MANAGEMENT'S DISCUSSION AND ANALYSIS
FISI
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q should be read in conjunction with the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2021. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein.
FORWARD LOOKING INFORMATION
Statements and financial analysis contained in this Quarterly Report on Form 10-Q that are based on other than historical data are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:
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statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Financial Institutions, Inc. (the "Parent" or "FII") and its subsidiaries (collectively, the "Company," "we," "our" or "us"); and
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statements preceded by, followed by or that include the words "may," "could," "should," "would," "believe," "anticipate," "estimate," "expect," "intend," "plan," "projects" or similar expressions.
These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management's views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended December 31, 2021 (the "Form 10-K"), including, but not limited to, those presented in the Management's Discussion and Analysis of Financial Condition and Results of Operations. Factors that might cause such material differences include, but are not limited to:
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The COVID-19 pandemic, and governmental and individual efforts to address the pandemic have introduced volatility into the U.S. and global economy which has and may continue to adversely affect our business, financial condition and results of operations;
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Changes in our operations in response to the COVID-19 pandemic have exposed us to additional risks;
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The impact of macroeconomic pressures including inflation, supply chain issues, and geopolitical risks associated with the Russia-Ukraine conflict;
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If we experience greater credit losses than anticipated, earnings may be adversely impacted;
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Geographic concentration may unfavorably impact our operations;
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Our commercial business and mortgage loans increase our exposure to credit risks;
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Our indirect and consumer lending involves risk elements in addition to normal credit risk;
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Lack of seasoning in portions of our loan portfolio could increase risk of credit defaults in the future;
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We accept deposits that do not have a fixed term, and which may be withdrawn by the customer at any time for any reason;
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We are subject to environmental liability risk associated with our lending activities;
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We operate in a highly competitive industry and market area;
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Changes to and replacement of the LIBOR Benchmark Interest Rate may adversely affect our business, financial condition, and results of operations;
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Legal and regulatory proceedings and related matters, such as the action brought by a class of consumers against us as described in Part II, Item 1, "Legal Proceedings," could adversely affect us and the banking industry in general;
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Any future FDIC insurance premium increases may adversely affect our earnings;
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We are highly regulated, and any adverse regulatory action may result in additional costs, loss of business opportunities, and reputational damage;
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The policies of the Federal Reserve have a significant impact on our earnings;
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Our insurance brokerage subsidiary is subject to risk related to the insurance industry;
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Our investment advisory and wealth management operations are subject to risk related to the regulation of the financial services industry and market volatility;
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We make certain assumptions and estimates in preparing our financial statements that may prove to be incorrect, which could significantly impact our results of operations, cash flows and financial condition, and we are subject to new or changing accounting rules and interpretations, and the failure by us to correctly interpret or apply these evolving rules and interpretations could have a material adverse effect;
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The value of our goodwill and other intangible assets may decline in the future;
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We may be unable to successfully implement our growth strategies, including the integration and successful management of newly-acquired businesses;
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Acquisitions may disrupt our business and dilute shareholder value;
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Our tax strategies and the value of our deferred tax assets and liabilities could adversely affect our operating results and regulatory capital ratios;
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Liquidity is essential to our businesses;
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We rely on dividends from our subsidiaries for most of our revenue;
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If our risk management framework does not effectively identify or mitigate our risks, we could suffer losses;
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Negative public opinion could damage our reputation and impact business operations and revenues;
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We face competition in staying current with technological changes and banking alternatives to compete and meet customer demands;
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We rely on other companies to provide key components of our business infrastructure;
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A breach in security of our or third-party information systems, including the occurrence of a cyber incident or a deficiency in cybersecurity, or a failure by us to comply with New York State cybersecurity regulations, may subject us to liability, result in a loss of customer business or damage our brand image;
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We are subject to interest rate risk, and a rising rate environment may reduce our income and result in higher defaults on our loans, whereas a falling rate environment may result in earlier loan prepayments than we expect, which may reduce our income;
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The soundness of other financial institutions could adversely affect us;
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We may need to raise additional capital in the future and such capital may not be available on acceptable terms or at all;
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We may not pay or may reduce the dividends on our common stock;
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We may issue debt and equity securities or securities convertible into equity securities, any of which may be senior to our common stock as to distributions and in liquidation, which could dilute our current shareholders or negatively affect the value of our common stock;
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Our certificate of incorporation, our bylaws, and certain banking laws may have an anti-takeover effect;
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The market price of our common stock may fluctuate significantly in response to a number of factors;
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We may not be able to attract and retain skilled people;
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We use financial models for business planning purposes that may not adequately predict future results;
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We depend on the accuracy and completeness of information about or from customers and counterparties;
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Our business may be adversely affected by conditions in the financial markets and economic conditions generally; and
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Severe weather, natural disasters, public health emergencies and pandemics, acts of war or terrorism, and other external events could significantly impact our business.
We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advise readers that various factors, including those described above, could affect our financial performance and could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected. See also Item 1A, Risk Factors, in the Form 10-K for further information. Except as required by law, we do not undertake, and specifically disclaim any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
GENERAL
The Parent is a financial holding company headquartered in New York State, providing diversified financial services through its operating subsidiaries, Five Star Bank (the "Bank"), SDN Insurance Agency, LLC ("SDN"), Courier Capital, LLC ("Courier Capital") and HNP Capital, LLC ("HNP Capital"). The Company offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York through its wholly-owned New York-chartered banking subsidiary, the Bank. The Bank also has a commercial loan production office in Ellicott City (Baltimore), Maryland, and our indirect lending network includes relationships with franchised automobile dealers in Western and Central New York, the Capital District of New York and Northern and Central Pennsylvania. SDN provides a broad range of insurance services to personal and business clients. Courier Capital and HNP Capital provide customized investment advice, wealth management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans.
Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from insurance, investment advisory and financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.
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Our business strategy has been to maintain a community bank philosophy, which consists of focusing on and understanding the individualized banking and other financial needs of individuals, municipalities and businesses of the local communities surrounding our primary service area. We believe this focus allows us to be more responsive to our customers' needs and provide a high level of personal service that differentiates us from larger competitors, resulting in long-standing and broad-based banking relationships. Our core customers are primarily small- to medium-sized businesses, individuals and community organizations who prefer to build banking, insurance and wealth management relationships with a community bank that combines high quality, competitively-priced products and services with personalized service. Because of our identity and origin as a locally operated bank, we believe that our level of personal service provides a competitive advantage over larger banks, which tend to consolidate decision-making authority outside local communities.
A key aspect of our current business strategy is to foster a community-oriented culture where our customers and employees establish long-standing and mutually beneficial relationships. We believe that we are well-positioned to be a strong competitor within our market area because of our focus on community banking needs and customer service, our comprehensive suite of deposit, loan, insurance and wealth management products typically found at larger banks, our highly experienced management team and our strategically located banking centers.
We have evolved to meet changing customer needs by opening what we refer to as financial solution center branches. These financial solution center branches have a smaller footprint than our traditional branches, focus on technology to provide solutions that fit our customer preferences for transacting business with us, and these branches are staffed by certified personal bankers who are trained to meet a broad array of customer needs. In recent years, we have opened four financial solution centers in the Rochester and Buffalo markets. We believe that the foregoing factors all help to grow our core deposits, which supports a central element of our business strategy - the growth of a diversified and high-quality loan portfolio.
EXECUTIVE OVERVIEW
Summary of 2022 First Quarter Results
Net income decreased $5.7 million to $15.0 million for the first quarter of 2022 compared to $20.7 million for the first quarter of 2021. Net income available to common shareholders for the first quarter of 2022 was $14.6 million, or $0.93 per diluted share, compared with $20.3 million, or $1.27 per diluted share, for the first quarter of 2021. Return on average common equity was 12.49% and return on average assets was 1.09% for the first quarter of 2022 compared to 18.28% and 1.66%, respectively, for the first quarter of 2021.
The decrease in net income for the first quarter of 2022 reflected a $2.3 million provision for credit losses as compared to a benefit of $2.0 million in the first quarter of 2021. Loan loss provision returned to a more normalized level in the first quarter of 2022 due to the impact of qualitative factors reflecting economic uncertainty associated with higher interest rates and global political unrest, partially offset by lower net charge-offs, national unemployment trends and a reduction in overall specific reserve levels. In addition, revenue related to Paycheck Protection Program ("PPP") loans was $2.5 million lower in the first quarter of 2022 than the first quarter of 2021. PPP loan balances are significantly lower in 2022 as a result of loan forgiveness.
Net interest income totaled $39.6 million in the first quarter of 2022 up from $37.9 million in the first quarter of 2021. The increase was primarily the result of a $505.4 million increase in average investment securities, partially offset by lower interest expense on deposits, primarily the result of continued repricing of time deposits at lower rates throughout 2021 and into 2022.
The provision for credit losses - loans was $2.1 million in the first quarter of 2022 compared to a benefit of $1.7 million in the first quarter of 2021. Net charge-offs during the recent quarter were $787 thousand compared to $887 thousand in the first quarter of 2021. Net charge-offs expressed as an annualized percentage of average loans outstanding was 0.09% during the first quarter of 2021 compared to 0.10% during the first quarter of 2021. See the "Allowance for Credit Losses - Loans" and "Non-Performing Assets and Potential Problem Loans" sections of this Management's Discussion and Analysis for further discussion regarding the provision (benefit) for credit losses - loans and net charge-offs.
Noninterest income totaled $11.3 million in the first quarter of 2022, compared to $13.0 million in the first quarter of 2021. The decrease in noninterest income for the first quarter of 2022 was primarily due to decreases in income from derivative instruments, net, and net (loss) gain on sale of loans held for sale, partially offset by increases in insurance income and investment advisory income. Income from derivative instruments, net was $1.4 million lower than the first quarter of 2021. Income from derivative instruments, net is based on the number and value of interest rate swap transactions executed during the quarter combined with the impact of changes in the fair market value of borrower-facing trades. Net loss (gain) on sale of loans held for sale was $1.2 million lower than the first quarter of 2021, primarily as a result of the current fair market value of pipeline commitments, negatively impacted by interest rate changes. Sale volume and margin were at historically high levels in the first quarter of 2021, driven by mortgage refinancing activity. The increase in insurance income of $701 thousand from the first quarter of 2021 was driven by the two 2021 bolt on acquisitions (North Woods in August 2021 and Landmark in February 2021), growth in the legacy SDN business, including the impact of increasing insurance premiums, and higher contingent revenues in 2022. The increase in investment advisory income of $269 thousand was primarily due to an increase in assets under management driven by a combination of market gains, new customer accounts and contributions to existing accounts.
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Noninterest expense totaled $30.1 million in the first quarter of 2022, compared to $26.7 million in the first quarter of 2021. The increase in noninterest expense was primarily the result of increases in salaries and employee benefits expense, computer and data processing expense and occupancy and equipment expense. The increase in salaries and employee benefits was primarily the result of investments in personnel, the impact of 2021 acquisitions and higher incentive compensation and commissions. Computer and data processing expense increased as a result of our strategic investment in technology, including digital banking initiatives and a customer relationship management solution across all business lines. The increase in occupancy and equipment expense in the first quarter of 2022 was primarily due to timing of routine repairs and maintenance in the retail branch network and expenses related to two Five Star Bank branches opened in Buffalo in June 2021.
The regulatory Common Equity Tier 1 Ratio and Total Risk-Based Capital Ratio were 9.85%, and 12.72%, respectively, at March 31, 2022. See the "Liquidity and Capital Management" section of this Management's Discussion and Analysis for further discussion regarding regulatory capital and the Basel III capital rules.
In February 2022, we announced the addition of a team of experienced commercial banking officers to launch a commercial platform in Baltimore, Maryland and Washington D.C. region.
Operational, Accounting and Reporting Impacts Related to the COVID-19 Pandemic
The COVID-19 pandemic has negatively impacted the global economy, including our operating footprint of Western and Central New York. In response to this crisis, the Coronavirus Aid, Relief, and Economic Security ("CARES") Act was passed by Congress and signed into law on March 27, 2020. The CARES Act provided an estimated $2.2 trillion to fight the COVID-19 pandemic and stimulate the economy by supporting individuals and businesses through loans, grants, tax changes, and other types of relief. Some of the provisions applicable to the Company include, but are not limited to:
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Accounting for Loan Modifications - The CARES Act provided that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a troubled debt restructuring ("TDR") and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes.
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Paycheck Protection Program - The CARES Act established the Paycheck Protection Program ("PPP"), an expansion of the Small Business Administration's ("SBA") 7(a) loan program and the Economic Injury Disaster Loan Program ("EIDL"), administered directly by the SBA. On December 27, 2020, the Consolidated Appropriations Act, 2021 provided approximately $284 billion for PPP loans in an additional round of funding under the program and extended the PPP through March 31, 2021. This additional round of PPP loan funding is authorized for first-time borrowers and for second draws be certain borrowers who have previously received PPP loans. On March 30, 2021, the PPP Extension Act of 2021 was signed into law, which extended the program to May 31, 2021.
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Mortgage Forbearance - Under the CARES Act, a borrower with a federally backed mortgage loan that was experiencing financial hardship due to COVID-19 was able to request a forbearance until December 31, 2021.
Also, in response to the COVID-19 pandemic, the Board of Governors of the Federal Reserve System ("FRB"), the Federal Deposit Insurance Corporation ("FDIC"), the National Credit Union Administration ("NCUA"), the Office of the Comptroller of the Currency ("OCC"), and the Consumer Financial Protection Bureau ("CFPB"), in consultation with the state financial regulators (collectively, the "agencies") issued a joint interagency statement (issued March 22, 2020; revised statement issued April 7, 2020). Some of the provisions applicable to the Company include, but are not limited to:
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Accounting for Loan Modifications - Loan modifications that do not meet the conditions of the CARES Act may still qualify as a modification that does not need to be accounted for as a TDR. The agencies confirmed with FASB staff that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or insignificant delays in payment.
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Past Due Reporting - With regard to loans not otherwise reportable as past due, financial institutions are not expected to designate loans with deferrals granted due to COVID-19 as past due because of the deferral. A loan's payment date is governed by the due date stipulated in the legal agreement. If a financial institution agrees to a payment deferral, these loans would not be considered past due during the period of the deferral.
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Nonaccrual Status and Charge-offs - During short-term COVID-19 modifications, these loans generally should not be reported as nonaccrual or as classified.
We have helped more than 2,900 customers obtain more than $370 million in loans through the PPP. We have helped customers complete the forgiveness process for approximately $346 million of these PPP loans through March 31, 2022. We had $532.4 million of loans with modifications related to COVID-19 during 2020, with $6.4 million and $46.2 million still on deferral as of March 31, 2022 and December 31, 2021, respectively. We have provided payment deferrals for approximately 6,600 borrowers, the majority being consumer indirect loan customers. Less than 1% of our loan customers have active payment deferrals as of March 31, 2022 as the majority of customers whose loans were subject to COVID-19 related deferrals have returned to making regular payments.
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RESULTS OF OPERATIONS
Net Interest Income and Net Interest Margin
Net interest income is our primary source of revenue, comprising 78% of revenue during the three months ended March 31, 2022. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.
We use interest rate spread and net interest margin to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds ("net free funds"), principally noninterest-bearing demand deposits and shareholders' equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.
The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis (dollars in thousands):
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