Months Ended		Twelve Months Ended		Six Months Ended
	June 30, 2020		December 31, 2019		June 30, 2019
Return on Tangible Equity (non-GAAP)
Net income	$	4,786	$	16,115	$	7,221

Average shareholders' equity		129,819		122,377		120,128
Less average intangible assets		(9,016)		(9,016)		(9,016)
Average tangible equity (non-GAAP)		120,803		113,361		111,112

Return on average tangible equity (non-GAAP)*		7.92%		14.22%		13.00%

Tangible Book Value (per share) (non-GAAP)
Shareholders' equity	$	134,840	$	127,528	$	123,914
Less intangible assets		(9,016)		(9,016)		(9,016)
Tangible book value (non-GAAP)		125,824		118,512		114,898

Shares outstanding (in thousands)		4,352		4,353		4,383

Tangible book value per share (non-GAAP)		28.91		27.23		26.21

Efficiency Ratio
Noninterest expense	$	19,173	$	38,314	$	19,017

Net interest income		20,585		42,122		20,890
Plus tax equivalent adjustment to net interest income		640		1,393		756
Plus noninterest income, net of securities transactions		7,411		15,102		6,593
Total revenue		28,636		58,617		28,239

Efficiency ratio (Noninterest expense/total revenue)		66.95%		65.36%		67.34%

* Year-to-date annualized

Net Interest Income

The largest source of the Corporation’s earnings is net interest income, which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities. Demand deposits enhance net interest income because they are noninterest-bearing deposits. For the purpose of this discussion, balance sheet items refer to the average balance for the year and net interest income is adjusted to a fully taxable-equivalent basis. This tax-equivalent adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Corporation’s 21% Federal statutory rate.

Comparison of the three months ended June 30, 2020 to the three months ended June 30, 2019:

Tax equivalent net interest income decreased $259 thousand to $10.7 million in the second quarter of 2020 compared to $10.9 million for the same period in 2019. Balance sheet volume contributed $855 thousand to tax equivalent net interest but was more than offset by a $1.1 million reduction due to rates.

The following table presents average balances, tax-equivalent (T/E) interest income, and yields earned or rates paid on the assets or liabilities. Nonaccrual loans are included in the average loan balance used to calculate the yield. All nontaxable interest income has been adjusted to a tax-equivalent basis using a tax rate of 21%.


	For the Three Months Ended June 30,
	2020					2019

	Average		Income or		Average	Average		Income or		Average
(Dollars in thousands)	balance		expense		yield/rate	balance		expense		yield/rate

Interest-earning assets:
Interest-bearing obligations in other banks	$	77,451	$	82	0.42%	$	66,267	$	403	2.44%
Investment securities:
Taxable		191,496		1,051	2.20%		85,825		587	2.74%
Tax Exempt		53,010		443	3.34%		41,913		353	3.38%
Investments		244,506		1,494	2.45%		127,738		940	2.95%
Loans:
Commercial, industrial and agricultural		846,686		8,559	4.01%		836,751		9,754	4.63%
Residential mortgage		68,918		698	4.11%		69,806		741	4.25%
Home equity loans and lines		67,930		608	3.59%		64,808		839	5.19%
Consumer		6,520		64	3.94%		5,771		87	6.05%
Loans		990,054		9,929	3.99%		977,136		11,421	4.65%
Total interest-earning assets		1,312,011	$	11,505	3.52%		1,171,141	$	12,764	4.37%
Other assets		62,982					71,890
Total assets	$	1,374,993				$	1,243,031

Interest-bearing liabilities:
Deposits:
Interest-bearing checking	$	372,373	$	199	0.21%	$	318,412	$	302	0.38%
Money Management		448,069		342	0.31%		414,949		1,066	1.03%
Savings		91,790		17	0.07%		82,977		106	0.51%
Time		81,240		275	1.36%		93,927		359	1.53%
Total interest-bearing deposits		993,472		833	0.34%		910,265		1,833	0.81%

Total interest-bearing liabilities		993,472		833	0.34%		910,265		1,833	0.81%
Noninterest-bearing deposits		236,193					196,355
Other liabilities		15,301					14,960
Shareholders' equity		130,027					121,451
Total liabilities and shareholders' equity	$	1,374,993				$	1,243,031
T/E net interest income/Net interest margin				10,672	3.26%				10,931	3.74%
Tax equivalent adjustment				(340)					(368)
Net interest income			$	10,332				$	10,563

Net Interest Spread					3.18%					3.56%
Cost of Funds					0.27%					0.66%

Provision for Loan Losses

Following its second quarter assessment and analysis, the Bank expensed $2.0 million of its provision for loan loss expense for the second quarter as the economic effects and impact of the COVID-19 pandemic caused several qualitative factors in the allowance for loan loss calculation to increase. The provision expense was $0 thousand in the second quarter of 2019. For more information refer to the Loan Quality and Allowance for Loan Losses discussion in the Financial Condition section.

Noninterest Income

For the second quarter of 2020, noninterest income decreased $284 thousand from the same period in 2019. Loan service charges increased as mortgage production was higher in 2020. Deposit fees and service charges decreased primarily in transaction-based fees due to stay-at-home orders and business shutdowns. There were no sales of debt

securities in the second quarter of 2020 compared to multiple sales in the same period in 2019 which generated net gains of $229 thousand.

The following table presents a comparison of noninterest income for the three months ended June 30, 2020 and 2019:


	For the Three Months Ended
	June 30,				Change
(Dollars in thousands)	2020		2019		Amount		%
Noninterest Income
Investment and trust services fees	$	1,590	$	1,647	$	(57)	(3.5)
Loan service charges		502		228		274	120.2
Deposit service charges and fees		397		603		(206)	(34.2)
Other service charges and fees		336		381		(45)	(11.8)
Debit card income		438		464		(26)	(5.6)
Increase in cash surrender value of life insurance		112		128		(16)	(12.5)
Net (losses)/gains on sales of debt securities		—		229		(229)	(100.0)
Change in fair value of equity securities		27		13		14	107.7
Other		10		3		7	233.3
Total noninterest income	$	3,412	$	3,696	$	(284)	(7.7)

Noninterest Expense

Noninterest expense for the second quarter of 2020 was flat compared to the same period in 2019 of $9.6 million. Due to the pandemic there was very little change in all categories of noninterest expense. The pandemic held many expense items in check, such as business travel, education and community activities. The Bank estimates it has spent approximately $53 thousand in additional expenses for COVID related mitigation efforts. In addition, the Bank contributed $100 thousand to various social service and first responder organizations in our community.

The following table presents a comparison of noninterest expense for the three months ended June 30, 2020 and 2019:


	For the Three Months Ended
(Dollars in thousands)	June 30,				Change
Noninterest Expense	2020		2019		Amount		%
Salaries and benefits	$	5,382	$	5,355	$	27	0.5
Net occupancy		865		858		7	0.8
Marketing and advertising		464		481		(17)	(3.5)
Legal and professional		430		471		(41)	(8.7)
Data processing		834		738		96	13.0
Pennsylvania bank shares tax		263		243		20	8.2
FDIC insurance		88		115		(27)	(23.5)
ATM/debit card processing		279		247		32	13.0
Telecommunications		108		107		1	0.9
Other		931		991		(60)	(6.1)
Total noninterest expense	$	9,644	$	9,606	$	38	0.4

Provision for Income Taxes

For the second quarter of 2020, the Corporation recorded a Federal income tax benefit of $942 thousand compared to a tax expense of $669 thousand for the same quarter in 2019. Contributing to the $942 thousand net benefit, the Corporation recorded an income tax benefit of $1.1 million in the second quarter of 2020 connected to the passage of the Coronavirus Aid, Relief and Economic Security Act (the CARES Act) in March 2020. The CARES Act allows for net operating losses (NOL) incurred in 2018, 2019 and 2020 to be carried back to offset taxable income earned during the five-year period prior to the year in which the NOL was incurred. The Corporation incurred an NOL in 2018 that it is able to carryback to prior periods when the statutory rate for the Corporation was 34% as compared to the current rate of 21%. The effective tax rate for the second quarter of 2020 was 8.0% (excluding the NOL benefit, compared to 14.4% for the same quarter in 2019. The federal statutory tax rate is 21% for 2020 and 2019.

Comparison of the six months ended June 30, 2020 to the six months ended June 30, 2019:

Tax equivalent net interest income decreased $421 thousand to $21.2 million in the first half of 2020 compared to $21.6 million for the same period in 2019. Balance sheet volume contributed $911 thousand to tax equivalent net interest but was more than offset by a $1.3 million reduction due to rates.


	For the Six Months Ended June 30,
	2020					2019

	Average		Income or		Average	Average		Income or		Average
(Dollars in thousands)	balance		expense		yield/rate	balance		expense		yield/rate

Interest-earning assets:
Interest-bearing obligations in other banks	$	73,213	$	340	0.93%	$	40,831	$	499	2.46%
Investment securities:
Taxable		181,908		2,119	2.34%		84,071		1,130	2.71%
Tax Exempt		38,435		659	3.43%		46,514		780	3.35%
Investments		220,343		2,778	2.53%		130,585		1,910	2.95%
Loans:
Commercial, industrial and agricultural		819,886		17,449	4.22%		837,326		19,398	4.62%
Residential mortgage		68,633		1,427	4.19%		69,637		1,492	4.28%
Home equity loans and lines		67,265		1,332	3.97%		65,391		1,671	5.15%
Consumer		6,514		145	4.46%		5,449		169	6.25%
Loans		962,298		20,353	4.20%		977,803		22,730	4.64%
Total interest-earning assets		1,255,854	$	23,471	3.75%		1,149,219	$	25,139	4.41%
Other assets		64,396					69,815
Total assets	$	1,320,250				$	1,219,034

Interest-bearing liabilities:
Deposits:
Interest-bearing checking	$	348,837	$	473	0.27%	$	307,161	$	565	0.37%
Money Management		440,170		1,083	0.49%		419,932		2,112	1.01%
Savings		87,924		74	0.17%		82,072		213	0.52%
Time		84,507		616	1.46%		83,263		567	1.37%
Total interest-bearing deposits		961,438		2,246	0.47%		892,428		3,457	0.78%

Other borrowings		—		—	—		2,678		36	2.61%
Total interest-bearing liabilities		961,438		2,246	0.47%		895,106		3,493	0.79%
Noninterest-bearing deposits		212,464					190,117
Other liabilities		16,529					13,683
Shareholders' equity		129,819					120,128
Total liabilities and shareholders' equity	$	1,320,250				$	1,219,034
T/E net interest income/Net interest margin				21,225	3.39%				21,646	3.80%
Tax equivalent adjustment				(640)					(756)
Net interest income			$	20,585				$	20,890

Net Interest Spread					3.28%					3.62%
Cost of Funds					0.38%					0.65%

Provision for Loan Losses

Year-to-date, the Bank expensed $5.0 million for provision for loan loss expense from the assessment and analysis of the Bank’s allowance for loan loss as the economic effects of the COVID-19 pandemic caused several qualitative factors in the calculation to increase from moderate risk to very high risk. The provision expense was $399 thousand in the first half of 2019. For more information refer to the Loan Quality and Allowance for Loan Losses discussion in the Financial Condition section.

Noninterest Income

For the first half of 2020, noninterest income increased $439 thousand from the same period in 2019. Loan service charges increased as mortgage production was higher in 2020 due to a higher volume of mortgage refinancing. Deposit fees and service charges decreased primarily in transaction-based fees due to stay-at-home orders and business shutdowns.

The life insurance gain was from a bank-owned life insurance policy. There was one debt security sale in the second quarter of 2020 compared to multiple sales in the same period in 2019 which generated net gains of $229 thousand The change in the fair value of equity investments recorded through income was a loss of $100 thousand compared to a gain of $16 thousand in the same period in 2019.

The following table presents a comparison of noninterest income for the six months ended June 30, 2020 and 2019:


	For the Six Months Ended
	June 30,				Change
(Dollars in thousands)	2020		2019		Amount		%
Noninterest Income
Investment and trust services fees	$	3,035	$	3,099	$	(64)	(2.1)
Loan service charges		786		431		355	82.4
Deposit service charges and fees		962		1,149		(187)	(16.3)
Other service charges and fees		683		734		(51)	(6.9)
Debit card income		857		866		(9)	(1.0)
Increase in cash surrender value of life insurance		236		255		(19)	(7.5)
Bank owned life insurance gain		812		—		812	NA
Net (losses)/gains on sales of debt securities		(10)		253		(263)	(104.0)
Change in fair value of equity securities		(100)		16		(116)	(725.0)
Other		40		59		(19)	(32.2)
Total noninterest income	$	7,301	$	6,862	$	439	6.4

Noninterest Expense

Noninterest expense for the first half of 2020 increased $156 thousand compared to the same period in 2019. The increase in salaries and benefits was primarily due to an increase in salary expense ($792 thousand) from merit increases, net of a decrease in health insurance ($198 thousand), compared to the same period in 2019. Data processing expenses increased due to more customers utilizing mobile banking during the pandemic closure and as the Bank added functionality to its mobile banking platform. Overall, the pandemic held many expense items in check, such as business travel, education and community activities. The Bank estimates it has spent approximately $53 thousand in additional expenses for COVID related mitigation efforts. In addition, the Bank contributed $100 thousand to various social service and first responder organizations in our community.

The following table presents a comparison of noninterest expense for the six months ended June 30, 2020 and 2019:


	For the Six Months Ended
(Dollars in thousands)	June 30,				Change
Noninterest Expense	2020		2019		Amount		%
Salaries and employee benefits	$	10,916	$	10,797	$	119	1.1
Net occupancy		1,695		1,715		(20)	(1.2)
Marketing and advertising		919		883		36	4.1
Legal and professional		825		901		(76)	(8.4)
Data processing		1,641		1,443		198	13.7
Pennsylvania bank shares tax		438		486		(48)	(9.9)
FDIC insurance		148		180		(32)	(17.8)
ATM/debit card processing		543		505		38	7.5
Telecommunications		213		211		2	0.9
Other		1,835		1,896		(61)	(3.2)
Total noninterest expense	$	19,173	$	19,017	$	156	0.8

Provision for Income Taxes

For the first half of 2020, the Corporation recorded a Federal income tax benefit of $1.0 million compared to a tax expense of $1.1 million for the same period in 2019. The Corporation recorded an income tax benefit of $1.1 million in the second quarter of 2020. This benefit was available due to the passage of the Coronavirus Aid, Relief and Economic Security Act (the CARES Act) in March 2020. The CARES Act allows for net operating losses (NOL) incurred in 2018m, 2019 and 2020 to be carried back to offset taxable income earned during the five-year period prior to the year in which the NOL was incurred. The Corporation incurred an NOL in 2018 that it is able to carryback to prior periods when the statutory rate for the Corporation was 34% as compared to the current rate of 21%. The effective tax rate for the first half of 2020 was 1.7% (excluding the NOL benefit), compared to 13.4% for the same period in 2019. The federal statutory tax rate is 21% for 2020 and 2019.

Financial Condition

Cash and Cash Equivalents:

Cash and cash equivalents totaled $58.6 million at June 30, 2020, a decrease of $25.2 million from the prior year-end balance of $83.8 million. The decrease was mainly due to lower interest-bearing balances at the Federal Reserve due to purchases in the investment portfolio. Interest-bearing deposits are held primarily at the Federal Reserve ($39.7 million).

Investment Securities:

AFS Securities: The AFS securities portfolio has increased $92.1 million on a cost basis, since year-end 2019. The composition of the portfolio has remained consistent with municipal securities and U.S. Agency mortgage-backed securities comprising the greatest portion of the portfolio at approximately 61% and 23% of the portfolio fair value, respectively. The average life of the portfolio was 7.05 years.

The AFS securities portfolio had a net unrealized gain of $6.9 million at June 30, 2020 compared to a net unrealized gain of $234 thousand at the prior year-end. The portfolio averaged $220.3 million with a yield of 2.53% for the first six months of 2020. This compares to an average of $130.6 million and a yield of 2.95% for the same period in 2019.

The municipal bond portfolio is well diversified geographically (164 issuers) and is comprised primarily of general obligation bonds (58%). Many municipal bonds have credit enhancements in the form of private bond insurance or other credit support. The largest geographic municipal bond exposure is in the states of Texas (11%), California (10%), and Michigan (9%). The average rating of the municipal portfolio from Moody’s is AA. No municipal bonds are rated below investment grade.

The unrealized loss in the municipal bond portfolio decreased to $177 thousand from $997 thousand at December 31, 2019. There are twenty securities in this portfolio with an unrealized loss and the loss in this portfolio is deemed to be non-credit related and no other-than-temporary impairment charges have been recorded.

The trust preferred portfolio contains five securities with a fair value of $3.7 million and an unrealized loss of $411 thousand. The trust-preferred securities held by the Bank are single entity issues, not pooled trust preferred securities. Therefore, the impairment review of these securities is based only on the issuer and the security cannot be impaired by the performance of other issuers as if it was a pooled trust-preferred bond. All of the Bank’s trust preferred securities are single issue, variable rate notes with long maturities (2027–2028). None of these issuers have suspended or missed a dividend payment. At June 30, 2020, the Bank believes it will be able to collect all interest and principal due on these bonds and no other-than-temporary-impairment charges were recorded.

The unrealized loss in the Asset-backed securities portfolio increased $544 thousand from December 31, 2019. This sector had the largest unrealized loss of $849 thousand, 53.3% of the total unrealized losses ($1.6 million). FFELP (Federal Family Education Loan Program) bonds make up the majority of this sector and have a 97% guarantee from the US Department of Education. The FFELP bonds are all rated AAA. Management fully expects to be paid back at par and no other-than-temporary impairment charges have been recorded.

Restricted Stock at Cost: The Bank held $468 thousand of restricted stock at June 30, 2020. Except for $30 thousand, this investment represents stock in FHLB Pittsburgh. The Bank is required to hold this stock to be a member of FHLB and it is carried at cost of $100 per share. The level of FHLB stock held is determined by FHLB and is comprised of a minimum membership amount plus a variable activity amount. FHLB stock is evaluated for impairment primarily based on an assessment of the ultimate recoverability of its cost. As a government sponsored entity, FHLB has the ability to raise funding through the U.S. Treasury that can be used to support its operations. There is not a public market for FHLB stock and the benefits of FHLB membership (e.g., liquidity and low-cost funding) add value to the stock beyond purely financial measures. Management intends to remain a member of the FHLB and believes that it will be able to fully recover the cost basis of this investment.

See Note 4 of the accompanying financial statements for additional information on Investment Securities.

Loans:

Residential real estate: This category is comprised of consumer purpose loans secured by residential real estate and to a lesser extent, commercial purpose loans secured by residential real estate. The consumer purpose category represents traditional residential mortgage loans and home equity products (primarily junior liens and lines of credit). Commercial purpose loans in this category represent loans made for various business needs but are secured with residential real estate. In addition to the real estate collateral, it is possible that additional security is provided by personal guarantees or UCC filings. These loans are underwritten as commercial loans and are not originated to be sold.

Total residential real estate loans increased $7.2 million over year-end 2019, as the Bank originated a higher volume of junior liens and lines of credit. For the first six months of 2020, the Bank originated $37.4 million and sold $25.6 million in mortgages for a fee through third party brokerage agreements. The Bank does not originate or hold any loans

that would be considered sub-prime or Alt-A and does not generally originate mortgages outside of its primary market area.

Residential real estate construction: This category contains loans for the vertical construction of 1-4 family residential properties. The largest component of this category represents loans to residential real estate developers ($9.3 million), while loans for individuals to construct personal residences totaled $4.3 million at June 30, 2020. The Bank’s exposure to residential construction loans is concentrated primarily in south central Pennsylvania. Real estate construction loans, including residential real estate and land development loans, occasionally provide an interest reserve in order to assist the developer during the development stage when minimal cash flow is generated. All real estate construction loans are underwritten in the same manner, regardless of the use of an interest reserve.

Commercial real estate (CRE): This category includes commercial, industrial, farm and agricultural loans and land development loans, where real estate serves as the primary collateral for the loans. Total commercial real estate loans increased slightly to $497.7 million from $494.2 million at the end of 2019, as originations largely kept pace with pay-downs. The largest sectors (by collateral) in the commercial real estate category are: hotels and motels ($70.0 million), land development ($63.6 million), office buildings ($55.6 million), shopping centers ($34.5 million) and warehouse ($31.1 million). The majority of the Bank’s hotel exposure is located along the Interstate 81 (I-81) corridor through south-central Pennsylvania. The portfolio is comprised of properties operating under 17 flagged brands, representing 9 hotel chains. Independent hotels represent only 4% of the hotel portfolio.

Also included in CRE are real estate construction loans totaling $90.6 million. At June 30, 2020, the Bank had $22.4 million in real estate construction loans funded with an interest reserve and capitalized $509 thousand of interest in 2020 from these reserves on active projects for commercial construction. Real estate construction loans are monitored on a regular basis by either an independent third-party inspector or the assigned loan officer depending on loan amount or complexity of the project. This monitoring process includes at a minimum, the submission of invoices and AIA documents (depending on the complexity of the project) detailing costs incurred by the borrower, on-site inspections, and a signature by the assigned loan officer for disbursement of funds.

Commercial: This category includes commercial, industrial, farm, agricultural, and municipal loans. Commercial loans increased $66.4 million to $296.4 million at June 30, 2020, compared to $230.0 million at the end of 2019, primarily due to PPP originations. At June 30, 2020, the Bank had approximately $153 million in tax-free loans in the commercial portfolio. The largest sectors (by industry) in the commercial category are: public administration ($76.1 million), utilities ($40.7 million), educational services ($23.1 million), real estate rental and leasing ($12.1 million) and finance and insurance ($11.2 million). This category also includes $63 million of PPP loans that are 100% guaranteed by the SBA.

Participations: The Bank may supplement its own commercial loan production by purchasing loan participations. These participations are primarily located in south-central Pennsylvania. At June 30, 2020, the outstanding commercial participations accounted for 6.3%, or $63.7 million, of total gross loans compared to 9.4% and $67.7 million at December 31, 2019. The Bank’s total exposure (including outstanding balances and unfunded commitments) to purchased participations is $80.2 million, compared to $84.0 million at December 31, 2019. The commercial loan participations are comprised of $13.8 million of Commercial loans and $49.9 million of CRE loans, reported in the respective loan class.

Consumer loans: This category increased by $242 thousand to $6.7 million at June 30, 2020, compared to $6.4 million at prior year-end and is mainly comprised of unsecured personal lines of credit.

‎

The following table presents a summary of loans outstanding, by class as of:



	June 30,		December 31,			Change
(Dollars in thousands)	2020		2019			Amount	%
Residential Real Estate 1-4 Family
Consumer first liens	$	80,774	$	85,319	$	(4,545)	(5.3)
Commercial first lien		62,158		57,627		4,531	7.9
Total first liens		142,932		142,946		(14)	(0.0)

Consumer junior liens and lines of credit		49,741		42,715		7,026	16.4
Commercial junior liens and lines of credit		5,092		4,882		210	4.3
Total junior liens and lines of credit		54,833		47,597		7,236	15.2
Total residential real estate 1-4 family		197,765		190,543		7,222	3.8

Residential real estate - construction
Consumer		4,314		4,107		207	5.0
Commercial		9,263		9,216		47	0.5
Total residential real estate construction		13,577		13,323		254	1.9

Commercial real estate		497,682		494,262		3,420	0.7
Commercial		296,432		230,007		66,425	28.9
Total commercial		794,114		724,269		69,845	9.6

Consumer		6,682		6,440		242	3.8
		1,012,138		934,575		77,563	8.3
Less: Allowance for loan losses		(16,555)		(11,966)		(4,589)	38.4
Net Loans	$	995,583	$	922,609	$	72,974	7.9


Paycheck Protection Program (PPP) loans (included in Commercial loans above)
Two-year loans	$	62,080	$	—
Five-year loans		433		—
Total Paycheck Protection Program loans	$	62,513	$	—	$	62,513	N/A

Loan Quality:

Management utilizes a risk rating scale ranging from 1-Prime to 9-Loss to evaluate loan quality. This risk rating scale is used primarily for commercial purpose loans. Consumer purpose loans are identified as either a pass or substandard rating based on the performance status of the loans. Substandard consumer loans are loans that are 90 days or more past due and still accruing. Loans rated 1 – 4 are considered pass credits. Loans rated 5 are pass credits but have been identified as credits that are likely to warrant additional attention and monitoring. Loans rated 6-Other Asset Especially Mentioned (OAEM) or worse begin to receive enhanced monitoring and reporting by the Bank. Loans rated 7-Substandard or 8-Doubtful exhibit the greatest financial weakness and present the greatest possible risk of loss to the Bank. Nonaccrual loans are rated no better than 7-Substandard. The following factors represent some of the factors used in determining the risk rating of a borrower: cash flow, debt coverage, liquidity, management, and collateral. Risk ratings, for pass credits, are generally reviewed annually for term debt and at renewal for revolving or renewing debt. The Bank monitors loan quality by reviewing three primary measurements: (1) loans rated 6-OAEM or worse (collectively “watch list”), (2) delinquent loans, and (3) net-charge-offs.,

Watch list loans exhibit financial weaknesses that increase the potential risk of default or loss to the Bank. However, inclusion on the watch list, does not by itself, mean a loss is certain. The watch list totaled $11.5 million at quarter end compared to $11.1 million at March 31, 2020 and $11.6 million at December 31, 2019. The watch list includes both performing and nonperforming loans. Included in the substandard total are $4.1 million of nonaccrual loans. The credit composition of the watch list (loans rated 6, 7, or 8), by primary collateral is shown in Note 6 of the accompanying financial statements.

Delinquent loans are a result of borrowers’ cash flow and/or alternative sources of cash being insufficient to repay loans. The Bank’s likelihood of collateral liquidation to repay the loans becomes more probable the further behind a borrower falls, particularly when loans reach 90 days or more past due. Management monitors the performance status of loans by the use of an aging report. The aging report can provide an early indicator of loans that may become severely

delinquent and possibly result in a loss to the Bank. See Note 6 in the accompanying financial statements for a table that presents the aging of payments in the loan portfolio.

Nonaccruing loans generally represent Management’s determination that the borrower will be unable to repay the loan in accordance with its contractual terms and that collateral liquidation may or may not fully repay both interest and principal. It is the Bank’s policy to evaluate the probable collectability of principal and interest due under terms of loan contracts for all loans 90-days or more past due, nonaccrual loans, or impaired loans. Further, it is the Bank’s policy to discontinue accruing interest on loans that are not adequately secured and in the process of collection. Upon determination of nonaccrual status, the Bank subtracts any current year accrued and unpaid interest from its income, and any prior year accrued and unpaid interest from the allowance for loan losses. Management continually monitors the status of nonperforming loans, the value of any collateral and potential of risk of loss. Nonaccrual loans are rated no better than 7-Substandard.

The Bank’s Loan Management Committee reviews these loans and risk ratings on a quarterly basis in order to proactively identify and manage problem loans. In addition, a committee meets monthly to discuss possible workout strategies for and all credits rated 7-Substandard or worse. Management also tracks other commercial loan risk measurements including high loan to value loans, concentrations, participations and policy exceptions and reports these to the Credit Risk Oversight Committee of the Board of Directors. The Bank also uses a third-party consultant to assist with internal loan review with a goal of reviewing 60% of commercial loans each year. The FDIC defines certain supervisory loan-to-value lending limits. The Bank’s internal loan–to-value limits are all equal to or have a lower loan-to-value limit than the supervisory limits. However, in certain instances, the Bank may make a loan that exceeds the supervisory loan-to-value limit. At June 30, 2020, the Bank had loans of $23 million (2.2% of gross loans) that exceeded the supervisory limit, compared to 2.69% at year-end 2019.

Loan quality, overall, has remained stable during the second quarter of 2020 with both nonaccrual loans, and loans past due 90 days or more increasing only approximately $300 thousand. The nonperforming ratios are comparable to the December 31, 2019 ratios. Loans that have been modified on a good-faith basis in response to COVID-19 to borrowers who were classified as current prior to any relief as outlined in the March 22, 2020 Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus do not need to be reported as past due during the period of the qualifying modification for short-term loan modifications (e.g. six months). Consequently, loan delinquencies and nonaccrual loans could increase during the second half of 2020 if modified loans are not able to return to a performing status. Potential problem loans, defined as watch list loans less loans on nonaccrual or past due more than 90 days totaled $7.4 million at quarter end compare to $6.3 million at March 31, 2020 and $7.7 million at December 31, 2019. The following table presents a summary of nonperforming assets as of:


	June 30,		December 31,
(Dollars in thousands)	2020		2019

Nonaccrual loans
Residential Real Estate 1-4 Family
First liens	$	41	$	68
Junior liens and lines of credit		14		31
Total		55		99
Residential real estate - construction		518		523
Commercial real estate		3,367		3,009
Commercial		207		197
Total nonaccrual loans		4,147		3,828

Loans past due 90 days or more and still accruing
Residential Real Estate 1-4 Family
First liens		—		31
Junior liens and lines of credit		12		46
Total		12		77
Consumer		2		—
Total loans past due 90 days or more and still accruing		14		77

Total nonperforming loans		4,161		3,905

Other real estate owned		—		—
Total nonperforming assets	$	4,161	$	3,905

Nonperforming loans to total gross loans		0.41%		0.42%
Nonperforming assets to total assets		0.29%		0.31%
Allowance for loan losses to nonperforming loans		397.86%		306.43%

‎

The following table identifies the most significant loans in nonaccrual status. These two nonaccrual loans account for 56% of the total nonaccrual balance. In July 2020, the Bank received a $761 thousand payment on Credit 2.

(Dollars in thousands)

ALL

Nonaccrual

TDR

Collateral

Balance

Reserve

Date

Status

Collateral

Location

Value (1)

Credit 1

1,299

—

Mar-12

1st and 2nd liens on commercial real estate, residential real estate and business assets

3,064

Credit 2

1,004

—

Mar-19

land for residential development, residential and commercial real estate

1,517

2,303

—

(1) Includes any estimated discount on appraised value and cost to sell.

In addition to monitoring nonaccrual loans, the Bank also closely monitors impaired loans and troubled debt restructurings (TDR). A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Nonaccrual loans (excluding consumer purpose loans) and TDR loans are considered impaired.

A loan is considered a troubled debt restructuring if the creditor (the Bank), for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. These concessions may include lowering the rate, extending the maturity, re-amortization of the payment, or a combination of multiple concessions. The Bank reviews all loans rated 6-OAEM or worse when it is providing a loan restructure, modification or new credit facility to determine if the action is a TDR. If a TDR loan is placed on nonaccrual status, it remains on nonaccrual status for at least six months to ensure performance. Loans that have been modified on a good-faith basis in response to COVID-19 to borrowers who were classified as current prior to any relief are not TDRs as outlined in the March 22, 2020 Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus.

In accordance with financial accounting standards, TDR loans are always considered impaired until they are paid off or in certain circumstances, refinanced. However, an impaired TDR loan can be a performing loan. Impaired loans totaled $12.3 million compared to $12.2 million at year-end 2019.

Pandemic Effect on Loan Quality: The credit quality of the Bank’s loan portfolio as of June 30, 2020 is stable. The ratio of nonperforming loans to total gross loans is .41%. However, the pandemic outbreak has the potential to affect the credit quality of the loan portfolio in future periods. The pandemic has resulted in certain federal, state and local governmental authorities taking action to stop the spread of the pandemic. These actions have included stay-at-home orders, restrictions on business activity, and proclamations and/or directives aimed at minimizing the spread of the pandemic by restricting the movement of people, products and services in the economy. As a result of these actions, the economic activity of the Bank’s market area has been curtailed, businesses have been shut down and unemployment has dramatically increased. The repayment of every loan is dependent, in some way, on an efficiently functioning economy. Any action that has the effect of restricting economic activity has the potential to reduce cash flow available to repay loans. At this time, the length of this economic downturn is uncertain, as is the effect on the Bank’s loan portfolio.

As addressed below in the Allowance for Loan Losses (ALL) section, the ALL was increased by $2.0 million in the second quarter of 2020 based on higher risk factors in the qualitative allowance. In evaluating the loan portfolio, the most significant things considered were; loan deferrals or modifications, the Paycheck Protection Program, and composition of the portfolio by industry segments.

Loan Deferrals. As the economy quickly contracted in March 2020 as the result of the pandemic, the Bank began to receive requests for payment modifications. Unlike past economic downturns, bank regulators provided favorable guidance for banks allowing them wide latitude to make modifications. Under guidance provided by the CARES Act and a joint regulatory agency statement issued by banking agencies, banks could, under certain circumstances, avoid reporting loan modifications as delinquent, nonperforming or as a trouble debt restructuring. As of June 30, 2020, the Bank has granted approximately $196 million loan deferrals or modifications (approximately 19% of gross loans). These modifications include the deferral of principal and interest payments, deferral of interest payments for interest only lines of credit or providing for an interest only payment. Any interest that is deferred is due and payable at the end of the deferral period. Principal that is deferred will be added to the end of the loan as an extension of the maturity date or as a balloon payment, depending on the loan structure. The Bank will continue to accrue interest during the deferral period. The majority of deferrals were for an initial period of 3 months with the potential for second 3-month deferral after review.

‎

The following tables show the loan deferrals made as of June 30, 2020 by North American Industry Classification System (NAICS) code and type of collateral, as well as the type of modifications made as of June 30, 2020.


					Percent of	Collateral
(Dollars in thousands)	Number of			Percent of	Risk-based	Real Estate		Non-Real Estate
Industry Description	Loans		Balance	Gross Loans	Capital (1)	secured		secured
Real Estate and Rental and Leasing	71	$	72,389	7%	8%	$	72,138	$	251
Accommodation and Food Services	52		70,796	7%	8%		70,260		536
Retail Trade	17		24,198	2%	3%		24,063		135
Health Care and Social Assistance	16		6,974	1%	1%		5,434		1,540
Construction	25		4,590	< 1%	1%		2,635		1,955
Arts, Entertainment, and Recreation	12		3,842	< 1%	< 1%		3,466		376
Agriculture, Forestry, Fishing and Hunting	7		2,705	< 1%	< 1%		2,603		102
Other Services (except Public Administration)	13		1,801	< 1%	< 1%		1,537		264
Administrative/Support & Waste Mgt Services	9		1,521	< 1%	< 1%		1,263		258
Transportation and Warehousing	12		1,407	< 1%	< 1%		440		967
Public Administration	1		396	< 1%	< 1%		396		—
Professional, Scientific, & Technical Services	7		360	< 1%	< 1%		—		360
Manufacturing	5		311	< 1%	< 1%		120		191
Residential and Consumer loans	43		5,198	1%	1%		5,161		37
Total	290	$	196,488	19%	23%	$	189,516	$	6,972
(1) Based on Bank's Risk-based Capital


	Number of
Types of Modifications	Loans		Balance
Interest only extension for 1-3 months	48	$	34,425
Interest only payment deferral for 1-3 months	20		2,316
Interest only extension for 4-6 months	1		280
Principal and interest payment deferral for 1-3 months	213		150,697
Principal and interest payment deferral for 4-6 months	8		8,770
	290	$	196,488

The performance of these loans as they come out of the deferral period will be critical in predicting the credit quality of the loans in the future.

Paycheck Protection Program. The Bank participated in the Paycheck Protection Program (PPP) administered by the Small Business Administration (SBA). The PPP is a small business loan program designed to assist in allowing small businesses to keep workers on the payroll during the COVID-19 pandemic. When workers are kept on the payroll for the qualifying period, the loan could be forgiven if the small business incurs eligible expenses. The PPP loans, are 100 percent guaranteed by the SBA, have a maturity of two-years and have a fixed interest rate of 1% for the life of the loan. Borrowers of PPP loans do not have to make payments on the loan for the first six months, then it is fully amortizing for the remainder of the two-year term. The SBA pays originating banks a processing fee ranging from 3% to 5% of the loan, depending on the loan balance. At June 30, 2020 the Bank held $62.5 million of PPP loans. The Bank recorded $233 thousand in income from PPP loan origination fees, reported in interest income, during the second quarter of 2020. The Bank expects to recognize additional processing fees of approximately $2.1 million over the contractual life of the PPP loans (two years or five years). As PPP loans are granted forgiveness by the SBA, fee recognition will accelerate. The PPP loans are 100% guaranteed by the SBA, thereby presenting no credit risk to the Bank once the SBA guarantee is fulfilled, if necessary. However, the PPP loan is only designed to cover short-term operating needs of the borrower. If the economy does not recover quickly from the pandemic and the borrower experiences long-term operational problems beyond the PPP funding, the performance of other loans to these customers could begin to deteriorate.

Industry Exposure. With the pandemic shut down of non-essential businesses and stay at home orders, nearly every business and industry has been affected. Certain businesses have had a complete stoppage of operations, while many others have seen their business significantly reduced. Some businesses have requested loan modifications and others have taken PPP loans to continue operations.

To better understand the risk in the portfolio from the pandemic, the Bank has segregated its portfolio by industry and the perceived exposure to be economically affected by the pandemic.

‎

The following table shows the loan portfolio by perceived pandemic risk at June 30, 2020.


(Dollars in thousands)

Low	$	517,628
Medium		366,645
High		127,865
Total	$	1,012,138

The following tables show the medium and high perceived pandemic risk by industry and collateral at June 30, 2020.


(Dollars in thousands)				Percent of
			Percent of	Risk-based
Medium Risk			Gross Loans	Capital (1)	Real Estate Secured		Non-Real Estate Secured
Retail - Consumer Loans - Non-Real Estate	$	5,821	1%	1%	$	—	$	5,821
Construction		65,792	7%	8%		57,710		8,082
Real Estate and Rental and Leasing		295,032	29%	34%		282,948		12,084
Total	$	366,645	36%	42%	$	340,658	$	25,987

High Risk
Arts, Entertainment, and Recreation	$	14,649	1%	2%	$	13,677	$	972
Retail Trade - Non-Operating Sectors		34,109	3%	4%		31,835		2,274
Accommodation and Food Services		79,107	8%	9%		77,611		1,496
Total	$	127,865	13%	15%	$	123,123	$	4,742
(1) Based on Bank's Risk-based Capital

Allowance for Loan Losses:

Management monitors loan performance on a monthly basis and performs a quarterly evaluation of the adequacy of the allowance for loan losses (ALL). The ALL is determined by segmenting the loan portfolio based on the loan’s collateral. When calculating the ALL, consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, historical charge-offs, the adequacy of the underlying collateral (if collateral dependent) and other relevant factors. The Bank begins enhanced monitoring of all loans rated 6-OAEM, or worse, and obtains a new appraisal or asset valuation for any placed on nonaccrual and rated 7-Substandard or worse. Management, at its discretion, may determine that additional adjustments to the appraisal or valuation are required. Valuation adjustments will be made as necessary based on factors, including, but not limited to; the economy, deferred maintenance, industry, type of property/equipment, age of the appraisal, etc. and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. When determining the allowance for loan losses, certain factors involved in the evaluation are inherently subjective and require material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans. Management monitors the adequacy of the allowance for loan losses on an ongoing basis and reports its adequacy quarterly to the Credit Risk Oversight Committee of the Board of Directors. Management believes that the allowance for loan losses at June 30, 2020 is adequate.

The analysis for determining the ALL is consistent with guidance set forth in generally accepted accounting principles (GAAP) and the Interagency Policy Statement on the Allowance for Loan and Lease Losses. The analysis has three components; specific, general and unallocated. The specific component addresses specific reserves established for impaired loans. A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Collateral values discounted for market conditions and selling costs are used to establish specific allocations for impaired loans. However, it is possible that as a result of the credit analysis, a specific reserve is not required for an impaired loan. Commercial loans with a balance less than $250 thousand, and all consumer purpose loans are not included in the specific reserve analysis as impaired loans but are added to the general allocation pool. These loans totaled $426 thousand at June 30, 2020 and are comprised primarily of loans secured by residential real estate. Management does not believe that excluding these loans from the specific reserve analysis presents any additional risk. There was no specific reserve established for any of the impaired loans. Note 6 of the accompanying financial statements provides additional information about the ALL established for impaired loans.

The general allocation component addresses the reserves established for pools of homogenous loans. The general component includes a quantitative and qualitative analysis. When calculating the general allocation, the Bank segregates

its loan portfolio into the following segments based primarily on the type of supporting collateral: residential real estate, commercial, industrial or agricultural real estate; commercial and industrial (C&I non-real estate), and consumer. Each segment may be further segregated by type of collateral, lien position, or owner/nonowner occupied properties. The quantitative analysis uses the Bank’s twenty quarter rolling historical loan loss experience as determined for each loan segment to determine a loss factor applicable to each loan segment. PPP loans, because of the SBA guarantee, were excluded from the quantitative analysis. The allowance established as a result of the quantitative analysis was $3.6 million at June 30, 2020, compared to $2.9 million at year-end 2019.

The qualitative analysis utilizes a risk matrix that incorporates four primary risk factors: economic conditions, delinquency, classified loans, and level of risk, and assigns a risk score (as measured in basis points) to each factor. The economic condition factor is primarily based on unemployment rates. The delinquency factor considers the level of past due loans and charge-offs. The classified loan factor considers the internal credit risk score of the portfolio. The level of risk factor considers operational factors such as: loan volume, management, loan review process, credit concentrations, competition, and legal and regulatory issues. The risk score (as measured in basis points) for each of the four risk factors is minimal, low, moderate, high and very high and is determined independently for commercial loans, residential mortgage loans and consumer loans. At June 30, the Bank increased the basis point adjustment connected to the very high range for the economic conditions risk factor to reflect increased risk presented by the pandemic. The risk score for delinquency and classified loan factors remained unchanged but could increase depending loan performance in the future. In addition, the Bank carved out the portfolio of modified loans for a qualitative assessment separate from the overall commercial loan portfolio. This allowed for assignment of a higher qualitative risk score on this portfolio. PPP loans, because of the SBA guarantee, were excluded from the qualitative analysis. Year-to-date, these changes resulted in a $4.4 million increase in the qualitative component of the ALL to $12.2 million as of June 30, 2020 compared to $7.7 million at December 31, 2019.

The unallocated component is maintained to cover uncertainties that could affect Management’s estimate of probable loss. The unallocated component of the ALL reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

The following table shows, by loan segment, the activity in the ALL, the amount of allowance established in each category and the loans that were evaluated for the ALL under a specific reserve (individually) and those that were evaluated under a general reserve (collectively) as of June 30, 2020.


	Residential Real Estate 1-4 Family
	First		Junior Liens &				Commercial
(Dollars in thousands)	Liens		Lines of Credit		Construction		Real Estate		Commercial		Consumer		Unallocated		Total


ALL at March 31, 2020	$	563	$	178	$	269	$	8,249	$	4,713	$	98	$	660	$	14,730
Charge-offs		—		—		—		—		(145)		(29)		—		(174)
Recoveries		1		—		—		—		19		4		—		24
Provision		16		19		(27)		588		1,258		32		89		1,975
ALL at June 30, 2020	$	580	$	197	$	242	$	8,837	$	5,845	$	105	$	749	$	16,555

ALL at December 31, 2019	$	416	$	119	$	187	$	6,607	$	4,021	$	84	$	532	$	11,966
Charge-offs		—		—		—		—		(365)		(59)		—		(424)
Recoveries		4		—		—		—		24		10		—		38
Provision		160		78		55		2,230		2,165		70		217		4,975
ALL at June 30, 2020	$	580	$	197	$	242	$	8,837	$	5,845	$	105	$	749	$	16,555

ALL at March 31, 2019	$	487	$	132	$	154	$	6,470	$	4,801	$	72	$	565	$	12,681
Charge-offs		(1)		—		—		(123)		(14)		(25)		—		(163)
Recoveries		2		1		—		20		9		3		—		35
Provision		(51)		(20)		10		85		(63)		45		(6)		-
ALL at June 30, 2019	$	437	$	113	$	164	$	6,452	$	4,733	$	95	$	559	$	12,553

ALL at December 31, 2018	$	491	$	133	$	110	$	6,278	$	4,783	$	70	$	550	$	12,415
Charge-offs		(34)		(1)		(3)		(186)		(75)		(51)		—		(350)
Recoveries		3		1		—		21		51		13		—		89
Provision		(23)		(20)		57		339		(26)		63		9		399
ALL at June 30, 2019	$	437	$	113	$	164	$	6,452	$	4,733	$	95	$	559	$	12,553


	Residential Real Estate 1-4 Family
	First		Junior Liens &				Commercial
(Dollars in thousands)	Liens		Lines of Credit		Construction		Real Estate		Commercial		Consumer		Unallocated		Total

June 30, 2020
Loans evaluated for ALL:
Individually	$	648	$	—	$	518	$	11,127	$	—	$	—	$	—	$	12,293
Collectively		142,284		54,833		13,059		486,555		296,432		6,682		—		999,845
Total	$	142,932	$	54,833	$	13,577	$	497,682	$	296,432	$	6,682	$	—	$	1,012,138

ALL established for ‎ loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		580		197		242		8,837		5,845		105		749		16,555
ALL at June 30, 2020	$	580	$	197	$	242	$	8,837	$	5,845	$	105	$	749	$	16,555

December 31, 2019
Loans evaluated for ALL:
Individually	$	659	$	—	$	523	$	10,994	$	—	$	—	$	—	$	12,176
Collectively		142,287		47,597		12,800		483,268		230,007		6,440		—		922,399
Total	$	142,946	$	47,597	$	13,323	$	494,262	$	230,007	$	6,440	$	—	$	934,575

ALL established for ‎ loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		416		119		187		6,607		4,021		84		532		11,966
ALL at December 31, 2019	$	416	$	119	$	187	$	6,607	$	4,021	$	84	$	532	$	11,966

Real estate appraisals and collateral valuations are an important part of the Bank’s process for determining potential loss on collateral dependent loans and thereby have a direct effect on the determination of loan reserves, charge-offs and the calculation of the allowance for loan losses. As long as the loan remains a performing loan, no further updates to appraisals are required. If a loan or relationship migrates to nonaccrual and a risk rating of 7-Substandard or worse, an evaluation for impairment status is made based on the current information available at the time of downgrade and a new appraisal or collateral valuation is obtained. We believe this practice complies with the regulatory guidance.

In determining the allowance for loan losses, Management, at its discretion, may determine that additional adjustments to the fair value obtained from an appraisal or collateral valuation are required. Adjustments will be made as necessary based on factors, including, but not limited to the economy, deferred maintenance, industry, type of property or equipment etc., and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. If an appraisal is not available, Management may make its best estimate of the real value of the collateral or use last known market value and apply appropriate discounts. If an adjustment is made to the collateral valuation, this will be documented with appropriate support and reported to the Loan Management Committee.

The allocation of the allowance for loan losses is based on estimates and is not intended to imply limitations on the usage of the allowance. The entire allowance is available to absorb any losses without regard to the category in which the loan is classified.

The following table shows the ALL and charge-off ratios for the periods ended:


	Six Months Ended		Year ended			Six Months Ended
	June 30, 2020			December 31, 2019		June 30, 2019
Net charge-offs (recoveries)/average loans*		0.08%			0.07%		0.05%
Net loan charge-offs (recoveries) as a percentage of the provision for loan losses		7.76%			289.54%		65.41%
Allowance for loan losses as a % of loans		1.64%			1.28%		1.28%
Net charge-offs (recoveries)	$	386		$	686	$	261
* Annualized

Deposits:

Total deposits increased $148.0 million during the first six months of 2020 to $1.273 billion. Of this increase, approximately $36.0 million are remaining PPP loan proceeds. These deposits are expected to be short-term in nature.

Noninterest-bearing deposits increased $56.7 million (primarily in small business and commercial checking deposits) and interest-bearing checking and savings deposits increased $100.9 million, while time deposits decreased $9.6 million. Interest-bearing checking increased by $54.3 million, primarily in commercial and municipal deposits, while the Bank’s Money Management increased $34.0 million and Savings products increased $12.5 million compared to year-end 2019, as customers deposited stimulus checks and did not spend the funds. Time deposits also decreased since year-end and primarily in retail accounts.

As of June 30, 2020, the Bank had $194.5 million placed in the ICS reciprocal deposit program ($142.3 million in interest-bearing checking and $52.2 million in money management) and $3.0 million in reciprocal time deposits in the CDARS program included in time deposits. These programs allow the Bank to offer full FDIC coverage to large depositors, but with the convenience to the customer of only having to deal with one bank. The Bank solicits these deposits from within its market and it believes they present no greater risk than any other local deposit. Only reciprocal deposits that exceed 20% of liabilities are considered brokered deposits. At June 30, 2020, the Bank’s reciprocal deposits were 15.5% of total liabilities compared to 14.2% at year-end 2019.


	June 30,		December 31,			Change
(Dollars in thousands)	2020		2019			Amount	%
Noninterest-bearing checking	$	248,851	$	192,108	$	56,743	29.5

Interest-bearing checking		386,230		331,886		54,344	16.4
Money management		463,207		429,199		34,008	7.9
Savings		95,355		82,851		12,504	15.1
Total interest-bearing checking and savings		944,792		843,936		100,856	12.0

Time deposits		79,710		89,348		(9,638)	(10.8)
Total deposits	$	1,273,353	$	1,125,392	$	147,961	13.1

Overdrawn deposit accounts reclassified as loans	$	93	$	153

Borrowings:

The Corporation had no borrowings at June 30, 2020 and December 31, 2019.

On August 4, 2020 the Corporation completed the sale of a subordinated debt note offering. The Corporation sold $15.0 million of subordinated debt notes with a maturity date of September 1, 2030. These notes are noncallable for 5 years and carry a fixed interest rate of 5% per year for 5 years and then convert to floating rate of SOFR plus 4.93% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The Corporation also sold $5.0 million of subordinated debt notes with a maturity date of September 1, 2035. These notes are noncallable for 10 years and carry a fixed interest rate of 5.25% per year for 10 years and then convert to floating rate of SOFR plus 4.92% per year for the remainder of the term. The notes can be redeemed at par beginning 5 years prior to maturity. The notes are structured to qualify as Tier 2 capital for the Corporation and any funds it invests in the Bank qualify as Tier 1 capital at the Bank. The Corporation paid an issuance fee of 2% of the total issue that will be amortized to the call date of each issue on a pro-rata basis. The proceeds are intended to be used for general corporate purposes.

Shareholders’ Equity:

Total shareholders’ equity increased $7.3 million to $134.8 million at June 30, 2020, from $127.5 million at the end of 2019. The Corporation’s net earnings of $4.8 million were partially offset by the cash dividend of $2.6 million. The Corporation’s Dividend Reinvestment Plan (DRIP) added $515 thousand in new capital from optional cash contributions and $425 thousand from the reinvestment of quarterly dividends. The Corporation’s dividend payout ratio was 54.49% for the first six months of 2020.

As part of its quarterly dividend decision, the Corporation considers current and future income projections, dividend yield, payout ratio, and current and future capital ratios. For the second quarter of 2020, the Corporation paid a $0.30 per share dividend, compared to $0.30 paid in the second quarter of 2019. On July 11, 2020 the Board of Directors declared a $0.30 per share regular quarterly dividend for the third quarter of 2020, which will be paid on August 26, 2020.

On September 12, 2019, the Board of Directors authorized the 2019 Repurchase Plan for the repurchase of up to 150,000 shares of the Corporation’s $1.00 par value common stock at market prices in open market or privately negotiated transactions beginning September 13, 2019 and continuing through September 12, 2020. During the first quarter of 2020, 36,401 shares were repurchased, under the 2019 plan. The Corporation suspended activity in the stock repurchase plan on March 19, 2020.

5%, (3) Tier 1 Risk-Based Capital of 8%, and (4) Total Risk-Based Capital of 10%. In addition, a capital conservation buffer of 2.50% is applicable to all of the capital ratios except for the Tier 1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum for each respective capital measurement. The Bank’s capital conservation buffer at June 30, 2020 was 7.64% (total risk-based capital 15.64% less 8.00%) compared to the 2020 regulatory buffer of 2.50%. Compliance with the capital conservation buffer is required in order to avoid limitations to certain capital distributions and is in addition to the minimum required capital requirements. As of June 30, 2020, the Bank was “well capitalized”.

The following table summarizes the regulatory capital requirements and results as of June 30, 2020 and December 31, 2019 for the Corporation and the Bank:


			Regulatory Ratios
			Adequately	Well
	June 30,	December 31,	Capitalized	Capitalized
(Dollars in thousands)	2020	2019	Minimum	Minimum

Common Equity Tier 1 Risk-based Capital Ratio (1)
Franklin Financial Services Corporation	14.66%	14.82%	N/A	N/A
Farmers & Merchants Trust Company	14.38%	14.62%	4.500%	6.50%

Tier 1 Risk-based Capital Ratio (2)
Franklin Financial Services Corporation	14.66%	14.82%	N/A	N/A
Farmers & Merchants Trust Company	14.38%	14.62%	6.000%	8.00%

Total Risk-based Capital Ratio (3)
Franklin Financial Services Corporation	15.93%	16.08%	N/A	N/A
Farmers & Merchants Trust Company	15.64%	15.87%	8.000%	10.00%

Tier 1 Leverage Ratio (4)
Franklin Financial Services Corporation	9.22%	9.72%	N/A	N/A
Farmers & Merchants Trust Company	9.05%	9.59%	4.000%	5.00%

(1) Common equity Tier 1 capital/ total risk-weighted assets (2) Tier 1 capital / total risk-weighted assets
(3) Total risk-based capital / total risk-weighted assets, (4) Tier 1 capital / average quarterly assets

Economy

The Corporation’s primary market area includes Franklin, Fulton, Cumberland and Huntingdon Counties, Pennsylvania. This area is diverse in demographic and economic makeup. County populations range from a low of approximately 15,000 in Fulton County to over 249,000 in Cumberland County. Unemployment in the Bank’s market area ranged from 9.9% in Cumberland County to 15.1% in Fulton County, as of the end of May. The market area has a diverse economic base and local industries include warehousing, truck & rail shipping centers, light and heavy manufacturers, healthcare, higher education institutions, farming and agriculture, and a varied service sector. The Corporation’s primary market area is located in South Central PA and provides easy access to the major metropolitan markets on the east coast via trucking and rail transportation. Because of this, warehousing and distribution companies continue to find the area

attractive. The local economy is not overly dependent on any one industry or business and Management believes that the Bank’s primary market area continues to be well suited for growth.

In early March 2020, the economic outlook changed dramatically driven primarily by the COVID-19 pandemic. The effects of the pandemic stretched into the second quarter of 2020 and are expected to last throughout the remainder of the year. The pandemic has resulted in certain federal, state and local governmental authorities taking action to stop the spread of the virus. These actions have included stay-at-home orders, restrictions on business activity, and proclamations and/or directives aimed at minimizing the spread of the pandemic by restricting the movement of people, products and services in the economy. As a result of these actions, the economic activity of the Bank’s market area has been curtailed, businesses have been shut down and unemployment has dramatically increased. The repayment of every loan is dependent, in some way, on an efficiently functioning economy. Any action that has the effect of restricting economic activity has the potential to reduce cash flow available to repay loans. At this time, the length of this economic downturn and its effect on the Corporation is uncertain.

Impact of Inflation

The impact of inflation upon financial institutions such as the Corporation differs from its effect upon other commercial enterprises. Unlike many companies, the assets and liabilities of the Corporation are financial in nature. As such, interest rates and changes in interest rates may have a more significant effect on the Corporation’s financial results than on other types of industries. Because of this, the Corporation watches the actions of the Federal Reserve Open Market Committee (FOMC) as it makes decisions about interest rate changes and how such changes affect market rates and the Corporation. Although inflation (and inflation expectations) may affect the interest rate environment, it is not possible to measure with any precision the effect of inflation on the Corporation.

Liquidity

The Corporation must meet the financial needs of the customers that it serves, while providing a satisfactory return on the shareholders’ investment. In order to accomplish this, the Corporation must maintain sufficient liquidity in order to respond quickly to the changing level of funds required for both loan and deposit activity. The goal of liquidity management is to meet the ongoing cash flow requirements of depositors who want to withdraw funds and of borrowers who request loan disbursements. The Bank regularly reviews it liquidity position by measuring its projected net cash flows (in and out) at a 30 and 90-day interval. The Bank stresses the measurements by assuming a level of deposit out-flows that have not historically been realized. In addition to this forecast, other funding sources are reviewed as a method to provide emergency funding if necessary. The objective of this measurement is to identify the amount of cash that could be raised quickly without the need to liquidate assets. The Bank also stresses its liquidity position utilizing different longer-term scenarios. The varying degrees of stress create pressure on deposit flows in its local market, reduce access to wholesale funding and limit access of funds available through brokered deposit channels. In addition to stressing cash flow, specific liquidity risk indicators are monitored to help identify risk areas. This analysis helps identify and quantify the potential cash surplus/deficit over a variety of time horizons to ensure the Bank has adequate funding resources. Assumptions used for liquidity stress testing are subjective. Should an evolving liquidity situation or business cycle present new data, potential assumption changes will be considered. The Bank believes it can meet all anticipated liquidity demands.

Historically, the Corporation has satisfied its liquidity needs from earnings, repayment of loans and amortizing investment securities, maturing investment securities, loan` sales, deposit growth and its ability to access existing lines of credit. All investment securities are classified as available for sale; therefore, securities that are unencumbered (approximately $200 million fair value) as collateral for borrowings are an additional source of readily available liquidity, either by selling the security or, more preferably, to provide collateral for additional borrowing. The Bank also has access to other wholesale funding via the brokered CD market.

The FHLB system has always been a major funding source for the Bank. There are no current indicators that lead the Bank to believe the FHLB would discontinue its lending function or restrict the Bank’s ability to borrow. If either of these events would occur, it would have a negative effect on the Bank, and it is unlikely that the Bank could replace the level of FHLB funding in a short time. The Bank has established credit at the Federal Reserve Discount Window and at correspondent banks.

‎

The following table shows the Bank’s available liquidity at June 30, 2020.


(Dollars in thousands)

Liquidity Source		Capacity		Outstanding		Available
Federal Home Loan Bank	$	372,200	$	—	$	372,200
Federal Reserve Bank Discount Window		21,000		—		21,000
Correspondent Banks		21,000		—		21,000
Paycheck Protection Program Liquidity Facility		62,513		—		62,513
Total	$	476,713	$	—	$	476,713

Pandemic Effect on Liquidity: The Bank is closely monitoring its liquidity needs as loans are modified and delinquencies are expected to increase. The Bank expects to see a reduction in monthly cash flow from loan deferrals, as discussed in the Loan Quality section. The Bank expects to be able to absorb this reduction through its current liquidity resources. To support its liquidity position, the Bank is participating in the Paycheck Protection Program Liquidity Facility (PPPLF) established by the Federal Reserve to fund loans made through the Paycheck Protection Program sponsored by the Small Business Administration. The PPPLF is a term financing facility with a fixed interest rate of .35% and a maturity equal to the maturity date of the PPP loans (2 years or 5 years). Loans made through the PPP are used as collateral for PPPLF funding. The PPPLF will allow the Bank to fully fund its PPP loans at a low fixed rate without having to access its normal liquidity sources described above. The Bank believes it can meet all anticipated liquidity demands of the pandemic through its current liquidity sources and the government sponsored programs.

The CARES Act also granted the FDIC authority to reinstitute the liquidity guarantee program to offer unlimited FDIC insurance on noninterest bearing deposits. If this is approved by the FDIC, it would provide less incentive for customers to withdraw deposits and possibly strain bank liquidity

Off Balance Sheet Commitments

The Corporation’s financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk. These commitments consist mainly of unfunded loans and letters of credit made under the same standards as on-balance sheet instruments. Because these instruments have fixed maturity dates, and because many of them will expire without being drawn upon, they do not generally present any significant liquidity risk to the Corporation. Unused commitments and standby letters of credit totaled $342.9 million and $336.6 million, respectively, at June 30, 2020 and December 31, 2019. As of June 30, 2018, the Bank established a $2.4 million allowance against letters of credit issued in connection with a commercial borrower that declared bankruptcy. In the first quarter of 2020, the Bank reversed $250 thousand of this reserve as one letter of credit was cancelled. At June 30, 2020 this reserve was $2.1 million.

The Corporation has entered into various contractual obligations to make future payments. These obligations include time deposits, long-term debt, operating leases, deferred compensation and pension payments. These amounts have not changed materially from those reported in the Corporation’s 2019 Annual Report on Form 10-K.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

There were no material changes in the Corporation’s exposure to market risk during the six months ended June 30, 2020. For more information on market risk refer to the Corporation’s 2019 Annual Report on Form 10-K.

Item 4. Controls and Procedures

Evaluation of Controls and Procedures

The Corporation carried out an evaluation, under the supervision and with the participation of the Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of its disclosure controls and procedures, as defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon the evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that as of June 30, 2020, the Corporation’s disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in the Corporation’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. There were no changes in the Corporation’s internal control over financial reporting during the quarterly period ended June 30, 2020, that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting.

The management of the Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. The Corporation’s internal control system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

‎

Part II – OTHER INFORMATION

Item 1. Legal Proceedings

The nature of the Corporation’s business generates a certain amount of litigation.

In management’s opinion, we do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of all litigation to which the Corporation is a party will have a material adverse effect on our financial position. We cannot now determine, however, whether or not any claim asserted against us will have a material adverse effect on our results of operations in any future reporting period, which will depend on, amount other things, the amount of loss resulting from the claim and the amount of income otherwise reported for the reporting period. Thus, at June 30, 2020, we are unable to provide an evaluation of the likelihood of an unfavorable outcome or an estimate of the amount or range of potential loss with respect to such other matters and, accordingly, have not yet established any specific accrual for such other matters.

No material proceedings are pending or are known to be threatened or contemplated against us by governmental authorities.

In management’s opinion, there are no other proceedings pending to which the Corporation is a party or to which its property is subject which, if determined adversely to the Corporation, would be material. No material proceedings are pending or are known to be threatened or contemplated against us by any governmental authorities.

Item 1A. Risk Factors

During the six months ended June 30, 2020 the Corporation has determined the following risk associated with its business, financial condition, results of operations and common stock. This risk factor supplements the risk factors described in the Corporation’s 2019 Annual Report on Form 10-K.

Public health crisis such as epidemics or pandemics could materially and adversely impact our business.

The COVID-19 pandemic has negatively impacted the global, national and local economies, disrupted global and national supply chains, lowered equity market valuations, created significant volatility and disruption in financial markets, and increased unemployment levels. In addition, the pandemic has resulted in temporary closures of many businesses and the institution of social distancing and sheltering in place requirements in many states and communities. As a result, the demand for our products and services may be significantly impacted, which could adversely affect our revenue and results of operations. Furthermore, the pandemic could continue to result in the recognition of credit losses in our loan portfolios and increase in our allowance for credit losses, particularly if businesses remain closed, the impact on the global, national and local economies worsen, or more customers draw on their lines of credit or seek additional loans to help finance their businesses. Similarly, because of changing economic and market conditions affecting issuers, we may be required to recognize further impairments on the securities we hold as well as reductions in other comprehensive income. Our business operations may also be disrupted if significant portions of our workforce are unable to work effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic. The extent to which the COVID-19 pandemic impacts our business, results of operations, and financial conditions, as well as our regulatory capital and liquidity ratios, will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities and other third parties in response to the pandemic.

We continue to closely monitor the COVID-19 pandemic and related risks as they evolve. The magnitude, duration and likelihood of the current outbreak of COVID-19, further outbreaks of COVID-19, future actions taken by governmental authorities and/or other third parties in response to the COVID-19 pandemic, and its future direct and

indirect effects on the global, national and local economy and our business and results of operation are highly uncertain. The COVID-19 pandemic may cause prolonged global or national recessionary economic conditions or longer lasting effects on economic conditions than currently exist, which could have a material adverse effect on our business, results of operations and financial condition.

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

On September 12, 2019, the Board of Directors authorized the 2019 Repurchase Plan for the repurchase of up to 150,000 shares of the Corporation’s $1.00 par value common stock at market prices in open market or privately negotiated transactions beginning September 13, 2019 and continuing through September 12, 2020. The Corporation suspended activity in the stock repurchase plan on March 19, 2020. There were no share purchases made during the second quarter of 2020.

Item 3. Defaults by the Company on its Senior Securities

None

Item 4. Mine Safety Disclosures

Not Applicable

‎

Item 5. Other Information

None

Item 6. Exhibits

Exhibits


3.1	Amended and Restated Articles of Incorporation of the Corporation.

3.2	Bylaws of the Corporation. (Filed as Exhibit 3.2 to Current Report on Form 8-K, as filed with the commission on December 21, 2018 and incorporated herein by reference.)

31.1	Rule 13a – 14(a)/15d-14(a) Certifications – Principal Executive Officer

31.2	Rule 13a – 14(a)/15d-14(a) Certifications – Principal Financial Officer

32.1	Section 1350 Certifications – Principal Executive Officer

32.2	Section 1350 Certifications – Principal Financial Officer

101	Interactive Data File (XBRL)

104	Cover Page Interactive Data File (the cover page XBRL tags are imbedded in the XBRL document)

‎

FRANKLIN FINANCIAL SERVICES CORPORATION

and SUBSIDIARIES

SIGNATURES

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

Franklin Financial Services Corporation



August 7, 2020		/s/ Timothy G. Henry
		Timothy G. Henry
		Chief Executive Office and President
		(Principal Executive Officer)

August 7, 2020		/s/ Mark R. Hollar
		Mark R. Hollar
		Treasurer and Chief Financial Officer
		(Principal Financial and Accounting Officer)

FRANKLIN FINANCIAL SERVICES CORP /PA/ - Quarter Report: 2020 June (Form 10-Q)

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

Consolidated Statements of Income

Consolidated Statements of Comprehensive Income

Consolidated Statements of Changes in Shareholders’ Equity

Consolidated Statements of Cash Flows

FRANKLIN FINANCIAL SERVICES CORPORATION and SUBSIDIARIES

Note 2. Recent Accounting Pronouncements

Note 11. Fair Value Measurements and Fair Values of Financial Instruments

Forward Looking Statements

Critical Accounting Policies

Results of Operations

Net Interest Income

Comparison of the three months ended June 30, 2020 to the three months ended June 30, 2019:

Provision for Loan Losses

Provision for Income Taxes

Comparison of the six months ended June 30, 2020 to the six months ended June 30, 2019:

Provision for Loan Losses

Provision for Income Taxes

Financial Condition

Item 3. Quantitative and Qualitative Disclosures about Market Risk