Item 1. Business
A. GENERAL
The holding company, Arrow Financial Corporation, a New York corporation, was incorporated on March 21, 1983 and is registered as a bank holding company within the meaning of the Bank Holding Company Act of 1956. Arrow owns two nationally-chartered banks in New York (Glens Falls National and Saratoga National), and through such banks indirectly owns various non-bank subsidiaries, including an insurance agency, a registered investment adviser and a REIT. See "The Company and Its Subsidiaries," above.
The holding company’s business consists primarily of the ownership, supervision and control of Arrow's two banks, including the banks' subsidiaries. The holding company provides various advisory and administrative services and coordinates the general policies and operation of the banks. There were 517 full-time equivalent employees, including 42 employees within Arrow's insurance agency affiliate, at December 31, 2020. See the discussion of our human capital resources in Section G ("HUMAN CAPITAL") of this Item 1.
The Company offers a broad range of commercial and consumer banking and financial products. The deposit base consists of deposits derived principally from the communities served. The Company targets lending activities to consumers and small- and mid-sized companies in Arrow's regional geographic area. In addition, through an indirect lending program the Company acquires consumer loans from an extensive network of automobile dealers that operate in a larger area of upstate New York, and in central and southern Vermont. Through the banks' trust operations, the Company provides retirement planning, trust and estate administration services for individuals, and pension, profit-sharing and employee benefit plan administration for corporations.
B. LENDING ACTIVITIES
Arrow engages in a wide range of lending activities, including commercial and industrial lending primarily to small and mid-sized companies; mortgage lending for residential and commercial properties; and consumer installment and home equity financing. An active indirect lending program is maintained through Arrow's sponsorship of automobile dealer programs under which consumer auto loans, primarily from dealers that meet pre-established specifications are purchased. From time to time, a portion of the residential real estate loan originations are sold into the secondary market, primarily to the Federal Home Loan Mortgage Corporation ("Freddie Mac") and other governmental agencies. Normally, the Company retains the servicing rights on mortgage loans originated and sold into the secondary markets, subject to periodic determinations on the continuing profitability of such activity.
Generally, Arrow continues to implement lending strategies and policies that are intended to protect the quality of the loan portfolio, including strong underwriting and collateral control procedures and credit review systems. Loans are placed on nonaccrual status either due to the delinquency status of principal and/or interest or a judgment by management that the full repayment of principal and interest is unlikely. Home equity lines of credit, secured by real property, are systematically placed on nonaccrual status when 120 days past due, and residential real estate loans are placed on nonaccrual status when 150 days past due. Commercial and commercial real estate loans are evaluated on a loan-by-loan basis and are placed on nonaccrual status when 90 days past due if the full collection of principal and interest is uncertain. (See Part II, Item 7.C.II.c. "Risk Elements.") Subsequent cash payments on loans classified as nonaccrual may be applied entirely to principal, although income in some cases may be recognized on a cash basis.
Arrow lends almost exclusively to borrowers within the normal retail service area in northeastern New York State, with the exception of the indirect consumer lending line of business, where Arrow acquires retail paper from an extensive network of automobile dealers that operate in a larger area of upstate New York and in Vermont. The loan portfolio does not include any foreign loans or any other significant risk concentrations. Arrow does not generally participate in loan syndications, either as originator or as a participant. However, from time to time, the Company buys participations in individual loans, typically commercial loans, originated by other financial institutions in New York and adjacent states. In recent periods, the total dollar amount of such participations has fluctuated, but generally represents less than 20% of commercial loans outstanding. Much of the portfolio is properly collateralized, and most commercial loans are further supported by personal guarantees. Arrow also
participates as a lender in the Paycheck Protection Program ("PPP") administered by the Small Business Administration ("SBA") under the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act"). In 2020, Arrow originated over $142.7 million in loans under the PPP. See the discussion of the CARES Act in Section D ("RECENT LEGISLATIVE DEVELOPMENTS") of this Item 1.
Arrow does not engage in subprime mortgage lending as a business line and does not extend or purchase so-called "Alt A," "negative amortization," "option ARM's" or "negative equity" mortgage loans.
C. SUPERVISION AND REGULATION
The following generally describes the laws and regulations to which Arrow is subject. Bank holding companies, banks and their affiliates are extensively regulated under both federal and state law. To the extent that the following information summarizes statutory or regulatory law, it is qualified in its entirety by reference to the particular provisions of the various statutes and regulations. Any change in applicable law may have a material effect on business operations, customers, prospects and investors.
Bank Regulatory Authorities with Jurisdiction over Arrow and its Subsidiary Banks
Arrow is a registered bank holding company within the meaning of the Bank Holding Company Act of 1956 ("BHC Act") and as such is subject to regulation by the Board of Governors of the Federal Reserve System ("FRB"). As a "bank holding company" under New York State law, Arrow is also subject to regulation by the New York State Department of Financial Services. Arrow's two subsidiary banks are both national banks and are subject to supervision and examination by the Office of the Comptroller of the Currency ("OCC"). The banks are members of the Federal Reserve System and the deposits of each bank are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC"). The BHC Act generally prohibits Arrow from engaging, directly or indirectly, in activities other than banking, activities closely related to banking, and certain other financial activities. Under the BHC Act, a bank holding company generally must obtain FRB approval before acquiring, directly or indirectly, voting shares of another bank or bank holding company, if after the acquisition the acquiror would own 5 percent or more of a class of the voting shares of that other bank or bank holding company. Bank holding companies are able to acquire banks or other bank holding companies located in all 50 states, subject to certain limitations. Bank holdings companies that meet certain qualifications may choose to apply to the FRB for designation as “financial holding companies.” Upon receipt of such designation, a financial holding company may engage a broader array of activities, such as insurance underwriting, securities underwriting and merchant banking. Arrow has not attempted to become, and has not been designated as, a financial holding company.
The FRB and the OCC have broad regulatory, examination and enforcement authority. The FRB and the OCC conduct regular examinations of the entities they regulate. In addition, banking organizations are subject to requirements for periodic reporting to the regulatory authorities. The FRB and OCC have the authority to implement various remedies if they determine that the financial condition, capital, asset quality, management, earnings, liquidity or other aspects of a banking organization's operations are unsatisfactory or if they determine the banking organization is violating or has violated any law or regulation. The authority of the federal bank regulators over banking organizations includes, but is not limited to, prohibiting unsafe or unsound practices; requiring affirmative action to correct a violation or unsafe or unsound practice; issuing administrative orders; requiring the organization to increase capital; requiring the organization to sell subsidiaries or other assets; restricting dividends, distributions and repurchases of the organization's stock; restricting the growth of the organization; assessing civil money penalties; removing officers and directors; and terminating deposit insurance. The FDIC may terminate a depository institution's deposit insurance upon a finding that the institution's financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices for certain other reasons.
Regulatory Supervision of Other Arrow Subsidiaries
The insurance agency subsidiary of Glens Falls National is subject to the licensing and other provisions of New York State Insurance Law and is regulated by the New York State Department of Financial Services. Arrow's investment adviser subsidiary is subject to the licensing and other provisions of the federal Investment Advisers Act of 1940 and is regulated by the SEC.
Regulation of Transactions between Banks and their Affiliates
Transactions between banks and their "affiliates" are regulated by Sections 23A and 23B of the Federal Reserve Act (FRA). Each of Arrow's non-bank subsidiaries (other than the business trusts formed to issue the TRUPs) is a subsidiary of one of the subsidiary banks, and also is an "operating subsidiary" under Sections 23A and 23B. This means the non-bank subsidiary is considered to be part of the bank that owns it and thus is not an affiliate of that bank for purposes of Section 23A and 23B. However, each of the two banks is an affiliate of the other bank, under Section 23A, and Arrow, the holding company, is also an affiliate of each bank under both Sections 23A and 23B. Extensions of credit that a bank may make to affiliates, or to third parties secured by securities or obligations of the affiliates, are substantially limited by the FRA and the Federal Deposit Insurance Act (FDIA). Such acts further restrict the range of permissible transactions between a bank and any affiliate, including a bank affiliate. Furthermore, under the FRA, a bank may engage in certain transactions, including loans and purchases of assets, with a non-bank affiliate, only if certain special conditions, including collateral requirements for loans, are met and if the other terms and conditions of the transaction, including interest rates and credit standards, are substantially the same as, or at least as favorable to the bank as, those prevailing at the time for comparable transactions by the bank with non-affiliated companies or, in the absence of comparable transactions, on terms and conditions that would be offered by the bank to non-affiliated companies.
Regulatory Capital Standards
An important area of banking regulation is the federal banking system's promulgation and enforcement of minimum capitalization standards for banks and bank holding companies.
Bank Capital Rules. In July 2013, federal bank regulators, including the FRB and the OCC, approved revised bank capital rules aimed at implementing capital requirements pursuant to Dodd-Frank. These rules were also intended to coordinate U.S. bank capital standards with the then-current drafts of the Basel III proposed bank capital standards for all of the developed world's banking organizations. The federal regulators' revised capital rules (the "Capital Rules"), which impose significantly higher minimum capital ratios on U.S. financial institutions than the rules they replaced, became effective for Arrow and its subsidiary banks on January 1, 2015, and were fully phased in by the end of 2019.
The Economic Growth Act was signed into law May 24, 2018. In accordance therewith, federal bank regulators issued a final rule to implement the “community bank leverage ratio”, introducing an optional simplified measure of capital adequacy for qualifying community banking organizations ("CBLR"). To qualify for the CBLR framework, a community banking organization must satisfy certain requirements, including having a leverage ratio of greater than 9%, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the CBLR framework will be considered to have met the well-capitalized ratio requirements under the “prompt corrective action” regulations and will not be required to report or calculate risk-based capital ratios. Subsequently, Section 4012 of the Coronavirus Aid, Relief, and Economic Security ("CARES") Act required the federal banking agencies to temporarily lower the threshold for election of the CBLR framework, issuing two interim final rules to set the CLBR at 8% as of the second quarter of 2020 and then gradually re-establish the CBLR at 9%.
Under the final rule, the CBLR threshold remained at 8% through the end of 2020. Community banks that have a leverage ratio of 8% or greater and meet certain other criteria may elect to use the CBLR framework. Beginning in 2021, the CBLR threshold increased to 8.5% for the calendar year. The requirement to use the CBLR framework will return to 9% on January 1, 2022 for community banks.
The final rule also maintains a two-quarter grace period for a qualifying community banking organization whose leverage ratio falls no more than one percentage point below the applicable CBLR requirement.
The CBLR final rule became effective as of January 1, 2020, and Arrow and both subsidiary banks have opted out of utilizing the CBLR framework. Thus, the Capital Rules promulgated under Dodd-Frank will remain applicable to Arrow.
The Capital Rules which remain applicable to Arrow consist of two basic types of capital measures, a leverage ratio and set of risk-based capital measures. Within these two broad types of rules, however, significant changes were made in the revised Capital Rules, as discussed as follows.
Leverage Ratio. The Capital Rules increased the minimum required leverage ratio from 3.0% to 4.0%. The leverage ratio continues to be defined as the ratio of the institution's "Tier 1" capital (as defined under the new leverage rule) to total tangible assets (as defined under the revised leverage rule).
Risk-Based Capital Measures. Current risk-based capital measures assign various risk weightings to all of the institution's assets, by asset type, and to certain off balance sheet items, and then establish minimum levels of capital to the aggregate dollar amount of such risk-weighted assets. Under the risk-based Capital Rules, there are 8 major risk-weighted categories of assets (although there are several additional super-weighted categories for high-risk assets that are generally not held by community banking organizations like Arrow's). The Capital Rules include a measure called the "common equity tier 1 capital ratio" (CET1). For this ratio, only common equity (basically, common stock plus surplus plus retained earnings) qualifies as capital (i.e., CET1). Preferred stock and trust preferred securities, which qualified as Tier 1 capital under the old Tier 1 risk-based capital measure (and continue to qualify as capital under the revised Tier 1 risk-based capital measure), are not included in CET1 capital. Under these rules, CET1 capital also includes most elements of accumulated other comprehensive income (AOCI), including unrealized securities gains and losses, as part of both total regulatory capital (numerator) and total assets (denominator). However, smaller banking organizations like Arrow's were given the opportunity to make a one-time irrevocable election to include or not to include certain elements of AOCI, most notably unrealized securities gains or losses. Arrow made such an election, i.e., not to include unrealized securities gains and losses in calculating the CET1 ratio under the Capital Rules. The minimum CET1 ratio under these rules, effective January 1, 2015, is 4.50%, which remained constant throughout the phase-in period.
Consistent with the general theme of higher capital levels, the Capital Rules also increased the minimum ratio for Tier 1 risk-based capital from 4.0% to 6.0%, effective January 1, 2015. The minimum level for total risk-based capital under the Capital Rules remained at 8.0%.
The Capital Rules incorporate a capital concept, the so-called "capital conservation buffer" (set at 2.5%, after full phase-in), which must be added to each of the minimum required risk-based capital ratios (i.e., the minimum CET1 ratio, the minimum Tier 1 risk-based capital ratio and the minimum total risk-based capital ratio). The capital conservation buffer was phased-in over four years beginning January 1, 2016 (see the table below). When, during economic downturns, an institution's capital begins to erode, the first deductions from a regulatory perspective would be taken against the conservation buffer. To the extent that such deductions should erode the buffer below the required level (2.5% of total risk-based assets after full phase-in), the institution will not necessarily be required to replace the buffer deficit immediately, but will face restrictions on paying dividends and other negative consequences until the buffer is fully replenished.
Also under the Capital Rules, and as required under Dodd-Frank, TRUPs issued by small- to medium-sized banking organizations (such as Arrow) that were outstanding on the Dodd-Frank grandfathering date for TRUPS (May 19, 2010) will continue to qualify as tier 1 capital, up to a limit of 25% of tier 1 capital, until the TRUPs mature or are redeemed, subject to certain limitations. See the discussion of grandfathered TRUPs in Section E ("CAPITAL RESOURCES AND DIVIDENDS") of Item 7.
The following is a summary of the definitions of capital under the various risk-based measures in the Capital Rules:
Common Equity Tier 1 Capital (CET1): Equals the sum of common stock instruments and related surplus (net of treasury stock), retained earnings, accumulated other comprehensive income (AOCI), and qualifying minority interests, minus applicable regulatory adjustments and deductions. Such deductions will include AOCI, if the organization has exercised its irrevocable option not to include AOCI in capital (Arrow made such an election). Mortgage-servicing assets, deferred tax assets, and investments in financial institutions are limited to 15% of CET1 in the aggregate and 10% of CET1 for each such item individually.
Additional Tier 1 Capital: Equals the sum of noncumulative perpetual preferred stock, tier 1 minority interests, grandfathered TRUPs, and Troubled Asset Relief Program instruments, minus applicable regulatory adjustments and deductions.
Tier 2 Capital: Equals the sum of subordinated debt and preferred stock, total capital minority interests not included in Tier 1, and allowance for loan and lease losses (not exceeding 1.25% of risk-weighted assets) minus applicable regulatory adjustments and deductions.
The following table presents the Capital Rules applicable to Arrow and its subsidiary banks:
These minimum capital ratios, especially the CET1 ratio (4.5%) and the enhanced Tier 1 risk-based capital ratio (6.0%), which began to apply to the Company on January 1, 2015, represent a heightened and more restrictive capital regime than institutions previously had to meet.
At December 31, 2020, Arrow and its two subsidiary banks exceeded by a substantial amount each of the applicable minimum capital ratios established under the revised Capital Rules, including the minimum CET1 Ratio, the minimum Tier 1 Risk-Based Capital Ratio, the minimum Total Risk-Based Capital Ratio, and the minimum Leverage Ratio, and including in the case of each risk-based ratio, the phased-in portion of the capital buffer. See Note 20, Regulatory Matters, to the notes to the Consolidated Financial Statements for a presentation of Arrow's period-end ratios for 2020 and 2019.
Regulatory Capital Classifications. Under applicable banking law, federal banking regulators are required to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. The regulators have established five capital classifications for banking institutions, ranging from the highest category of "well-capitalized" to the lowest category of "critically under-capitalized". Under the Capital Rules, a banking institution is considered "well-capitalized" if it meets the following capitalization standards on the date of measurement: a CET1 risk-based capital ratio of 6.50% or greater, a Tier 1 risk-based capital ratio of 8.00% or greater, and a total risk-based capital ratio of 10.00% or greater, provided the institution is not subject to any regulatory order or written directive regarding capital maintenance.
As of December 31, 2020, Arrow and its two subsidiary banks qualified as "well-capitalized" under the revised capital classification scheme.
Dividend Restrictions; Other Regulatory Sanctions
A holding company's ability to pay dividends or repurchase its outstanding stock, as well as its ability to expand its business, including for example, through acquisitions of additional banking organizations or permitted non-bank companies, may be restricted if its capital falls below minimum regulatory capital ratios or fails to meet other informal capital guidelines that the regulators may apply from time to time to specific banking organizations. In addition to these potential regulatory limitations on payment of dividends, the holding company's ability to pay dividends to shareholders, and the subsidiary banks' ability to pay dividends to the holding company are also subject to various restrictions under applicable corporate laws, including banking laws (which affect the subsidiary banks) and the New York Business Corporation Law (which affects the holding company). The ability of the holding company and banks to pay dividends or repurchase shares in the future is, and is expected to continue to be, influenced by regulatory policies, the Capital Rules and other applicable law.
In cases where banking regulators have significant concerns regarding the financial condition, assets or operations of a bank holding company or one of its banks, the regulators may take enforcement action or impose enforcement orders, formal or informal, against the holding company or the particular bank. If the ratio of tangible equity to total assets of a bank falls to 2% or below, the bank will likely be closed and placed in receivership, with the FDIC as receiver.
Cybersecurity
In addition to the provisions in the Gramm-Leach-Bliley Act relating to data security (discussed below), Arrow and its subsidiaries are subject to many federal and state laws, regulations and regulatory interpretations which impose standards and requirements related to cybersecurity.
In March 2015, federal regulators issued related statements regarding cybersecurity. One statement indicates that financial institutions should design multiple layers of security controls to establish lines of defense and to ensure that their risk management processes also address the risk posed by compromised customer credentials, including security measures to reliably authenticate customers accessing internet-based services of the financial institution. The other statement indicates that a financial institution’s management is expected to maintain sufficient business continuity planning processes to ensure the rapid recovery, resumption and maintenance of the institution’s operations after a cyber-attack involving destructive malware. A financial institution is also expected to develop appropriate processes to enable recovery of data and business operations and address rebuilding network capabilities and restoring data if the institution or its critical service providers fall victim to this type of cyber-attack. Financial institutions that fail to observe this regulatory guidance on cybersecurity may be subject to various regulatory sanctions, including financial penalties.
In February 2018, the Securities and Exchange Commission (“SEC”) issued the “Commission Statement and Guidance on Public Company Cybersecurity Disclosures” to assist public companies in preparing disclosures about cybersecurity risks and incidents. With the increased frequency and magnitude of cybersecurity incidents, the SEC indicated that it is critical that public companies take all required actions to inform investors about material cybersecurity risks and incidents in a timely fashion. Additionally, in October 2018 the SEC issued the “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding Certain Cyber-Related Frauds Perpetrated Against Public Companies and Related Internal Controls Requirements” which cited business email compromises that led to the incidents and that internal accounting controls may need to be reassessed in light of these emerging risks. Certain Arrow subsidiaries are subject to certain New York state cybersecurity regulations.
Privacy and Confidentiality Laws
Arrow and its subsidiaries are subject to a variety of laws that regulate customer privacy and confidentiality. The Gramm-Leach-Bliley Act requires financial institutions to adopt privacy policies, to restrict the sharing of nonpublic customer information with nonaffiliated parties upon the request of the customer, and to implement data security measures to protect customer information. Certain state laws may impose additional privacy and confidentiality restrictions. The Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act of 2003, regulates use of credit reports, providing of information to credit reporting agencies and sharing of customer information with affiliates, and sets identity theft prevention standards.
Anti-Money Laundering, the U.S. Patriot Act and OFAC
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act of 2001 initially adopted in 2001 and re-adopted by the U.S. Congress in 2006 with certain changes (the “Patriot Act”), imposes substantial record-keeping and due diligence obligations on banks and other financial institutions, with a particular focus on detecting and reporting money-laundering transactions involving domestic or international customers. The U.S. Treasury Department has issued and will continue to issue regulations clarifying the Patriot Act's requirements.
Under the Patriot Act and other federal anti-money laundering laws and regulations, including, but not limited to, the Currency and Foreign Transactions Report Act (collectively, “Anti-Money Laundering Laws”), financial institutions, including banks, must maintain certain anti-money laundering compliance, customer identification and due diligence programs that include established internal policies, procedures, and controls. Financial institutions are also prohibited from entering into specified financial transactions and account relationships and must meet enhanced standards for due diligence and customer identification. Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships to guard against money laundering and to report suspicious transactions. Law enforcement authorities have been granted increased access to financial information maintained by financial institutions. Bank regulators routinely examine institutions for compliance with these obligations and they must consider an institution's compliance in connection with the regulatory review of applications, including applications for banking mergers and acquisitions. The U.S. Treasury Department's Financial Crises Enforcement Network (“FinCEN”) issued a final rule in 2016 increasing customer due diligence requirements for banks, including adding a requirement to identify and verify the identity of beneficial owners of customers that are legal entities, subject to certain exclusions and exemptions. The Company has established procedures for compliance with these requirements. Compliance with the provisions of the Patriot Act and other Anti-Money Laundering Laws results in substantial costs on all financial institutions.
The U.S. Department of the Treasury's Office of Foreign Assets Control (“OFAC”) is responsible for helping to insure that United States persons, including banks, do not engage in transactions with certain prohibited parties, as defined by various Executive Orders and Acts of Congress. OFAC publishes lists of persons, organizations, and countries suspected of aiding, harboring or engaging in terrorist acts, including, but not limited to, Specially Designated Nationals and Blocked Persons. If Arrow finds a name on any transaction, account or wire transfer that is on an OFAC list, Arrow must freeze or block such account or transaction, file a suspicious activity report, if required, notify the appropriate authorities and maintain appropriate records.
Community Reinvestment Act
Arrow's subsidiary banks are subject to the Community Reinvestment Act ("CRA") and implementing regulations. CRA regulations establish the framework and criteria by which the bank regulatory agencies assess an institution's record of helping to meet the credit needs of its community, including low and moderate-income individuals. CRA ratings are taken into account by regulators in reviewing certain applications made by Arrow and its bank subsidiaries.
The Dodd-Frank Act
Dodd-Frank significantly changed the regulatory structure for financial institutions and their holding companies, for example, through provisions requiring the Capital Rules. Among other provisions, Dodd-Frank implemented corporate governance
revisions that apply to all public companies, not just financial institutions, permanently increased the FDIC’s standard maximum deposit insurance amount to $250,000, changed the FDIC insurance assessment base to assets rather than deposits and increased the reserve ratio for the deposit insurance fund to ensure the future strength of the fund. The federal prohibition on the payment of interest on certain demand deposits was repealed, thereby permitting depository institutions to pay interest on business transaction accounts. Dodd-Frank established a new federal agency, the Consumer Financial Protection Bureau (the “CFPB”), centralizing significant aspects of consumer financial protection under this agency. Limits were imposed for debit card interchange fees for issuers that have assets greater than $10 billion, which also could affect the amount of interchange fees collected by financial institutions with less than $10 billion in assets. Dodd-Frank also imposed new requirements related to mortgage lending, including prohibitions against payment of steering incentives and provisions relating to underwriting standards, disclosures, appraisals and escrows. The Volcker Rule prohibited banks and their affiliates from engaging in proprietary trading and investing in certain unregistered investment companies.
Federal banking regulators and other agencies including, among others, the FRB, the OCC and the CFPB, have been engaged in extensive rule-making efforts under Dodd-Frank, and the Community Bank Leverage Ratio has impacted certain Dodd-Frank requirements, as explained above.
Incentive Compensation
Dodd-Frank required the federal bank regulatory agencies and the SEC to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities, such as the Company, having at least $1 billion in total assets that encourage inappropriate risks by providing an executive officer, employee, director or principal shareholder with excessive compensation, fees, or benefits or that could lead to material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure to regulators of incentive-based compensation arrangements.
The federal bank regulators issued proposed rules to address incentive-based compensation arrangements in June 2016. Final rules have not yet been issued by the federal bank regulatory agencies under this Dodd-Frank provision.
In 2010, the FRB, OCC and FDIC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Management believes the current and past compensation practices of the Company do not encourage excessive risk taking or undermine the safety and soundness of the organization.
The FRB will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
Deposit Insurance Laws and Regulations
In February 2011, the FDIC finalized a new assessment system that took effect in the second quarter of 2011. The final rule changed the assessment base from domestic deposits to average assets minus average tangible equity, adopted a new large-bank pricing assessment scheme, and set a target size for the Deposit Insurance Fund. The rule (as mandated by Dodd-Frank) finalizes a target size for the Deposit Insurance Fund Reserve Ratio at 2.0% of insured deposits. It also implements a lower assessment rate schedule when the ratio reaches 1.15% (so that the average rate over time should be about 8.5 basis points) and, in lieu of dividends, provides for a lower rate schedule when the reserve ratio reaches 2.0% and 2.5%.
In August 2016, the FDIC announced that the reserve ratio reached 1.17% at the end of June 2016. This represents the highest level the ratio has reached in more than eight years. The reduction in assessment rates went into effect in the third quarter of 2016. Arrow is unable to predict whether or to what extent the FDIC may elect to impose additional special assessments on insured institutions in upcoming years, if bank failures should once again become a significant problem.
In January 2019, both of the Company's banking subsidiaries received preliminary notification of eligibility for small bank assessment credits. These credits were related to the Deposit Insurance Recovery Fund Reserve Ratio reaching 1.36% and reduced the banks' future quarterly assessments. In September 2019, both of the Company's banking subsidiaries received notification of the final credits of $687 thousand, which were fully recorded in the third quarter of 2019.
Reserve Requirements
Pursuant to regulations of the FRB, all banking organizations are required to maintain average daily reserves at mandated ratios against their transaction accounts and certain other types of deposit accounts. These reserves must be maintained in the form of vault cash or in an account at a Federal Reserve Bank.
D. RECENT LEGISLATIVE DEVELOPMENTS
The CARES Act
In response to the COVID-19 pandemic, the CARES Act was signed into law on March 27, 2020. The CARES Act is a $2.2 trillion economic stimulus bill that was enacted to provide relief in the wake of the COVID-19 pandemic. Several provisions within the CARES Act directly impacted financial institutions and led to action from the bank regulatory agencies.
Section 1102 of the CARES Act created the PPP, a program administered by the SBA to provide loans to small businesses for payroll and other basic expenses during the COVID-19 pandemic. Arrow has participated in the PPP as a lender, originating over $142.7 million in loans in 2020. These loans are eligible to be forgiven if certain conditions are satisfied and are fully guaranteed by the SBA. Additionally, loan payments for PPP-generated loans are deferred for the first six months of the loan term and no collateral or personal guarantees were required.
On December 27, 2020, the President signed into law omnibus federal spending and economic stimulus legislation titled the “Consolidated Appropriations Act (the "CAA") that included the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the “HHSB”). Among other things, the HHSB Act renewed the PPP, allocating $284.45 billion for both new first time PPP loans under the existing PPP and the expansion of existing PPP loans for certain qualified, existing PPP borrowers. In addition to extending and amending the PPP, the HHSB Act also creates a new grant program for “shuttered venue operators.” As a participating lender in the PPP, Arrow continues to monitor legislative, regulatory, and supervisory developments related thereto, including the most recent changes implemented by the HHSB Act.
On March 22, 2020, a statement was issued by the Board of Governors of the Federal Reserve Bank, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the office of the Comptroller of the Currency and the Consumer Financial Protection Bureau, titled the “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus” (the “Interagency Statement”) that encourages financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations due to the effects of COVID-19. Additionally, Section 4013 of the CARES Act further provides that a qualified loan modification is exempt from classification as a troubled debt restructuring ("TDR") as defined by GAAP, from the period beginning March 1, 2020 until the earlier of December 31, 2020 or the date that is 60 days after the date on which the national emergency concerning the COVID-19 outbreak declared by the President of the United States under the National Emergencies Act terminates. Section 541 of the CAA extends this relief to the earlier of January 1, 2022, or 60 days after the national emergency termination date. The Interagency Statement was subsequently revised in April 2020 to clarify the interaction of the original guidance with Section 4013 of the CARES Act, as well as setting forth the federal banking regulators’ views on consumer protection considerations. In accordance with such guidance, Arrow offered short-term modifications in response to COVID-19 to qualified borrowers. As of December 31, 2020, $15.3 million in eligible loans, or 0.6% of the loan portfolio, continue to be deferred as a result of the COVID-19 pandemic.
In June 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-13 “Financial Instruments - Credit Losses” (“CECL”), which changes the way financial entities measure expected credit losses for financial assets, primarily loans. In 2019, the OCC, FRB and FDIC issued a final rule to address the new CECL standard. The final rule included a three (3) year transition period, within which a banking organization could phase in the CECL impacts upon its capital ratios. Subsequently, with the enactment of the CARES Act, the OCC, FRB and FDIC issued an alterative transition provision to address the impacts of the COVID-19 pandemic (the “Interim CECL Rule”). Under the Interim CECL Rule, financial institutions that were required to adopt CECL in 2020 were permitted to postpone their estimation upon regulatory capital for two (2) years, followed by a three (3) year transition period. Arrow implemented CECL on January 1, 2021.
Economic Growth, Regulatory Relief and Consumer Protection Act (the “Economic Growth Act”)
In May 2018, the Economic Growth Act, was enacted to modify or remove certain legal requirements, including some requirements imposed under Dodd-Frank. While the Economic Growth Act maintains much of the regulatory structure established by Dodd-Frank, it amends certain aspects of that regulatory framework. Many of these changes could result in meaningful regulatory relief for community banking organizations, such as Arrow's.
Health Care Reform
Various proposals have been discussed for consideration that would substantially modify various health care laws. At present, the Company is not able to estimate the likelihood of adoption of any such provisions or the potential impact thereof if adopted.
Other Legislative Initiatives
From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory authorities. These initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to change the financial institution regulatory environment. Such legislation could change banking laws and the operating environment of our Company in substantial, but unpredictable ways. Arrow cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations would have on the Company's financial condition or results of operations.
E. STATISTICAL DISCLOSURE - (GUIDE 3)
Set forth below is an index identifying the location in this Report of various items of statistical information required to be included in this Report by the SEC’s industry guide for Bank Holding Companies.
Required InformationLocation in Report
Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest DifferentialPart II, Item 7.B.I.
Investment PortfolioPart II, Item 7.C.I.
Loan PortfolioPart II, Item 7.C.II.
Summary of Loan Loss ExperiencePart II, Item 7.C.III.
DepositsPart II, Item 7.C.IV.
Return on Equity and AssetsPart II, Item 6.
Short-Term BorrowingsPart II, Item 7.C.V.
F. COMPETITION
Arrow faces intense competition in all markets served. Competitors include traditional local commercial banks, savings banks and credit unions, non-traditional internet-based lending alternatives, as well as local offices of major regional and money center banks. Like all banks, the Company encounters strong competition in the mortgage lending space from a wide variety of other mortgage originators, all of whom are principally affected in this business by the rate and terms set, and the lending practices established from time-to-time by the very large government sponsored enterprises ("GSEs") engaged in residential mortgage lending, most importantly, “Fannie Mae” and “Freddie Mac.” For many years, these GSEs have purchased and/or guaranteed a very substantial percentage of all newly-originated mortgage loans in the U.S. Additionally, non-banking financial organizations, such as consumer finance companies, insurance companies, securities firms, money market funds, mutual funds, credit card companies and wealth management enterprises offer substantive equivalents of the various other types of loan and financial products and services and transactional accounts that are offered, even though these non-banking organizations are not subject to the same regulatory restrictions and capital requirements that apply to Arrow. Under federal banking laws, such non-banking financial organizations not only may offer products and services comparable to those offered by commercial banks, but also may establish or acquire their own commercial banks.
G. HUMAN CAPITAL
Arrow believes that its employees are among its most important assets. Accordingly, Arrow has prioritized investment in the well-being, performance, engagement and development of Arrow's employees. This includes, but is not limited to, providing access to well-being resources and assistance, offering competitive compensation and benefits to attract and retain top-level talent, empowering team members to take an active role in the formation and execution of the business strategy, and fostering a diverse and inclusive work environment that reflects the many values of the communities Arrow serves. At December 31, 2020, Arrow had 517 full-time equivalent employees. In light of the COVID-19 pandemic, Arrow has taken steps to mitigate the risk of harm to its employees and customers and to its operations from the pandemic. In particular, Arrow, when necessary, has limited access to facilities to appointments only and encouraged customers to use contact-free alternatives like digital banking and ATMs. Arrow has also minimized contact for a large portion of its employee base through remote working, minimal travel and in-person meetings and social distancing.
H. EXECUTIVE OFFICERS OF THE REGISTRANT
The names and ages of the executive officers of Arrow and positions held by each are presented in the following table. Officers are elected annually by the Board of Directors.
I. AVAILABLE INFORMATION
Arrow's Internet address is www.arrowfinancial.com. The Company makes available, free of charge on or through Arrow's website, the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after they are filed or furnish them with the SEC pursuant to the Exchange Act. Various other documents related to corporate operations, including Corporate Governance Guidelines, the charters of principal board committees, and codes of ethics are available on the website. The Company has adopted a financial code of ethics that applies to Arrow’s chief executive officer, chief financial officer and principal accounting officer and a business code of ethics that applies to all directors, officers and employees of the holding company and its subsidiaries.
Item 1A.
Item 1A. Risk Factors
Arrow's financial results and the market price of its stock are subject to risks arising from many factors, including the risks listed below, as well as other risks and uncertainties, some of which have been, and may continue to be, exacerbated by the COVID-19 pandemic and any adverse impact on Arrow's business or the general economic environment as a result. Any of these risks could materially and adversely affect Arrow's business, financial condition or results of operations. Please note that the discussion below regarding the potential impact on Arrow of certain of these factors that may develop in the future is not meant to provide predictions by Arrow's management that such factors will develop, but to acknowledge the possible negative consequences to the Company and business if certain conditions materialize.
MACROECONOMIC AND INDUSTRY RISKS
Market conditions could present significant challenges to the U.S. commercial banking industry and its core business of making and servicing loans and any substantial downturn in the regional markets in which Arrow operates or in the U.S. economy generally could adversely affect Arrow's ability to maintain steady growth in the loan portfolio and earnings. Arrow's business is highly dependent on the business environment in the markets in which the Company operates as well as the United States as a whole. Arrow's business is dependent upon the financial stability of the Company's borrowers, including their ability to pay interest on and repay the principal amount of, outstanding loans, the value of the collateral securing those loans, and the overall demand for loans and other products and services, all of which impact Arrow's stability and future growth. Although Arrow's market area has experienced a stabilizing of economic conditions in recent years and even periods of modest growth, if unpredictable or unfavorable economic conditions unique to the market area should occur in upcoming periods, these conditions will likely have an adverse effect on the quality of the loan portfolio and financial performance. As a community bank, Arrow is less able than larger regional competitors to spread the risk of unfavorable local economic conditions over a larger market area. Further, if the overall U.S. economy deteriorates, then Arrow's business, results of operations, financial condition and prospects could be adversely affected. In particular, financial performance may be adversely affected by short-term and long-term interest rates, the prevailing yield curve, inflation, monetary supply, fluctuations in the debt and equity capital markets, and the strength of the domestic economy and the local economies in the markets in which Arrow operates, all of which are beyond Arrow's control.
Arrow operates in a highly competitive industry and market areas that could negatively affect growth and profitability. Competition for commercial banking and other financial services is fierce in Arrow's market areas. In one or more aspects of business, Arrow's subsidiaries compete with other commercial banks, savings and loan associations, credit unions, finance companies, Internet-based financial services companies, mutual funds, insurance companies, brokerage and investment banking companies, and other financial intermediaries. Additionally, due to their size and other factors, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services, as well as better pricing for those products and services, than Arrow can. Technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. In addition, many of Arrow's competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally insured banks. Failure, by Arrow, to offer competitive services in Arrow's market areas could
significantly weaken Arrow's market position, adversely affecting growth, which, in turn, could have a material adverse effect on Arrow's financial condition and results of operations.
Uncertainty relating to LIBOR and other reference rates and their potential discontinuance may negatively impact our access to funding and the value of our financial instruments and commercial agreements. Due to uncertainty surrounding the suitability and sustainability of the London interbank offered rate (LIBOR), central banks and global regulators have called for financial market participants to prepare for the discontinuance of LIBOR and the establishment of alternative reference rates. ICE Benchmark Administration (IBA), the administrator of LIBOR, announced that it will consult on its intention to cease publication of one-week and two-month U.S. dollar LIBOR at December 31, 2021, and stop the remaining U.S. dollar settings immediately after publication on June 30, 2023. At this time, it is not possible to predict the effect that any discontinuance, modification or other reforms to LIBOR or any other reference rate, the establishment of alternative reference rates, or the impact of any such events on contractual mechanisms may have on the markets, Arrow, or Arrow's financial instruments or commercial agreements that reference LIBOR.
Certain of our financial instruments and commercial agreements contain provisions to replace LIBOR as the benchmark following the occurrence of specified transition events. Such provisions may not be sufficient to trigger a change in the benchmark at all times when LIBOR is no longer representative of market interest rates, or that these events will align with similar events in the market generally or in other parts of the financial markets, such as the derivatives market.
Alternative reference rates are calculated using components different from those used in the calculation of LIBOR and may fluctuate differently than, and not be representative of, LIBOR. In order to compensate for these differences, certain of our financial instruments and commercial agreements allow for a benchmark replacement adjustment. However, there is no assurance that any benchmark replacement adjustment will be sufficient to produce the economic equivalent of LIBOR, either at the benchmark replacement date or over the life of such instruments and agreements.
Uncertainty as to the nature and timing of the potential discontinuance or modification of LIBOR, the replacement of LIBOR with one or more alternative reference rates or other reforms may negatively impact market liquidity, Arrow's access to funding required to operate Arrow's business and/or the trading market for financial instruments. Furthermore, the timing of implementation and use of alternative reference rates and corresponding adjustments or other reforms could be subject to disputes, could cause the interest payable on Arrow's outstanding financial instruments and commercial agreements to be materially different than expected and may impact the value of financial instruments and commercial agreements.
The financial services industry is faced with technological advances and changes on a continuing basis, and failure to adapt to these advances and changes could have a material adverse impact on Arrow's business. Technological advances and changes in the financial services industry are pervasive and constant. The retail financial services sector, like many other retail goods and services sectors, is constantly evolving, involving new delivery and communications systems and technologies that are extraordinarily far-reaching and impactful. For Arrow to remain competitive, Arrow must comprehend and adapt to these systems and technologies. Proper implementation of new technologies can increase efficiency, decrease costs and help to meet customer demand. However, many competitors have greater resources to invest in technological advances and changes. Arrow may not always be successful in utilizing the latest technological advances in offering its products and services or in otherwise conducting its business. Failure to identify, consider, adapt to and implement technological advances and changes could have a material adverse effect on business.
Problems encountered by other financial institutions could adversely affect the Company. Arrow's ability to engage in routine funding transactions could be adversely affected by financial or commercial problems confronting other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships. Arrow has exposure to many different counterparties in the normal course of business, and routinely executes transactions with counterparties in the financial services industry, including brokers and dealers, other commercial banks, investment banks, mutual and hedge funds, and other financial institutions. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity problems and losses or defaults by Arrow or by other financial institutions on whom Arrow relies or with whom Arrow interacts. Some of these transactions expose Arrow to credit and other potential risks in the event of default of Arrow's counterparty or client. In addition, credit risk may be exacerbated when the collateral held by Arrow cannot be liquidated or only may be liquidated at prices not sufficient to recover the full amount due Arrow under the underlying financial instrument, held by Arrow. There is no assurance that any such losses would not materially and adversely affect results of operations.
OPERATIONAL RISKS
Any future economic or financial downturn, including any significant correction in the equity markets, may negatively affect the volume of income attributable to, and demand for, fee-based services of banks such as Arrow, including the Company's fiduciary business, which could negatively impact Arrow's financial condition and results of operation. Revenues from trust and wealth management business are dependent on the level of assets under management. Any significant downturn in the equity markets may lead Arrow's trust and wealth management customers to liquidate their investments, or may diminish account values for those customers who elect to leave their portfolios with Arrow, in either case reducing assets under management and thereby decreasing revenues from this important sector of the business. Other fee-based businesses are also susceptible to a sudden economic or financial downturn.
In addition, Arrow's loan quality is affected by the condition of the economy. Like all financial institutions, Arrow maintains an allowance for loan losses to provide for probable loan losses at the balance sheet date. Arrow's allowance for loan losses is based on its historical loss experience as well as an evaluation of the risks associated with its loan portfolio, including the size and composition of the portfolio, current economic conditions and geographic concentrations within the portfolio and other factors. While Arrow has continued to enjoy a very high level of quality in its loan portfolio generally and very low levels of loan charge-offs and non-performing loans, if the economy in Arrow's geographic market area should deteriorate to the point that recessionary conditions return, or if the regional or national economy experiences a protracted period of stagnation, the quality of our loan portfolio may weaken so significantly that its allowance for loan losses may not be adequate to cover actual or expected loan losses. In such events, Arrow may be required to increase its provisions for loan losses and this could materially and
adversely affect financial results. Moreover, weak or worsening economic conditions often lead to difficulties in other areas of its business, including growth of its business generally, thereby compounding the negative effects on earnings.
Arrow faces continuing and growing security risks to its information base including the information maintained relating to customers, and any breaches in the security systems implemented to protect this information could have a material negative effect on Arrow's business operations and financial condition. In the ordinary course of business, Arrow relies on electronic communications and information systems to conduct its operations and to store sensitive data. Arrow employs an in-depth, layered, defensive approach that leverages people, processes and technology to manage and maintain cybersecurity controls. Arrow employs a variety of preventative and detective tools to monitor, block, and provide alerts regarding suspicious activity, as well as to report on any suspected advanced persistent threats. Arrow has implemented and regularly review and update extensive systems of internal controls and procedures as well as corporate governance policies and procedures intended to protect its business operations, including the security and privacy of all confidential customer information. In addition, Arrow relies on the services of a variety of vendors to meet data processing and communication needs. No matter how well designed or implemented its controls are, Arrow cannot provide an absolute guarantee to protect its business operations from every type of cybersecurity or other security problem in every situation, whether as a result of systems failures, human error or negligence, cyberattacks, security breaches, fraud or misappropriation. Any failure or circumvention of these controls could have a material adverse effect on Arrow's business operations and financial condition. Notwithstanding the strength of defensive measures, the threat from cyberattacks is severe, attacks are sophisticated and increasing in volume, and attackers respond rapidly to changes in defensive measures. While to date, Arrow has not experienced a significant compromise, significant data loss or any material financial losses related to cybersecurity attacks or other security problems, Arrow's systems and those of its customers and third-party service providers are under constant threat. Risks and exposures related to cybersecurity attacks or other security problems are expected to remain high for the foreseeable future due to the rapidly evolving nature and sophistication of these threats and issues, as well as due to the expanding use of Internet banking, mobile banking and other technology-based products and services by Arrow and customers.
The computer systems and network infrastructure that Arrow uses are always vulnerable to unforeseen disruptions, including theft of confidential customer information (“identity theft”) and interruption of service as a result of fire, natural disasters, explosion, general infrastructure failure, cyberattacks or other security problems. These disruptions may arise in Arrow's internally developed systems, or the systems of our third-party service providers or may originate from the actions of our consumer and business customers who access our systems from their own networks or digital devices to process transactions. Information security and cyber security risks have increased significantly in recent years because of consumer demand to use the Internet and other electronic delivery channels to conduct financial transactions. Cybersecurity risk and other security problems are a major concern to financial services regulators and all financial service providers, including Arrow. These risks are further exacerbated due to the increased sophistication and activities of organized crime, hackers, terrorists and other disreputable parties. Arrow regularly assesses and tests security systems and disaster preparedness, including back-up systems, but the risks are substantially escalating. As a result, cybersecurity and the continued enhancement of Arrow's controls and processes to protect its systems, data and networks from attacks or unauthorized access remain a priority. Accordingly, Arrow may be required to expend additional resources to enhance its protective measures or to investigate and remediate any information security vulnerabilities or exposures. Any breach of Arrow's system security could result in disruption of its operations, unauthorized access to confidential customer information, significant regulatory costs, litigation exposure and other possible damages, loss or liability. Such costs or losses could exceed the amount of available insurance coverage, if any, and would adversely affect Arrow's earnings. Also, any failure to prevent a security breach or to quickly and effectively deal with such a breach could negatively impact customer confidence, damaging Arrow's reputation and undermining its ability to attract and keep customers. In addition, if Arrow fails to observe any of the cybersecurity requirements in federal or state laws, regulations or regulatory guidance, Arrow could be subject to various sanctions, including financial penalties.
Business could suffer if Arrow loses key personnel unexpectedly or if employee wages increase significantly. Arrow's success depends, in large part, on Arrow's ability to retain key personnel for the duration of their expected terms of service. On an ongoing basis, Arrow prepares and reviews back-up plans, in the event key personnel are unexpectedly rendered incapable of performing or depart or resign from their positions. However, any sudden unexpected change at the senior management level may adversely affect business. In addition, should Arrow's industry begin to experience a shortage of qualified employees, Arrow, like other financial institutions, may have difficulty attracting and retaining entry level or higher bracket personnel and also may experience, as a result of such shortages or the enactment of higher minimum wage laws locally or nationwide, increased salary expense, which would likely negatively impact results of operations.
The outbreak of the novel coronavirus, COVID-19, may adversely affect Arrow’s business activities, financial condition and results of operations. The business of Arrow and its subsidiary banks depends on the willingness and ability of its customers to conduct financial transactions. The spread of COVID-19 and the resulting “shelter in place” and “stay at home” orders, travel restrictions and other precautions have caused significant disruptions in the United States economy, which could in turn disrupt the business, activities, and operations of Arrow’s customers, as well as Arrow's business and operations. The pandemic has also caused significant disruption in the financial markets both globally and in the United States. The spread of COVID-19 may result in a significant decrease in business and/or cause Arrow’s customers to be unable to meet existing obligations to the Company, particularly in the event of another significant outbreak in the Upstate New York region. The virus’s spread could also interfere with the availability of key personnel or third party service providers necessary to conduct business activities.
Arrow has taken steps to mitigate the risk of harm to its employees and customers and to its operations from the pandemic. In particular, Arrow, when necessary, has limited access to facilities to appointments only and encouraged customers to use contact-free alternatives like digital banking and ATMs. Arrow has also minimized contact for a large portion of its employee base through remote working, minimal travel and in-person meetings and social distancing. Nevertheless, there are a number of uncertainties related to the potential effects of the pandemic that may not be able to be addressed by these efforts. If the spread of COVID-19 has an adverse effect on (i) customer deposits, (ii) the ability of borrowers to satisfy their obligations, (iii) the demand for loans or other financial products and services, (iv) the ability of Arrow’s personnel and third party service providers to perform effectively, (v) financial markets, real estate markets, or economic growth, or (vi) other aspects of operations, then Arrow’s liquidity, financial condition and/or results of operations may be materially and adversely affected.
FINANCIAL RISKS
Arrow is subject to interest rate risk, which could adversely affect profitability. Profitability, like that of most financial institutions, depends to a large extent on Arrow's net interest income, which is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Changes in monetary policy, including changes in interest rates, could influence not only the interest received on loans and securities and the amount of interest paid on deposits and borrowings, but also (1) Arrow's ability to originate loans and obtain deposits, (2) the fair value of financial assets and liabilities, and (3) the average duration of mortgage-backed securities portfolio. If the interest rates Arrow pays on deposits and other borrowings increase at a faster rate than the interest rates received on loans, securities and other interest-earning investments, net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. Changes in interest rates, whether they are increases or decreases, can also trigger repricing and changes in the pace of payments for both assets and liabilities.
In addition, an increase in interest rates could have a negative impact on results of operations by reducing the ability of borrowers to repay their current loan obligations. These circumstances could not only result in increased loan defaults, foreclosures and charge-offs, but also necessitate further increases to the allowance for loan losses which may materially and adversely affect Arrow's business, results of operations, financial condition and prospects.
The Company's allowance for possible loan and lease losses may be insufficient, and an increase in the allowance would reduce earnings. The allowance is established through a provision for loan and lease losses based on management’s evaluation of the risks inherent in the loan portfolio and the general economy. The allowance is based upon a number of factors, including the size of the loan and lease portfolio, asset classifications, economic trends, industry experience and trends, industry and geographic concentrations, estimated collateral values, management’s assessment of the credit risk inherent in the portfolio, historical loan and lease loss experience and loan underwriting policies. In addition, Arrow evaluates all loans and leases identified as problem loans and augments the allowance based upon an estimation of the potential loss associated with those problem loans and leases. Additions to the allowance for loan and lease losses decrease net income through provisions for loan and lease losses. If the evaluation performed in connection with establishing loan and lease loss reserves is wrong, the allowance for loan and lease losses may not be sufficient to cover Arrow's losses, which would have an adverse effect on operating results. Arrow's regulators, in reviewing the loan and lease portfolio as part of a regulatory examination, may from time to time require Arrow to increase the allowance for loan and lease losses, thereby negatively affecting earnings, financial condition and capital ratios at that time. Moreover, additions to the allowance may be necessary based on changes in economic and real estate market conditions, new information regarding existing loans and leases, identification of additional problem loans and leases and other factors, both within and outside of Arrow's control. Additions to the allowance could have a negative impact on Arrow's results of operations. Although asset quality remained strong as of December 31, 2020, as a result of the uncertainty created by the COVID-19 pandemic, Arrow increased its loan loss reserves based on management's assessment of the related risks. As of January 1, 2021, Arrow implemented a new accounting standard to estimate the Company's allowance for credit losses. For more information, see Part II, Item 7.H. “Recently Issued Accounting Standards.” Although Arrow believes that the allowance for credit losses is in compliance with the new accounting standard at January 1, 2021, there is no guarantee that it will be sufficient to address credit losses, particularly if economic conditions deteriorate quickly and/or significantly. In such an event, the Company may increase the size of the allowance for loan and lease losses which would reduce Arrow's earnings.
The increasing complexity of Arrow's operations presents varied risks that could affect earnings and financial condition. Arrow processes a large volume of transactions on a daily basis and is exposed to numerous types of risks related to internal processes, people and systems. These risks include, but are not limited to, the risk of fraud by persons inside or outside the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, breaches of data security, human error or negligence, and Arrow's internal control system and compliance with a complex array of consumer and safety and soundness regulations. Arrow could also experience additional loss as a result of potential legal actions that could arise as a result of operational deficiencies or as a result of noncompliance with applicable laws and regulations.
Arrow has established and maintained a system of internal controls that provides management with information on a timely basis and allows for the monitoring of compliance with operational standards. These systems have been designed to manage operational risks at an appropriate, cost effective level. Procedures exist that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. Losses from operational risks may still occur, however, including losses from the effects of operational errors.
RISKS RELATED TO OWNING OUR COMMON STOCK
The Company relies on the operations of its banking subsidiaries to provide liquidity, which, if limited, could impact Arrow's ability to pay dividends to its shareholders or to repurchase its common stock. Arrow is a bank holding company, a separate legal entity from its subsidiaries. The bank holding company does not have significant operations of its own. The ability of the subsidiaries, including bank and insurance subsidiaries, to pay dividends is limited by various statutes and regulations. It is possible, depending upon the financial condition of Arrow's subsidiaries and other factors, that the subsidiaries might be restricted at some point in the ability to pay dividends to the holding company, including by a bank regulator asserting that the payment of such dividends or other payments would constitute an unsafe or unsound practice. In addition, under federal banking law, Arrow is subject to consolidated capital requirements at the holding company level. If the holding company or the bank subsidiaries are required to retain or increase capital, Arrow may not be able to maintain the cash dividends or pay dividends at all, or to repurchase shares of Arrow's common stock.
LEGAL, TAX, REGULATORY AND COMPLIANCE RISKS
Capital and liquidity standards require banks and bank holding companies to maintain more and higher quality capital and greater liquidity than has historically been the case. Capital standards, particularly those adopted as a result of Dodd-Frank, continue to have a significant effect on banks and bank holding companies, including Arrow. The need to maintain
more and higher quality capital, as well as greater liquidity, and generally increased regulatory scrutiny with respect to capital levels, may at some point limit business activities, including lending, and its ability to expand. It could also result in Arrow being required to take steps to increase regulatory capital and may dilute shareholder value or limit the ability to pay dividends or otherwise return capital to investors through stock repurchases. The Capital Rules promulgated under Dodd-Frank will remain applicable to Arrow.
Federal banking statutes and regulations could change in the future, which may adversely affect Arrow. Arrow is subject to extensive federal and state banking regulations and supervision. Banking laws and regulations are intended primarily to protect bank depositors’ funds (and indirectly the Federal Deposit Insurance Fund) as well as bank retail customers, who may lack the sophistication to understand or appreciate bank products and services. These laws and regulations generally are not, however, aimed at protecting or enhancing the returns on investment enjoyed by bank shareholders.
Arrow's depositor/customer awareness of the changing regulatory environment is particularly true of the set of laws and regulations under Dodd-Frank, which were passed in the aftermath of the 2008-09 financial crisis and in large part were intended to better protect bank customers (and to some degree, banks) against a wide variety of lending products and aggressive lending practices that pre-dated the crisis and are seen as having contributed to its severity. Although not all banks offered such products or engaged in such practices, all banks are affected by these laws and regulations to some degree.
Dodd-Frank restricts Arrow's lending practices, requires us to expend substantial additional resources to safeguard customers, significantly increases its regulatory burden, and subjects Arrow to significantly higher minimum capital requirements which, in the long run, may serve as a drag on its earnings, growth and ultimately on its dividends and stock price (the Dodd-Frank capital standards are separately addressed in a previous risk factor).
Although the Economic Growth Act and similar initiatives may mitigate the impact of Dodd-Frank, other statutory and regulatory changes could add to the existing regulatory burden imposed on banking organizations like Arrow, resulting in a potential material adverse effect on Arrow's financial condition and results of operations.
Non-compliance with the Patriot Act, Bank Secrecy Act, or other anti-money laundering laws and regulations could result in fines or sanctions and restrictions on conducting acquisitions or establishing new branches. The Patriot Act and Bank Secrecy Act require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are suspected, financial institutions are obligated to file suspicious activity reports with FinCEN. Federal anti-money laundering rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure to comply with these regulations could result in fines or sanctions, and restrictions on conducting acquisitions or establishing new branches. During the last few years, several banking institutions have received large fines for non-compliance with these laws and regulations. The policies and procedures Arrow adopted that are designed to assist in compliance with these laws and regulations may not be effective in preventing violations of these laws and regulations.
The Company, through its banking subsidiaries, is subject to the Community Reinvestment Act ("CRA") and fair lending laws, and failure to comply with these laws could lead to material penalties. CRA, the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations impose nondiscriminatory lending requirements on financial institutions. A successful regulatory challenge to an institution’s performance under the CRA or fair lending laws and regulations could result in a wide variety of sanctions, including the required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on mergers and acquisitions activity and restrictions on expansion. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation. Such actions could have a material adverse effect on Arrow's business, financial condition and results of operations.
Item 1B.
Item 1B. Unresolved Staff Comments - None
Item 2.
Item 2. Properties
Arrow's main office is at 250 Glen Street, Glens Falls, New York. The building is owned by the Company and serves as the main office for Arrow and Glens Falls National, the principal subsidiary bank. Arrow is in the midst of a multi-year renovation project to enhance and improve the downtown Glens Falls Main Campus. The project began in 2012 with the construction of our 20 South Street Building. Once this multi-year, multi-building project is complete, Arrow will have renovated and improved the entire Main Campus. The main office of the other banking subsidiary, Saratoga National, is in Saratoga Springs, New York. Arrow owns twenty-seven branch banking offices, leases thirteen branch banking offices, leases two residential loan origination offices and a business development office, all at market rates. Arrow's insurance agency is co-located in seven bank-owned branches, as well as three leased insurance offices. Arrow also leases office space in buildings and parking lots near the main office in Glens Falls as well as a back-up site for business continuity purposes.
In the opinion of management, the physical properties of the holding company and the various subsidiaries are suitable and adequate. For more information on Arrow's properties, see Notes 2, Summary of Significant Accounting Policies, 6, Premises and Equipment, and 18, Leases, in the notes to the Consolidated Financial Statements contained in Part II, Item 8 of this Report.
Item 3.
Item 3. Legal Proceedings
Except as noted below, the Company, including its subsidiary banks, is not currently the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of their business. On an ongoing basis, the Company is often the subject of, or a party to, various legal claims by other parties against the Company, by the Company against other parties, or involving the Company, which arise in the normal course of business. Except as noted below, the various pending legal claims against the Company will not, in the opinion of management based upon consultation with counsel, result in any material liability.
On July 1, 2020, Daphne Richard, a customer of GFNB filed a putative class action complaint against GFNB in the United States District Court for the Northern District of New York. The complaint alleges that GFNB assessed overdraft fees on certain transactions drawn on her checking account without having sufficiently disclosed its overdraft-fee practices in its account agreement. Ms. Richard, on behalf of two purported classes, seeks compensatory damages, disgorgement of profits, statutory damages, treble damages, enjoinment of the conduct complained of, and costs and fees. The complaint is similar to complaints filed against other financial institutions pertaining to overdraft fees. The Company denies any wrongdoing and the case is being vigorously defended.
Item 4.
Item 4. Mine Safety Disclosures - None
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Arrow's common stock is traded on the Global Select Market of the National Association of Securities Dealers, Inc. ("NASDAQ®") Stock Market under the symbol AROW.
Based on information received from Arrow's transfer agent and various brokers, custodians and agents, Arrow estimates there were approximately 7,600 beneficial owners of Arrow’s common stock at December 31, 2020. Arrow has no other class of stock outstanding.
Equity Compensation Plan Information
The following table sets forth certain information regarding Arrow's equity compensation plans as of December 31, 2020. These equity compensation plans were (i) the 2013 Long-Term Incentive Plan ("LTIP") and its predecessor, Arrow's 2008 Long-Term Incentive Plan; (ii) the 2014 Employee Stock Purchase Plan ("ESPP"); and (iii) the 2020 Directors' Stock Plan ("DSP"). All of these plans have been approved by Arrow's shareholders.
(1)The total of 275,753 shares listed in column (a) includes 264,090 which are issuable pursuant to outstanding stock options and 11,663 which are issuable pursuant to restricted stock units all granted under the LTIP or its predecessor plans.
(2)The total of 287,868 shares listed in column (c) includes (i) 178,391 shares of common stock available for future award grants under the LTIP, (ii) 62,349 shares of common stock available for future issuance under the ESPP, and (iii) 47,128 shares of common stock available for future issuance under the DSP.
STOCK PERFORMANCE GRAPHS
The following two graphs provide a comparison of the total cumulative return (assuming reinvestment of dividends) for the common stock of Arrow as compared to the Russell 2000 Index, the NASDAQ Banks Index and the Zacks $1B-$5B Bank Assets Index.
The first graph presents comparative stock performance for the five-year period from December 31, 2015 to December 31, 2020 and the second graph presents comparative stock performance for the fifteen-year period from December 31, 2005 to December 31, 2020.
The historical information in the graphs and accompanying tables may not be indicative of future performance of Arrow stock on the various stock indices.
Source: Prepared by Zacks Investment Research, Inc. Used with permission. All rights reserved. Copyright 1980-2021.
Source: Prepared by Zacks Investment Research, Inc. Used with permission. All rights reserved. Copyright 1980-2021.
The preceding stock performance graphs and tables shall not be deemed incorporated by reference, by virtue of any general statement contained herein or in any other filing incorporated by reference herein, into any other SEC filing by the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent the Company specifically incorporates this information by reference into such filing, and shall not otherwise be deemed filed as part of any such other filing.
Unregistered Sales of Equity Securities
None.
Issuer Purchases of Equity Securities
The following table presents information about repurchases by Arrow during the three months ended December 31, 2020 of Arrow's common stock (the only class of equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934):
1 The total number of shares purchased and the average price paid per share listed in columns (a) and (b) consist of (i) any shares purchased in such periods in open market or private transactions under the Arrow Financial Corporation Automatic Dividend Reinvestment Plan (the "DRIP") by the administrator of the DRIP, and (ii) shares surrendered or deemed surrendered to Arrow in such periods by holders of options to acquire Arrow common stock received by them under Arrow's long-term incentive plans ("LTIPs") in connection with their stock-for-stock exercise of such options, and shares repurchased by Arrow pursuant to its publicly-announced stock repurchase program. In the months indicated, the listed number of shares purchased included the following numbers of shares purchased by Arrow through such methods: October - DRIP purchases (1,091 shares); November - DRIP purchases (1,973 shares), and December - DRIP purchases (15,843 shares).
2 Includes only those shares acquired by Arrow pursuant to its publicly-announced stock repurchase programs. Arrow's only publicly announced stock repurchase program in effect for 2020 was the 2020 Repurchase Program approved by the Board of Directors and announced in October 2019, under which the Board authorized management, in its discretion, to repurchase from time to time during calendar year 2020, in the open market or in privately negotiated transactions, up to $5 million of Arrow common stock subject to certain exceptions. Arrow had no repurchases of its shares in the fourth quarter of 2020 under the 2020 Program.
Item 6.
Item 6. Selected Financial Data
FIVE YEAR SUMMARY OF SELECTED DATA
Arrow Financial Corporation and Subsidiaries
(Dollars In Thousands, Except Per Share Data)
1 Share and per share amounts have been adjusted for subsequent stock splits and dividends, including the most recent September 25, 2020 3% stock dividend.
2 Tangible book value excludes goodwill and other intangible assets from total equity.
3 Nonperforming assets consist of nonaccrual loans, loans past due 90 or more days but still accruing interest, repossessed assets, restructured loans, other real estate owned and nonaccrual investments.
4 Dividend Payout Ratio - cash dividends per share to fully diluted earnings per share.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Selected Quarterly Information
Dollars in thousands, except per share amounts
Share and per share amounts have been restated for the September 2020 3% stock dividend
Selected Twelve-Month Information
Dollars in thousands, except per share amounts
Share and per share amounts have been restated for the September 2020 3% stock dividend
*See "Use of Non-GAAP Financial Measures" on page 4.
Arrow Financial Corporation
Reconciliation of Non-GAAP Financial Information
(Dollars In Thousands, Except Per Share Amounts)
CRITICAL ACCOUNTING ESTIMATES
The significant accounting policies, as described in Note 2 - Summary of Significant Accounting Policies to the notes to the Consolidated Financial Statements are essential in understanding the Management Discussion and Analysis. Many of the significant accounting policies require complex judgments to estimate the values of assets and liabilities. Arrow has procedures and processes in place to facilitate making these judgments. The more judgmental estimates are summarized in the following discussion. In many cases, there are numerous alternative judgments that could be used in the process of determining the inputs to the models. Where alternatives exist, Arrow has used the factors that are believed to represent the most reasonable value in developing the inputs. Actual performance that differs from estimates of the key variables could impact the results of operations.
Allowance for loan losses: The allowance for loan losses represents management’s estimate of probable losses inherent in Arrow's loan portfolio. The process for determining the allowance for loan losses is discussed in Note 2, Summary of Significant Accounting Policies and Note 5, Loans, to the notes to the Consolidated Financial Statements. Arrow evaluates the allowance at the portfolio segment level and the portfolio segments are commercial, commercial real estate, consumer loans and residential real estate. Due to the variability in the drivers of the assumptions used in this process, estimates of the portfolio’s inherent risks and overall collectability change with changes in the economy, individual industries, and borrowers’ ability and willingness to repay their obligations. The degree to which any particular assumption affects the allowance for loan losses depends on the severity of the change and its relationship to the other assumptions. Key judgments used in determining the allowance for loan losses for individual commercial loans include credit quality indicators, collateral values and estimated cash flows for impaired loans. For pools of loans, Arrow considers the historical net loss experience, and as necessary, adjustments to address current events and conditions, considerations regarding economic uncertainty, and overall credit conditions. The historical net loss factors incorporate a rolling average annual twelve quarter look-back period of the respective segment that have occurred within each pool of loans over the loss emergence period (LEP), adjusted as necessary based upon consideration of qualitative considerations impacting the inherent risk of loss in the respective loan portfolios. The LEP is an estimate of the average amount of time from the point at which a loss is incurred on a loan to the point at which the loss is recognized in the financial statements. Since the LEP may change under various economic environments, the LEP calculation is updated on an annual basis. The process of determining the level of the allowance for loan losses requires a high degree of judgment. Any downward trend in the economy, regional or national, may require Arrow to increase the allowance for loan losses resulting in a negative impact on the results of operations and financial condition.
A. OVERVIEW
The following discussion and analysis focuses on and reviews Arrow's results of operations for each of the years in the three-year period ended December 31, 2020 and the financial condition as of December 31, 2020 and 2019. The discussion below should be read in conjunction with the selected quarterly and annual information set forth above and the Consolidated Financial Statements and other financial data presented elsewhere in this Report. When necessary, prior-year financial information has been reclassified to conform to the current-year presentation.
COVID-19 Pandemic:
In March 2020, the World Health Organization recognized COVID-19 as a pandemic. In response, the United States federal government and various state and local governments have, among other actions, imposed travel and business restrictions and required or advised communities in which we do business to adopt stay-at-home orders and social distancing guidelines, causing some businesses to adjust, reduce or suspend operating activities. Like many businesses, Arrow expects the operations and financial results to continue to be adversely impacted by the COVID-19 pandemic. The severity, magnitude and duration of the current pandemic are still uncertain, rapidly changing and hard to predict.
Arrow continues to manage its COVID-19 response with health and safety concerns as a top priority. Throughout 2020, the Business Continuity Task Force, representing leadership from across the organization, focused on maintaining protocols that have allowed Arrow to continue operations. Arrow actively monitors developments, and if future restrictions are imposed, is confident in its ability to continue to provide essential banking services and meet customer needs.
Arrow provided full access at its facilities or appointment-only access depending on conditions present at that time. Drive-ins and ATMs are open, and Arrow continues to promote digital banking alternatives. Inside Arrow's facilities, safety measures continue to be followed, including required face coverings, social distancing and personal protective equipment such as shields and hand sanitizing stations, along with frequent cleanings. Remote work is encouraged whenever feasible for employees. In addition, work-related travel remains paused and in-person meetings have been minimized. Arrow remains committed to delivering essential financial services to its communities.
Requests for financial hardship assistance were reduced from early pandemic levels. Loans being deferred as a result of the COVID-19 pandemic were $15.3 million, or 0.6% of loans outstanding, as of December 31, 2020. Arrow worked closely with small business borrowers from the initial round of PPP loans on the forgiveness process. Arrow is currently helping customers obtain funding through an additional round of PPP support. As of year-end, Arrow had assisted more than 1,400 small businesses, with more than $142.7 million in aggregate PPP loans.
While COVID-19 did not have a material adverse effect on 2020 financial results, Arrow is actively monitoring the impact of the pandemic on the business and results of operations.
As Arrow cannot predict the duration or scope of the pandemic or its impact on economic and financial markets or its impact on the business, Arrow is unable to reasonably estimate the overall impact on the Company. For further discussion of the impact COVID-19 has had and may in the future have on Arrow and its financial results and operations, please refer to the Risk Factors included in Part I, Item 1A, beginning on page 13 of this Report.
Summary of 2020 Financial Results: For the year ended December 31, 2020, net income was a record $40.8 million, up 8.9% over net income of $37.5 million for 2019. Diluted EPS was $2.64 for 2020, up 8.5% from $2.43 in 2019.
Arrow's profitability ratios remained solid in 2020, as return on average equity and return on average assets were 12.77% and 1.17%, respectively, for the year, as compared to 13.17% and 1.24%, respectively, for 2019.
At December 31, 2020, total loan balances reached $2.6 billion, up $209 million, or 8.8%, from the prior-year level. The consumer loan portfolio grew by $48.6 million, or 6.0%, over the balance at December 31, 2019, primarily as a result of continued strength in the indirect automobile lending program. The residential real estate loan portfolio increased $9.2 million, or 1.0%. The increase in the real estate loan portfolio is net of approximately $83.9 million of loans sold in 2020. Commercial loans, including commercial real estate, increased $151.1 million, or 22.9%, over the balances at December 31, 2019. The increase in commercial loans includes $110.4 million in remaining PPP loans.
At December 31, 2020, total deposit balances reached $3.2 billion, up by $618.7 million, or 23.6%, from the prior-year level. Noninterest-bearing deposits grew by $216.4 million, or 44.6%, during 2020, and represented 21.7% of total deposits at year-end as compared to the prior-year level of 18.5%. At December 31, 2020, total time deposits decreased $117.7 million from the prior-year level, including a reduction of $80.6 million in brokered time deposits.
Net interest income for the year ending December 31, 2020 was $99.2 million, an increase of $11.2 million, or 12.7%, from the prior year. Loan growth generated $100.5 million in interest and fees on loans, an increase of 5.3% from the $95.5 million in interest and fees on loans for the year ending December 31, 2019. Interest expense for the year ending December 31, 2020 was $12.7 million. This is a decrease of $9.0 million, or 41.5%, from the $21.7 million in expense for the year ending December 31, 2019. The net interest margin was 2.99% for the year ending December 31, 2020, as compared to 3.05% for the year ended December 31, 2019. The change in net interest margin from the prior year was due to a variety of factors, including lower interest rates, increased cash balances and the impact of participating in the PPP.
Noninterest income was $32.7 million for the year ending December 31, 2020, an increase of 14.4% as compared to $28.6 million for the year ending December 31, 2019. Gain on sale of loans increased $3.3 million due to a variety of factors, including strong demand for residential mortgages in our operating markets, favorable market conditions for mortgage sales and strategic balance sheet and interest-rate risk management decisions. Income generated from fiduciary activities as well as fees for other services from customers were flat compared to the prior year. Insurance revenue decreased by $306 thousand from the prior year. Noninterest income represented 24.8% of total revenues in 2020 as compared to 24.5% for the year ending December 31, 2019. Other operating income increased in 2020 as compared to 2019 as a result of several factors, including gain on sale of
fixed assets and other real estate owned, as well as increased income related to interest rate swap agreements and bank owned life insurance.
Noninterest expense for the year ending December 31, 2020 increased by $3.2 million, or 4.8%, to $70.7 million compared to $67.5 million in 2019. The largest component of noninterest expense is salaries and benefits paid to our employees, which totaled $42.1 million in 2020, as compared to $38.4 million in 2019.
In 2020, Arrow opened a 12th Saratoga National Bank Branch, as well as a Capital Region Business Development Office in Latham, New York. Additionally, Glens Falls National Bank consolidated Branches in Queensbury and Greenwich into nearby locations.
Asset quality remained strong in 2020, as evidenced by low levels of nonperforming assets and charge-offs. Net loan losses for the full year 2020 were 0.05% of average loans outstanding, consistent with the 2019 ratio. Nonperforming assets of $6.6 million at December 31, 2020, represented 0.18% of period-end assets, consistent with December 31, 2019.
Arrow's allowance for loan losses was $29.2 million at December 31, 2020, which represented 1.13% of loans outstanding, an increase from 0.89% at year-end 2019. Although credit quality remains strong, the increase in the allowance reflects the uncertainty related to the COVID-19 pandemic. When expressed as a percentage of nonperforming loans, the allowance for loan loss coverage ratio was 456.3% at year-end 2020. Arrow adopted the Current Expected Credit Losses (CECL) accounting standard as of January 1, 2021.
At December 31, 2020, Arrow’s liquidity position was strong. Interest-bearing cash balances at December 31, 2020 were $338.9 million. Arrow continues to be well-prepared to address any unexpected volatility due to the COVID-19 pandemic, which may affect cash flow and deposit balances. At December 31, 2020, contingent collateralized lines of credit available through the Federal Home Loan Bank of New York and Federal Reserve Bank, totaled $1.5 billion. Arrow also has additional liquidity options currently available, including unsecured Fed Funds lines of credit and brokered deposit markets.
The changes in net income, net interest income and net interest margin between the current and prior year are discussed in detail under the heading "RESULTS OF OPERATIONS," beginning on page 32.
Regulatory Capital and Increase in Stockholders' Equity: As of December 31, 2020, Arrow continued to exceed all required minimum capital ratios under the current bank regulatory capital rules as implemented under Dodd-Frank (the "Capital Rules") at both the holding company and bank levels. At that date, both subsidiary banks, as well as the holding company, continued to qualify as "well-capitalized" under the capital classification guidelines as defined by the Capital Rules. Because of continued profitability and strong asset quality, the regulatory capital levels throughout recent years have consistently remained well in excess of the various required regulatory minimums in effect from time to time, as they do at present. Pursuant to the Capital Rules, required minimum regulatory capital levels for insured banks and their parent holding companies increased in 2019.
The federal bank regulators have issued a final rule to implement the “community bank leverage ratio”, introducing an optional simplified measure of capital adequacy for qualifying community banking organizations ("CBLR"). To qualify for the CBLR framework, a community banking organization must satisfy certain requirements, including having a leverage ratio of greater than 9%, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all the requirements under the CBLR framework will be considered to have met the well-capitalized ratio requirements under the “prompt corrective action” regulations and will not be required to report or calculate risk-based capital ratios. Subsequently, Section 4012 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act required the federal banking agencies to temporarily lower the threshold for election of the CBLR framework, issuing two interim final rules to set the CBLR at 8% as of the second quarter of 2020 and then gradually re-establish the CBLR at 9%.
Under the final rule, the CBLR remained at 8% through the end of 2020. Community banks that have a leverage ratio of 8% or greater and meet certain other criteria may elect to use the CBLR framework. Beginning in 2021, the CBLR increased to 8.5% for the calendar year. Community banks will have until January 1, 2022, before the leverage ratio requirement to use the CBLR framework will return to 9%.
The final rule also maintains a two-quarter grace period for a qualifying community banking organization whose leverage ratio falls no more than one percentage point below the applicable CBLR requirement.
The CBLR final rule became effective as of January 1, 2020, and Arrow and both subsidiary banks have opted out of utilizing the CBLR framework. Therefore, the Capital Rules promulgated under Dodd-Frank will remain applicable to Arrow.
Total stockholders' equity was $334.4 million at December 31, 2020, an increase of $32.7 million, or 10.8%, from the year earlier level. The components of the change in stockholders' equity since year-end 2018 are presented in the Consolidated Statement of Changes in Stockholders' Equity on page 62. Total book value per share increased by 10.3% over the prior year level. At December 31, 2020, tangible book value per share, a non-GAAP financial measure calculated based on tangible book value (total stockholders' equity minus intangible assets including goodwill) was $20.02, an increase of $2.01, or 11.2%, over the December 31, 2019 amount. The increase in total stockholders' equity during 2020 principally reflected the following factors: $40.83 million of net income for the year, plus $1.81 million of equity related to various stock-based compensation plans, plus $1.81 million of equity resulting from the dividend reinvestment plan, plus other comprehensive income of $5.54 million reduced by cash dividends of $15.74 million and the repurchases of common stock of $1.58 million. As of December 31, 2020, Arrow's closing stock price was $29.91, resulting in a trading multiple of 1.49 to Arrow's tangible book value. The Board of Directors declared and the Company paid a cash dividend of $0.252 per share for the first three quarters of 2020, as adjusted for a 3% stock dividend distributed September 25, 2020, a cash dividend of $0.26 per share for the fourth quarter of 2020, and has declared a $0.26 per share cash dividend for the first quarter of 2021.
Loan quality: Nonperforming loans were $6.4 million at December 31, 2020, an increase of $2.0 million, or 45.6%, from year-end 2019. The ratio of nonperforming loans to period-end loans at December 31, 2020 was 0.25%, an increase from 0.18% at December 31, 2019 and less than the Company's peer group ratio of 0.64% at September 30, 2020. Loans charged-off (net of recoveries) against the allowance for loan losses was $1.3 million for 2020, an increase of $186 thousand from 2019. The ratio of net charge-offs to average loans was 0.05% for 2020 and 2019, compared to the peer group ratio of 0.10% for the period ended September 30, 2020. At December 31, 2020, the allowance for loan losses was $29.2 million, representing 1.13% of total loans, an increase of 24 basis points from the December 31, 2019 ratio. Although credit quality remains strong, the increase in loan loss provision expense reflects the uncertainty resulting from the COVID-19 pandemic. Arrow adopted the Current Expected Credit Losses ("CECL") accounting standard as of January 1, 2021.
Loan Segments: As of December 31, 2020, total loans grew $208.9 million, or 8.8%, as compared to the balance at December 31, 2019. The largest increase was in commercial and commercial real estate loans, which increased by $151.1 million or 22.9%, from December 31, 2019. The majority of the increase in commercial loans resulted from the origination of PPP loans, of which $114.6 million remained outstanding at December 31, 2020. The residential real estate loan portfolio increased $9.2 million, or 1.0%. The increase in the real estate loan portfolio is net of approximately $83.9 million of loans sold in 2020. In addition, consumer loans expanded $48.6 million, or 6.0%. The economic factors resulting from the COVID-19 pandemic, including but not limited to restrictions on non-essential businesses, will most likely adversely impact loan growth for all or a portion of 2021.
◦ Commercial and Commercial Real Estate Loans: Combined, these loans comprise 31.3% of the total loan portfolio at period-end. Commercial property values in the Company’s region have largely remained stable in 2020, however, there remains uncertainty surrounding market conditions due to the pandemic. Appraisals on nonperforming and watched CRE loan properties are updated as deemed necessary, usually when the loan is downgraded or when there has been significant market deterioration since the last appraisal. The temporary closure of nonessential business in New York impacted, and may continue to impact, Arrow's customer base. Government intervention, with programs such as the PPP, may mitigate the economic risk to both Arrow and its customers, however the full impact cannot be determined at this time.
◦ Consumer Loans: These loans (primarily automobile loans) comprised approximately 33.1% of the total loan portfolio at period-end. Consumer automobile loans at December 31, 2020, were $854.7 million, or 99.4% of this portfolio segment. In 2020, Arrow did not experience any significant increase in the delinquency rate or in the percentage of nonperforming loans in this segment. The vast majority of automobile loans are initiated through the purchase of vehicles by consumers with automobile dealers. As of December 31, 2020, the physical sale of vehicles through dealerships is occurring, however, it had been curtailed for a portion of 2020 as part of the response to the COVID-19 pandemic in New York and Vermont, our primary dealer network.
◦ Residential Real Estate Loans: These loans, including home equity loans, made up 35.6% of the total loan portfolio at period-end. The residential real estate market in the Company's service area has been stable in recent periods. Arrow originated nearly all of the residential real estate loans currently held in the loan portfolio and applies conservative underwriting standards to loan originations. Arrow typically sells a portion of residential real estate mortgage originations into the secondary market. The ratio of the sales of originations to total originations tends to fluctuate from period to period based on market conditions and other factors. Sales increased in 2020, due to a variety of factors, including strong demand for residential mortgages in our operating markets, favorable market conditions for mortgage sales and strategic balance sheet and interest-rate risk management decisions. The rate at which mortgage loan originations are sold in future periods will depend on various circumstances, including prevailing mortgage rates, other lending opportunities, capital and liquidity needs, and the availability of a market for such transactions. Due to the COVID-19 pandemic, it is not yet possible to determine the long term economic impact on our residential real estate loan portfolio. It should be noted, however, that historically low interest rates led to higher originations in 2020 as compared to 2019.
Liquidity and access to credit markets: Arrow did not experience any liquidity problems or special concerns in recent years or in 2020. Arrow’s liquidity position provides the necessary flexibility to address any unexpected near-term disruptions that may develop as a result of the COVID-19 pandemic such as: reduced cash-flows from the investment and loan portfolios and aggressive funding of programs associated with response efforts. Interest-bearing cash balances at December 31, 2020 were $338.9 million compared to $23.2 million at December 31, 2019. Operating collateralized lines of credit are established and available through the FHLBNY and FRB, totaling $1.5 billion. The terms of Arrow's lines of credit have not changed significantly in recent periods (see the general liquidity discussion on page 48). To address liquidity needs beyond maintaining and growing core deposit balances, Arrow has principally relied on asset-based liquidity (i.e., funds in overnight investments and cash flow from maturing investments and loans) with liability-based liquidity as a secondary source of funds (the main liability-based sources are an overnight borrowing arrangement with correspondent banks, an arrangement for overnight borrowing and term credit advances from the FHLBNY, and an additional arrangement for short-term advances at the Federal Reserve Bank discount window). Regular liquidity stress tests and tests of the contingent liquidity plan are performed to ensure that an adequate amount of available funds can be generated to meet a wide variety of potential liquidity crises including the current COVID-19 pandemic.
Visa Class B Common Stock: Arrow's subsidiary bank, Glens Falls National, like other Visa member banks, bears some indirect contingent liability for Visa's direct liability arising out of certain antitrust claims involving merchant discounts to the extent that Visa's liability might exceed the amount funded in its litigation escrow account. On December 13, 2019 the Court granted final approval to a settlement in this class action lawsuit. But, on January 3, 2020 an appeal of the final-approved order was filed
with the court. It is unknown how long the appeals process will take. When the appeals process is resolved and assuming the balance in the litigation escrow account is sufficient to cover the litigation claims and related expenses, Arrow could potentially realize a gain on the receipt of Visa Class A common stock. At December 31, 2020, Glens Falls National held 27,771 shares of Visa Class B common stock, and utilizing the conversion ratio to Class A common stock at that time, these Class B shares would convert to 45,000 shares of Visa Class A common stock. Since the litigation settlement is not certain, the Company has not recognized any economic value for these shares.
B. RESULTS OF OPERATIONS
The following analysis of net interest income, the provision for loan losses, noninterest income, noninterest expense and income taxes, highlights the factors that had the greatest impact on the results of operations for December 31, 2020 and the prior two years. For a comparison of the years ended December 31, 2018 and 2019, see Part II. Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in our Form 10-K for the year ended December 31, 2019.
I. NET INTEREST INCOME
Net interest income represents the difference between interest, dividends and fees earned on loans, securities and other earning assets and interest paid on deposits and other sources of funds. Changes in net interest income result from changes in the level and mix of earning assets and sources of funds (volume) and changes in the yields earned and interest rates paid (rate). Net interest margin is the ratio of net interest income to average earning assets. Net interest income may also be described as the product of average earning assets and the net interest margin.
CHANGE IN NET INTEREST INCOME
(Dollars In Thousands) (GAAP Basis)
Net interest income was $99.2 million in 2020, an increase of $11.2 million, or 12.7%, from the $88.0 million in 2019. This compared to an increase of $4.0 million, or 4.8%, from 2018 to 2019. Factors contributing to the year-to-year changes in net interest income over the three-year period are discussed in the following portions of this Section B.I.
The following tables reflects the components of net interest income, setting forth, for years ended December 31, 2020, 2019 and 2018: (i) average balances of assets, liabilities and stockholders' equity, (ii) interest and dividend income earned on earning assets and interest expense incurred on interest-bearing liabilities, (iii) average yields earned on earning assets and average rates paid on interest-bearing liabilities, (iv) the net interest spread (average yield less average cost) and (v) the net interest margin (yield) on earning assets. The yield on securities available-for-sale is based on the amortized cost of the securities. Nonaccrual loans are included in average loans.
Average Consolidated Balance Sheets and Net Interest Income Analysis
(GAAP basis)
(Dollars in Thousands)
Changes between periods are attributed to movement in either the average daily balances or average rates for both earning assets and interest-bearing liabilities. Changes attributable to both volume and rate have been allocated proportionately between the categories.
Net Interest Income Rate and Volume Analysis
(Dollars in Thousands) (GAAP basis)
NET INTEREST MARGIN
Arrow's earnings are derived predominantly from net interest income, which is interest income, net of interest expense. Changes in balance sheet composition, including interest-earning assets, deposits, and borrowings, combined with changes in market interest rates, impact net interest income. Net interest margin is net interest income divided by average interest-earning assets. Interest-earning assets and funding sources are managed, including noninterest and interest-bearing liabilities, in order to maximize this margin.
2020 Compared to 2019: Net interest income increased $11.2 million, or 12.7%, to $99 million for the year ended December 31, 2020 from $88.0 million for the year ended December 31, 2019, as the positive impact of continued balance sheet growth outweighed the negative impact of a tighter net interest margin. The net interest margin was 2.99% for the year ended December 31, 2020 as compared to 3.05% for the year ended December 31, 2019. The decrease in net interest margin from the prior year was due to a variety of factors, including historically low interest rates and increased cash balances.
Interest income on investment securities and interest-bearing deposits at banks (cash) decreased $2.9 million, or 20.2%, between the years ended December 31, 2020 and December 31, 2019. Cash balances increased sharply for the year, by $169.0 million, but the average rate paid on excess cash balances fell by 253 basis points as the Federal Reserve cut interest rates to near-zero in March 2020. Average balances on investment securities were higher for the year, but portfolio yields were lower, with fully taxable securities falling by 69 basis points and securities exempt from federal taxes falling by 12 basis points.
Interest income from loans increased $5.0 million, or 5.3%, to $100.5 million for the year ended December 31, 2020 from $95.5 million for the year ended December 31, 2019. Although the Loan portfolio yield dropped by 0.20% in 2020, to 3.98%, continued loan growth pushed interest income higher. Average loan balances increased by $243.1 million, a 10.6% increase over 2019 average balances. Within the loan portfolio, the three principal segments are residential real estate loans, consumer loans
(primarily through the indirect automobile lending program) and commercial loans. The largest increase was in commercial and commercial real estate loans, which increased by $151.1 million or 22.9%, from December 31, 2019. The majority of the increase in commercial loans resulted from the origination of PPP loans, of which $114.6 million remain at December 31, 2020. The residential real estate loan portfolio increased $9.2 million, or 1.0%. The increase in the real estate loan portfolio is net of approximately $83.9 million of loans sold in 2020. In 2020, Arrow originated a higher volume of residential mortgages than in the previous year, and sold a larger volume of these loans to the secondary market. In addition, consumer loans expanded $48.6 million, or 6.0%, reflecting continuing strong automobile sales.
Total interest expense on interest-bearing liabilities decreased $9.0 million, or 41.5%, to $12.7 million for the year ended December 31, 2020 from $21.7 million for the year ended December 31, 2019. Although average interest bearing deposit balances increased by $383.6 million, the total cost of interest-bearing deposits decreased by 0.38% to 0.51%. In addition, average demand deposits, which are non-interest bearing, increased by $140.9 million. Total deposit growth outpaced loan growth in 2020. As a result, excess deposit balances were utilized to pay-down borrowings, and average borrowings decreased by $133.3 million.
II. PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES
Arrow considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy, given the uncertainty involved in evaluating the level of the allowance required to cover loan losses inherent in the loan portfolio, and the material effect that such judgments may have on the results of operations. The provision for loan losses for 2020 was $9.3 million, compared to the $2.1 million provision for 2019. The increase in the allowance reflects loan growth and the uncertainty related to the COVID-19 pandemic. The analysis of the method employed for determining the amount of the loan loss provision is explained in detail in Notes 2, Summary of Significant Accounting Policies, and 5, Loans, to the notes to the Consolidated Financial Statements.
SUMMARY OF THE ALLOWANCE AND PROVISION FOR LOAN LOSSES
(Dollars In Thousands) (Loans, Net of Unearned Income)
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
(Dollars in Thousands)
The allowance for loan losses increased to $29.2 million at year-end 2020 from $21.2 million at year-end 2019, an increase of 38.0%. A variety of factors were considered in evaluating the adequacy of the allowance for loan losses at December 31, 2020 and the provision for loan losses for the year. See Note 5, Loans, to the notes to the Consolidated Financial Statements for a complete list of all the factors used to calculate the provision for loan losses, including the factors that did not change during the year. Most of the adversely classified loans (special mention and substandard - see the definition for these classifications in Note 5, Loans, to the notes to the Consolidated Financial Statements) continued to perform under their contractual terms.
III. NONINTEREST INCOME
The majority of the noninterest income constitutes fee income from services, principally fees and commissions from fiduciary services, deposit account service charges, insurance commissions, net gains (losses) on securities transactions, net gains on sales of loans and other recurring fee income.
ANALYSIS OF NONINTEREST INCOME
(Dollars In Thousands)
2020 Compared to 2019: Total noninterest income in 2020 was $32.7 million, an increase of $4.1 million, or 14.4%, from total noninterest income of $28.6 million for 2019. Income from fiduciary activities increased slightly from 2019 to 2020. Assets under trust administration and investment management at December 31, 2020 were $1.66 billion, an increase of $115.4 million, or 7.5%, from the prior year-end balance of $1.54 billion.
Fees for other services to customers (primarily service charges on deposit accounts, income from debit card transactions, and servicing income on sold loans) were $10.0 million for 2020, decreased slightly as compared to 2019, mostly the result of a decline in overdraft charges.
Insurance commissions decreased by $306 thousand, or 4.3% from 2019 to 2020. The reduction in commissions is due in large part to continued increased competition. Arrow has enacted expense control initiatives related to the insurance business to ensure expenses appropriately correspond to the decreased revenue.
Net loss on securities in 2020 consisted of a change in the fair value of equity investments of $427 thousand and a realized loss of $37 thousand on the sale of securities.
Net gains on the sales of loans increased in 2020 to $3.9 million, from $622 thousand in 2019, an increase of $3.3 million, or 525.2%. Sales increased due to a variety of factors, including strong demand for residential mortgages in our operating markets, favorable market conditions for mortgage sales and strategic balance sheet and interest-rate risk management decisions. The rate at which mortgage loan originations are sold in future periods will depend on various circumstances, including prevailing mortgage rates, other lending opportunities, capital and liquidity needs, and the availability of a market for such transactions. Therefore, Arrow is unable to predict what the retention rate of such loans in future periods may be. Servicing rights are generally retained for loans originated and sold, which also generates additional noninterest income in subsequent periods (fees for other services to customers).
Other operating income increased by $2.0 million, or 134.5% between the two years due to a variety of factors. In 2020, Arrow had a gain on the sale of OREO properties of $192.0 thousand compared to a loss of the sale of OREO properties in 2019 of $242.1 thousand. Fees received as part of interest rate swap agreements increased $781.4 thousand. Arrow purchased additional bank owned life insurance in 2020 which generated an increase in income of $130.6 thousand from the prior year. In 2020, Arrow had a gain on the sale of fixed assets of $16.5 thousand compared to charges related to the disposal of fixed assets of $559.5 thousand in 2019.
IV. NONINTEREST EXPENSE
Noninterest expense is the measure of the delivery cost of services, products and business activities of a company. The key components of noninterest expense are presented in the following table.
ANALYSIS OF NONINTEREST EXPENSE
(Dollars In Thousands)
2020 compared to 2019: Noninterest expense for 2020 amounted to $70.7 million, an increase of $3.2 million, or 4.8%, from 2019. For 2020, the efficiency ratio was 55.69%. This ratio, which is a commonly used non-GAAP financial measure in the banking industry, is a comparative measure of a financial institution's operating efficiency. The efficiency ratio (a ratio where lower is better), as defined by Arrow, is the ratio of operating noninterest expense (excluding intangible asset amortization) to net interest income (on a tax-equivalent basis) plus operating noninterest income (excluding net securities gains or losses). See the discussion of the efficiency ratio on page 4 of this Report under the heading “Use of Non-GAAP Financial Measures.”
Salaries and employee benefits expense, which typically represents between 55% and 60% of total noninterest expense, increased $3.7 million or 9.5%, from 2019. A significant portion of the increase, $1.3 million, was the result of a decrease in the reclassification out of salaries and employee benefits into other operating expenses. Under ASU 2017-07, interest cost, expected return on plan assets, amortization of prior service cost and amortization of net loss are required to be reclassified out of salaries and employee benefits. The reclassification is also a factor contributing to the decrease in other operating expense between 2020 and 2019. Salaries and benefits were also impacted by increased overtime, benefit costs, incentive payments and a recognition bonus that was paid to most employees in 2020. Many of these costs were related to the challenges of the COVID-19 pandemic and the required response needed to address customer needs.
FDIC assessment increased $906 thousand or 577.1%, from 2019 as the result of the increased assets of Arrow's subsidiaries.
Other operating expense decreased $1.4 million, or (14.2)%, from 2019. In addition to the reclassification described above, the remaining decrease was primarily related to travel, supplies and advertising.
V. INCOME TAXES
The following table sets forth the provision for income taxes and effective tax rates for the periods presented.
INCOME TAXES AND EFFECTIVE RATES
(Dollars In Thousands)
The provisions for federal and state income taxes amounted to $11.0 million for 2020, $9.6 million for 2019, and $9.0 million for 2018. The effective income tax rates for 2020, 2019 and 2018 were 21.3%, 20.4% and 19.9%, respectively. The increase in the effective tax rate in 2020 over 2019 and 2018 was primarily due to the reduction of tax exempt investments held and the related investment income.
C. FINANCIAL CONDITION
I. INVESTMENT PORTFOLIO
Beginning January 1, 2018, upon adoption of Accounting Standards Update ("ASU") 2016-01, equity securities with readily determined fair values are stated at fair value, with realized and unrealized gains and losses reported in income. During 2020, 2019 and 2018, Arrow held no trading securities.
The available-for-sale securities portfolio, held-to-maturity securities portfolio and the equity securities portfolio are further detailed below.
Securities Available-for-Sale:
The following table sets forth the carrying value of the securities available-for-sale portfolio at year-end December 31, 2020, December 31, 2019 and December 31, 2018.
SECURITIES AVAILABLE-FOR-SALE
(Dollars In Thousands)
In the periods above, Arrow held no investment securities in the securities portfolio that consisted of or included, directly or indirectly, obligations of foreign governments or government agencies of foreign issuers.
In the periods referenced above, Mortgage-Backed Securities consisted solely of mortgage pass-through securities and Collateralized Mortgage Obligations ("CMOs") issued or guaranteed by U.S. federal agencies. Mortgage pass-through securities provide to the investor monthly portions of principal and interest pursuant to the contractual obligations of the underlying mortgages. CMOs are pools of mortgages, the repayments on which have generally been separated into two or more components (tranches), where each tranche has a separate estimated life and yield. Arrow's practice has been to purchase pass-through securities and CMOs that are issued or guaranteed by U.S. federal agencies, and the tranches of CMOs purchased are generally those having shorter average lives and/or durations. As a result of payment deferrals on underlying loan collateral that make up mortgage-backed securities, some cashflows may be temporarily impacted.
The following table sets forth the maturities of the debt securities in the available-for-sale portfolio as of December 31, 2020. CMOs and other mortgage-backed securities are included in the table based on their expected average lives.
MATURITIES OF DEBT SECURITIES AVAILABLE-FOR-SALE
(Dollars In Thousands)
The following table sets forth the tax-equivalent yields of the debt securities in the available-for-sale portfolio at December 31, 2020.
YIELDS ON SECURITIES AVAILABLE-FOR-SALE
(Fully Tax-Equivalent Basis)
The yields on obligations of states and municipalities exempt from federal taxation were computed on a tax-equivalent basis. The yields on other debt securities shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the amortized cost of the securities at December 31, 2020.
At December 31, 2020 and 2019, the weighted average maturity was 2.3 and 4.2 years, respectively, for debt securities in the available-for-sale portfolio.
At December 31, 2020, the net unrealized gains on securities available-for-sale amounted to $7.8 million. The net unrealized gain or loss on such securities, net of tax, is reflected in accumulated other comprehensive income/loss. The net unrealized gains on securities available-for-sale was $0.6 million at December 31, 2019. For both periods, net unrealized gains were primarily attributable to changes in market rates between the date of purchase and the balance sheet date resulting in higher or lower valuations of the portfolio securities.
For further information regarding the portfolio of securities available-for-sale, see Note 4, Investment Securities, to the notes to the Consolidated Financial Statements.
Securities Held-to-Maturity:
The following table sets forth the carrying value of the portfolio of securities held-to-maturity at December 31 of each of the last three years.
SECURITIES HELD-TO-MATURITY
(Dollars In Thousands)
For a description of certain categories of securities held in the securities held-to-maturity portfolio on the reporting dates, as listed in the table above, specifically, "Mortgage-Backed Securities - Residential" and "Corporate and Other Debt Securities," see the paragraph under "SECURITIES AVAILABLE-FOR-SALE" table, above.
For information regarding the fair value of the portfolio of securities held-to-maturity at December 31, 2020, see Note 4, Investment Securities, to the notes to the Consolidated Financial Statements.
The following table sets forth the maturities of the portfolio of securities held-to-maturity as of December 31, 2020.
MATURITIES OF DEBT SECURITIES HELD-TO-MATURITY
(Dollars In Thousands)
The following table sets forth the tax-equivalent yields of the portfolio of securities held-to-maturity at December 31, 2020.
YIELDS ON SECURITIES HELD-TO-MATURITY
(Fully Tax-Equivalent Basis)
The yields shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the amortized cost of the securities at December 31, 2020. Yields on obligations of states and municipalities exempt from federal taxation were computed on a fully tax-equivalent basis.
At December 31, 2020 and 2019, the weighted average maturity was 2.7 and 3.5 years, respectively, for the debt securities in the held-to-maturity portfolio.
EQUITY SECURITIES
(Dollars In Thousands)
The following table is the schedule of Equity Securities at December 31 of each of the last three years.
II. LOAN PORTFOLIO
The amounts and respective percentages of loans outstanding represented by each principal category on the dates indicated were as follows:
a. Types of Loans
(Dollars In Thousands)
Maintenance of High Quality in the Loan Portfolio: Prior to the COVID-19 pandemic, there were no significant fluctuations in the quality of the loan portfolio or any segment thereof. In general, residential real estate loans have historically been underwritten to secondary market standards for prime loans and Arrow has not engaged in subprime mortgage lending as a business line. Similarly, high underwriting standards have generally been applied to commercial and commercial real estate lending operations and generally in the indirect lending program as well. The economic events related to the COVID-19 pandemic, specifically elevated unemployment and the temporary mandated closure of nonessential business, may impact the ability of our borrowers to satisfy their obligations.
Commercial and Commercial Real Estate Loans: Over the last three years, commercial and commercial real estate loans have continued to grow. Outstanding balances have increased by $151.1 million, $39.7 million and $48.0 million in 2020, 2019 and 2018, respectively.
Substantially all commercial and commercial real estate loans in the loan portfolio were extended to businesses or borrowers located in the Company's regional markets. A portion of the loans in the commercial portfolio have variable rates tied to Prime, LIBOR or FHLBNY rates.
Many of the commercial and commercial real estate loans are in industries that have been heavily impacted by the COVID-19 pandemic. In 2020, Arrow originated over 1,400 PPP loans totaling approximately $142.7 million. The PPP loans have an interest rate of 1% and Arrow expects to earn approximately $5.6 million in fees related to the origination of these loans. The original term on the PPP loans is two years, however the borrower will have the option to apply for forgiveness. Subsequent to the funding of certain PPP loans, additional guidance was provided permitting the term of a PPP loan to be extended to five years if both parties agree to the revised terms. Arrow is recognizing the fees earned over the life of the loan and will accelerate recognition of the fees if the loan is forgiven by the Small Business Administration. Additional government intervention, if any, may mitigate the economic risk to both Arrow and its customers, however, the extent of such intervention and its impact cannot be determined at this time.
Consumer Loans: At December 31, 2020, consumer loans (primarily automobile loans originated through dealerships located primarily in upstate New York and Vermont) represented 33% of loans in the loan portfolio, and continue to be a significant component of the Company's business.
Consumer loan originations have remained strong in 2020, with origination volume for the last three years at $386.4 million, $407.4 million and $391.6 million for 2020, 2019 and 2018, respectively.
The physical sale of vehicles through dealerships had been curtailed for a portion of the year as part of the New York State and Vermont response to the COVID-19 pandemic. Accordingly, we believe, the volume of originations of consumer loans have been impacted. However, the magnitude of the impact cannot be determined.
For credit quality purposes, Arrow assigns potential automobile loan customers into one of four tiers, ranging from lower to higher quality in terms of anticipated credit risk. Arrow's experienced lending staff not only utilizes credit evaluation software tools but also reviews and evaluates each loan individually prior to the loan being funded. Arrow believes that this disciplined approach to evaluating risk has contributed to maintaining the strong credit quality in this portfolio. The COVID-19 pandemic has created elevated unemployment, which may impact borrowers' ability to satisfy their obligations to Arrow. Government intervention may mitigate a significant portion of the credit risk, however, the extent of such intervention and its impact cannot be determined at this time.
Residential Real Estate Loans: In recent years, residential real estate and home equity loans have represented the largest single segment of the loan portfolio (comprising approximately 36% of the entire portfolio at December 31, 2020), slightly higher than the consumer loan portfolio (33% of the portfolio) and the commercial and commercial real estate loans (31%). Gross originations for residential real estate loans (including refinancings of mortgage loans) were $250.1 million, $164.7 million and $142.9 million for the years 2020, 2019, and 2018, respectively.
During each of these years, gross origination totals have significantly exceeded the sum of repayments and prepayments of such loans previously in the portfolio. Arrow may sell portions of these originations in the secondary market, primarily to Freddie Mac. Sales amounted to $83.9 million, or 43.7%, of the total loans originated in 2020. The increase from previous years was due to a variety of factors, including strong demand for residential mortgages in our operating markets, favorable market
conditions for mortgage sales and strategic balance sheet and interest-rate risk management decisions. Sales of originations amounted to $24.5 million for 2019 and $4.3 million for 2018 which represented 16.9% and 3.3%, respectively of the gross originations for those years.
Arrow expects to continue to sell a portion of mortgage loan originations in upcoming periods if market conditions and strategic balance sheet and interest-rate risk management decisions warrant. It is not currently possible to determine the long term economic impact of the COVID-19 pandemic, which had resulted in the temporary closure of non-essential business and elevated unemployment.
The following table indicates the changing mix in the loan portfolio by including the quarterly average balances for the significant loan segments for the past five quarters. The remaining quarter-by-quarter tables present the percentage of total loans represented by each category and the annualized yield of each category.
LOAN PORTFOLIO
Quarterly Average Loan Balances
(Dollars In Thousands)
Percentage of Total Quarterly Average Loans
Quarterly Yield on Loans
The average yield on the loan portfolio decreased from 4.19% for the fourth quarter of 2019 to 3.94% for the fourth quarter of 2020. Market rates declined in 2020, which impacted the new loan yields for fixed rate loans, and variable loan yields as these loans reached their repricing dates. Commercial loan yields were affected by the $142.7 million of PPP loans originated in 2020. Commercial loan yields rose in the 4th quarter due to fees from the Small Business Administration being recognized in full for the $24.8 million loans forgiven in the 4th quarter. Residential real estate yields declined each quarter of 2020 consistent with overall market behavior as well as the effect of variable home equity loans.
Loan Deferrals Related to COVID-19 Pandemic
The COVID-19 pandemic has created economic uncertainty resulting in elevated unemployment as well as the temporary closure of nonessential businesses. In the table below, loans deferred by industry sector as the result of the COVID-19 pandemic are presented and compared to total loans by sector as of December 31, 2020. In accordance with the CARES Act, the deferrals listed below are not considered troubled debt restructurings. In 2020, Arrow originated $142.7 million of PPP loans. These loans are included in the loan balances by sector as listed below, however, these loans are not considered deferred as of December 31, 2020.
PPP Loans
Many of the commercial and commercial real estate loans are in industries that have been heavily impacted by the COVID-19 pandemic. In 2020, Arrow originated over 1,400 PPP loans totaling $142.7 million. The PPP loans have an interest rate of 1% and Arrow expects to earn approximately $5.6 million in fees related to the origination of these loans. The original term on the PPP loans is two years, however the borrower will have the option to apply for forgiveness. Subsequent to the funding of the loans, additional guidance was provided that the term of the loan may be extended to five years if both parties agree to the revised terms. Arrow will recognize the fees earned over the life of the loan and will accelerate recognition of the fees if the loan is forgiven by the Small Business Administration. Arrow expects to fund additional PPP loans in early 2021, subject to the availability of government programs and the needs of the communities Arrow serves.
The following table indicates the respective maturities and interest rate structure of commercial loans and commercial real estate construction loans at December 31, 2020. For purposes of determining relevant maturities, loans are assumed to mature at (but not before) their scheduled repayment dates as required by contractual terms. Demand loans and overdrafts are included in the “Within 1 Year” maturity category. Most of the commercial construction loans are made with a commitment for permanent financing, whether extended by us or unrelated third parties. The maturity distribution below reflects the final maturity of the permanent financing.
b. Maturities and Sensitivities of Loans to Changes in Interest Rates
(Dollars in Thousands)
COMMITMENTS AND LINES OF CREDIT
Stand-by letters of credit represent extensions of credit granted in the normal course of business, which are not reflected in the financial statements at a given date because the commitments are not funded at that time. As of December 31, 2020, the total contingent liability for standby letters of credit amounted to $3.7 million. In addition to these instruments, there are lines of credit to customers, including home equity lines of credit, commitments for residential and commercial construction loans and other personal and commercial lines of credit, which also may be unfunded or only partially funded from time-to-time. Commercial lines, generally issued for a period of one year, are usually extended to provide for the working capital requirements of the borrower. At December 31, 2020, outstanding unfunded loan commitments in the aggregate amount were approximately $399.9 million.
c. Risk Elements
1. Nonaccrual, Past Due and Restructured Loans
The amounts of nonaccrual, past due and restructured loans at year-end for each of the past five years are presented in the table on page 36 under the heading "Summary of the Allowance and Provision for Loan Losses."
Loans are placed on nonaccrual status either due to the delinquency status of principal and/or interest or a judgment by management that the full repayment of principal and interest is unlikely. Unless already placed on nonaccrual status, loans secured by home equity lines of credit are put on nonaccrual status when 120 days past due and residential real estate loans are put on nonaccrual status when 150 days past due. Commercial and commercial real estate loans are evaluated on a loan-by-loan basis and are placed on nonaccrual status when 90 days past due if the full collection of principal and interest is uncertain. Under the Uniform Retail Credit Classification and Account Management Policy established by banking regulators, fixed-maturity consumer loans not secured by real estate must generally be charged-off no later than when 120 days past due. Loans secured with non-real estate collateral in the process of collection are charged-down to the value of the collateral, less cost to sell. Arrow had no material commitments to lend additional funds on outstanding nonaccrual loans at December 31, 2020. Loans past due 90 days or more and still accruing interest are those loans which were contractually past due 90 days or more but because of expected repayments, were still accruing interest.
The balance of loans 30-89 days past due and still accruing interest totaled $9.2 million at December 31, 2020 and represented 0.35% of loans outstanding at that date, as compared to approximately $10.7 million, or 0.45% of loans outstanding at December 31, 2019. These non-current loans at December 31, 2020 were composed of approximately $7.7 million of consumer loans (principally indirect automobile loans), $1.3 million of residential real estate loans and $0.2 million of commercial and commercial real estate loans.
Arrow evaluates nonaccrual loans over $250 thousand and all troubled debt restructured loans individually for impairment. All impaired loans are measured based on either (i) the present value of expected future cash flows discounted at the loan's effective interest rate, (ii) the loan's observable market price or (iii) the fair value of the collateral, less cost to sell, if the loan is collateral dependent. Arrow determines impairment for collateralized loans based on the fair value of the collateral less estimated cost to sell. For other impaired loans, impairment is determined by comparing the recorded value of the loan to the present value of the expected cash flows, discounted at the loan's effective interest rate. Arrow determines the interest income recognition method for impaired loans on a loan-by-loan basis. Based upon the borrowers' payment histories and cash flow projections, interest recognition methods include full accrual or cash basis. The method for measuring all other loans is described in detail in Notes 2, Summary of Significant Accounting Policies, and 5, Loans, to the notes to the Consolidated Financial Statements.
Note 5, Loans, to the notes to the Consolidated Financial Statements contains detailed information on modified loans and impaired loans.
2. Potential Problem Loans
On at least a quarterly basis, the internal credit quality rating is re-evaluated for commercial loans that are either past due or fully performing but exhibit certain characteristics that could reflect well-defined weaknesses. Loans are placed on nonaccrual status when the likely amount of future principal and interest payments are expected to be less than the contractual amounts, even if such loans are not past due.
Periodically, Arrow reviews the loan portfolio for evidence of potential problem loans. Potential problem loans are loans that are currently performing in accordance with contractual terms, but where known information about possible credit problems of the borrower may jeopardize loan repayment and result in a non-performing loan. In the credit monitoring program, Arrow treats loans that are classified as substandard but continue to accrue interest as potential problem loans. At December 31, 2020, Arrow identified 47 commercial loans totaling $38.1 million as potential problem loans. At December 31, 2019, Arrow identified 54 commercial loans totaling $32.0 million as potential problem loans. For these loans, although positive factors such as payment history, value of supporting collateral, and/or personal or government guarantees led Arrow to conclude that accounting for them as non-performing at year-end was not warranted, other factors, specifically, certain risk factors related to the loan or the borrower justified concerns that they may become nonperforming at some point in the future.
The economic impact of the COVID-19 pandemic, specifically unemployment levels and the temporary mandated closure of nonessential businesses, may impact borrowers' ability to satisfy their obligations, and may therefore result in increased delinquencies. Government interventions, on both the federal and state level, have been deployed to mitigate a significant portion of the credit risk. Arrow cannot make a determination as to the overall impact on its business of the COVID-19 pandemic at this time.
3. Foreign Outstandings - None
4. Loan Concentrations
The loan portfolio is well diversified. There are no concentrations of credit that exceed 10% of the portfolio, other than the general categories reported in the preceding Section C.II.a. of this Item 7, beginning on page 42. For further discussion, see Note 1, Risks and Uncertainties, to the notes to the Consolidated Financial Statements.
5. Other Real Estate Owned and Repossessed Assets
Other real estate owned ("OREO") primarily consists of real property acquired in foreclosure. OREO is carried at fair value less estimated cost to sell. Arrow establishes allowances for OREO losses, which are determined and monitored on a property-by-property basis and reflect the ongoing estimate of the property's estimated fair value less costs to sell. All Repossessed Assets for each of the five years in the table below consist of motor vehicles.
The following table summarizes changes in the net carrying amount of OREO and the number of properties for each of the periods presented.
III. SUMMARY OF LOAN LOSS EXPERIENCE
The information required in this section is presented in the discussion of the "Provision for Loan Losses and Allowance for Loan Losses" in Part II Item 7, Section B.II. beginning on page 36 of this Report, including:
•Charge-offs and Recoveries by loan type
•Factors that led to the amount of the Provision for Loan Losses
•Allocation of the Allowance for Loan Losses by loan type
The percent of loans in each loan category is presented in the table of loan types in the preceding section on page 42 of this Report.
IV. DEPOSITS
The following table sets forth the average balances of and average rates paid on deposits for the periods indicated.
AVERAGE DEPOSIT BALANCES
(Dollars In Thousands)
Average total deposit balances increased by $524.5 million, or 21.3% in 2020, mainly in the demand deposit and savings deposit categories.
Arrow used reciprocal deposits for a select group of municipalities to reduce the amount of investment securities required to be pledged as collateral for municipal deposits where municipal deposits in excess of the FDIC insurance coverage limits were transferred to other participating banks, divided into portions so as to qualify such transferred deposits for FDIC insurance coverage at each transferee bank. In return, reciprocal amounts are transferred to Arrow in equal amounts of deposits from the participant banks. The balances of reciprocal deposits were $404.2 million and $256.1 million at December 31, 2020 and 2019, respectively.
The following table presents the quarterly average balance by deposit type for each of the most recent five quarters.
DEPOSIT PORTFOLIO
Quarterly Average Deposit Balances
(Dollars In Thousands)
The quarterly average balances of both noninterest-bearing deposits and interest-bearing checking and savings accounts have increased significantly in the last three quarters. Time deposits, over $250,000 as well as other time deposits, have decreased over the last three quarters, including $80.6 million of brokered deposits that matured. Market rates, which began to decline prior to the COVID-19 pandemic, reached historic lows in the first quarter and have remained low for the remainder of 2020. Short term interest rates, heavily impacted by Federal Reserve monetary policy, are not expected to change for an extended period.
In general, there is a seasonal pattern to municipal deposits which dip to a low point in August each year. Account balances tend to increase throughout the fall and into early winter from tax deposits, flatten out after the beginning of the ensuing calendar year, and increase again at the end of March from the electronic deposit of NYS Aid payments to school districts. In addition to seasonal behavior, the overall level of municipal deposit balances fluctuates from year-to-year as a result of local economic factors as well as competition from other banks and non-bank entities.
The total quarterly average balances as a percentage of total deposits are illustrated in the table below.
Demand deposits, as well as lower costing interest-bearing checking accounts and savings deposits, all increased or remained consistent as a percentage of total deposits to the previous year. Higher costing time deposits decreased as a percentage of total deposits.
The total quarterly interest cost of deposits, by type of deposit and in total, for each of the most recent five quarters is set forth in the table below:
Throughout 2020, the total cost of deposits continued to decrease. The Federal Reserve lowered the Fed Funds target rate to 0.00%-0.25% in response to the economic disruption related to the COVID-19 pandemic. Arrow's balance sheet is well positioned for a variety of rate environments.
The maturities of time deposits of $250,000 or more at December 31, 2020 are presented below. (Dollars In Thousands)
V. SHORT-TERM BORROWINGS (Dollars in Thousands)
D. LIQUIDITY
The objective of effective liquidity management is to ensure that the Company has the ability to raise cash when needed at a reasonable cost. This includes the capability of meeting expected and unexpected obligations to Arrow's customers at any time. Given the uncertain nature of customer demands and the need to maximize earnings, Arrow must have available reasonably priced sources of funds, both on- and off-balance sheet, that can be accessed quickly in time of need. With the COVID-19
pandemic, liquidity management is critical for Arrow. Arrow’s liquidity position provides the necessary flexibility to address any unexpected near-term disruptions that may develop as a result of the COVID-19 pandemic such as: reduced cash-flows from the investment and loan portfolios and aggressive funding of programs associated with response efforts.
Arrow's primary sources of available liquidity are overnight investments in federal funds sold, interest bearing bank balances at the Federal Reserve Bank of New York, and cash flow from investment securities and loans. Certain investment securities are categorized as available-for-sale at time of purchase based on their marketability and collateral value, as well as their yield and maturity. The securities available-for-sale portfolio was $365.3 million at year-end 2020, an increase of $8.0 million from the year-end 2019 level. Due to the potential for volatility in market values, Arrow may not always be able to sell securities on short notice at their carrying value, even to provide needed liquidity. Arrow also held interest-bearing cash balances at December 31, 2020 of $338.9 million compared to $23.2 million at December 31, 2019.
In addition to liquidity from cash, short-term investments, investment securities and loans, the Company has supplemented available operating liquidity with additional off-balance sheet sources such as a federal funds lines of credit with correspondent banks and credit lines with the FHLBNY. The federal funds lines of credit are with two correspondent banks totaling $52 million which were not drawn on in 2020.
To support the borrowing relationship with the FHLBNY, Arrow has pledged collateral, including residential mortgage, home equity and commercial real estate loans. At December 31, 2020, Arrow had outstanding collateralized obligations with the FHLBNY of $45 million; as of that date, the unused borrowing capacity at the FHLBNY was approximately $814 million. Brokered deposits have also been identified as an available source of funding accessible in a relatively short time period. At December 31, 2020, the balance of outstanding brokered deposits totaled $47.5 million. Also, Arrow's two bank subsidiaries have each established a borrowing facility with the Federal Reserve Bank of New York, pledging certain consumer loans as collateral for potential "discount window" advances, which are maintained for contingency liquidity purposes. At December 31, 2020, the amount available under this facility was approximately $610 million in the aggregate, and there were no advances then outstanding.
Arrow performs regular liquidity stress tests and tests of the contingent liquidity plan to ensure that an adequate amount of available funds can be generated to meet a wide variety of potential liquidity crises including the current COVID-19 pandemic.
Arrow measures and monitors basic liquidity as a ratio of liquid assets to total short-term liabilities, both with and without the availability of borrowing arrangements. Based on the level of overnight funds investments, available liquidity from the investment securities portfolio, cash flows from the loan portfolio, the stable core deposit base and the significant borrowing capacity, the Company believes that the available liquidity is sufficient to meet all funding needs that may arise in connection with the COVID-19 pandemic or any other reasonably likely events or occurrences, although there can be no assurance that it will be sufficient. At December 31, 2020, Arrow's basic liquidity ratio, including FHLBNY collateralized borrowing capacity, was 32.1% of total assets, or $1.04 billion in excess of Arrow's internally-set minimum target ratio of 4%.
Arrow did not experience any liquidity constraints in 2020 and did not experience any such constraints in recent prior years. Arrow has not at any time during such period been forced to pay above-market rates to obtain retail deposits or other funds from any source.
E. CAPITAL RESOURCES AND DIVIDENDS
Important Regulatory Capital Standards: Dodd-Frank, enacted in 2010, directed U.S. bank regulators to promulgate revised bank organization capital standards, which were required to be at least as strict as the regulatory capital standards for banks then in effect. The Capital Rules under Dodd-Frank were adopted by the Federal bank regulatory agencies in 2013 and became effective for Arrow and its subsidiary banks on January 1, 2015. These Capital Rules are summarized in an earlier section of this Report, "Regulatory Capital Standards," beginning on page 7.
The table below sets forth the various capital ratios achieved by Arrow and its subsidiary banks, Glens Falls National and Saratoga National, as of December 31, 2020, as determined under the bank regulatory capital standards in effect on that date, as well as the minimum levels for such capital ratios that bank holding companies and banks are required to maintain under the Capital Rules (not including the "capital conservation buffer"). As demonstrated in the table, all of Arrow's and the banks' capital ratios at year-end were well in excess of the minimum required levels for such ratios, as established by the regulators. (See Item 1, Section C, under "Regulatory Capital Standards" and Item 8, Note 19 in the Notes to Consolidated Financial Statements, for information regarding the "capital conservation buffer.") In addition, on December 31, 2020, Arrow and each of the banks qualified as "well-capitalized", the highest capital classification category under the revised capital classification scheme recently established by the federal bank regulators, that was in effect on that date.
As reported in the Regulatory Reform section above, the federal bank regulators have issued a final rule to implement the Community Bank Leverage Ratio ("CBLR"), introducing an optional simplified measure of capital adequacy for qualifying community banks that satisfy certain requirements, including having a leverage ratio of greater than 9%, less than $10 billion in
total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community bank that opts into the CBLR framework and meets all requirements under the CBLR framework will be considered to have met the well-capitalized ratio requirements under the “prompt corrective action” regulations and will not be required to report or calculate risk-based capital ratios. The CBLR is calculated as the ratio of “tier 1 capital” divided by “average total consolidated assets.” This final rule was effective as of January 1, 2020, and qualifying community banks can utilize the CBLR framework for purposes of filing their call reports or Form FR Y-9C, as applicable, for the first quarter of 2020 (i.e., as of March 31, 2020). Arrow elected to opt out of utilizing the CBLR framework. The Capital Rules promulgated under Dodd-Frank will remain applicable to Arrow.
Stockholders' Equity at Year-end 2020: Total stockholders' equity was $334.4 million at December 31, 2020, an increase of $32.7 million, or 10.8%, from the year earlier level. The increase in total stockholders' equity during 2020 principally reflected the following factors: $40.83 million of net income for the year, plus $1.81 million of equity related to various stock-based compensation plans, plus $1.81 million of equity resulting from the dividend reinvestment plan, plus other comprehensive income of $5.54 million reduced by cash dividends of $15.74 million and the repurchases of common stock of $1.58 million.
Trust Preferred Securities: In each of 2003 and 2004, Arrow issued $10 million of trust preferred securities (TRUPs) in a private placement. Under the Federal Reserve Board's regulatory capital rules then in effect, TRUPs proceeds typically qualified as Tier 1 capital for bank holding companies such as Arrow, but only in amounts up to 25% of Tier 1 capital, net of goodwill less any associated deferred tax liability. Under the Dodd-Frank Act, any trust preferred securities that Arrow might issue on or after the grandfathering date set forth in Dodd-Frank (May 19, 2010) would not qualify as Tier 1 capital under bank regulatory capital guidelines. For Arrow, TRUPs outstanding prior to the grandfathering cutoff date set forth in Dodd-Frank (May 19, 2010) would continue to qualify as Tier 1 capital until maturity or redemption, subject to limitations. Thus, Arrow's outstanding TRUPs continue to qualify as Tier 1 regulatory capital, subject to such limitations.
In the first quarter of 2020, Arrow entered into two interest rate swap agreements to synthetically fix the variable rate interest payments associated with $20 million in outstanding subordinated trust securities. The effective fixed rate is 3.43% until maturity. These agreements are designated as cash flow hedges.
Dividends: The source of funds for the payment by Arrow of cash dividends to stockholders consists primarily of dividends declared and paid to it by its bank subsidiaries. In addition to legal and regulatory limitations on payments of dividends by Arrow (i.e., the need to maintain adequate regulatory capital), there are also legal and regulatory limitations applicable to the payment of dividends by the bank subsidiaries to Arrow. As of December 31, 2020, under the statutory limitations in national banking law, the maximum amount that could have been paid by the bank subsidiaries to Arrow, without special regulatory approval, was approximately $71.8 million The ability of Arrow and its banks to pay dividends in the future is and will continue to be influenced by regulatory policies, capital guidelines and applicable laws.
See Part II, Item 5, "Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for a recent history of its cash dividend payments.
Stock Repurchase Program: In October 2019, the Board of Directors approved a $5.0 million stock repurchase program. effective January 1, 2020 (the 2020 program), under which management was authorized, in its discretion, to cause Arrow to repurchase up to $5 million of shares of Arrow's common stock during 2020, in the open market or in privately negotiated transactions, to the extent management believed the Company's stock was reasonably priced and such repurchases appeared to be an attractive use of available capital and in the best interests of its shareholders. This 2020 program replaced a similar repurchase program which was in effect over the period from January 30, 2019 through December 31, 2019 (the 2019 program), which also authorized the repurchase of up to $5.0 million of shares of Arrow's common stock. As of December 31, 2020 approximately $1.5 million had been used under the 2020 program to repurchase Arrow shares. This total does not include approximately $1.6 million of Arrow's Common Stock that the Company repurchased during 2020 other than through its repurchase program, i.e., repurchases of Arrow shares on the market utilizing funds accumulated under Arrow's Dividend Reinvestment Plan and the surrender or deemed surrender of Arrow stock to the Company in connection with employees' stock-for-stock exercises of compensatory stock options to buy Arrow stock. The 2020 program expired on December 31, 2020. A similar 2021 program, allowing for stock repurchases of up to $5 million over the period of January 27, 2021 through December 31, 2021, was approved by the Board of Directors in January 2021.
F. OFF-BALANCE SHEET ARRANGEMENTS
In the normal course of operations, Arrow may engage in a variety of financial transactions or arrangements, including derivative transactions or arrangements, that in accordance with GAAP are not recorded in the financial statements, or are recorded in amounts that differ from the notional amounts. These transactions or arrangements involve, to varying degrees, elements of credit, interest rate, and liquidity risk. Such transactions or arrangements may be used by Arrow or Arrow's customers for general corporate purposes, such as managing credit, interest rate, or liquidity risk or to optimize capital, or may be used by Arrow or Arrow's customers to manage funding needs.
In 2020 and 2019, Arrow entered into interest rate swap agreements with its commercial customers to provide them with a long-term fixed rate, while simultaneously Arrow entered into offsetting interest rate swap agreements with a counterparty to swap the fixed rate to a variable rate to manage interest rate exposure. In the first quarter of 2020, Arrow entered into two interest rate swap agreements to synthetically fix the variable rate interest payments associated with $20 million in outstanding subordinated trust securities.
Arrow's commercial loan interest rate swap agreements are not designated as a hedge for accounting purposes. The commercial loan interest rate swap agreements have substantially equivalent and offsetting terms, they do not present any material exposure to Arrow's consolidated statements of income. Arrow records its interest rate swap agreements at fair value and is presented on a gross basis within other assets and other liabilities on the consolidated balance sheets. Changes in the fair value of assets and liabilities arising from these derivatives are included, net, in other income in the consolidated statement of income.
G. CONTRACTUAL OBLIGATIONS (Dollars In Thousands)
1 See Note 10, Debt, to the Consolidated Financial Statements for additional information on Federal Home Loan Bank Advances, including call provisions.
2 See Note 10, Debt, to the Consolidated Financial Statements for additional information on Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts (trust preferred securities).
3 See Note 18, Leases, to the Consolidated Financial Statements for additional information on Operating Lease Obligations.
4 See Note 13, Retirement Benefit Plans, to the Consolidated Financial Statements for additional information on Retirement Benefit Plans.
H. RECENTLY ISSUED ACCOUNTING STANDARDS
The following accounting standards have been issued and become effective for the Company at a future date:
In June 2016, the FASB issued ASU 2016-13 "Financial Instruments - Credit Losses" ("CECL") which will change the way financial entities measure expected credit losses for financial assets, primarily loans. Under this ASU, the "incurred loss" model will be replaced with an "expected loss" model which will recognize losses over the life of the instrument and requires consideration of a broader range of reasonable and supportable information. Currently, credit losses on available-for-sale securities reduce the carrying value of the instrument and cannot be reversed. Under CECL, the amount of the credit loss is carried as a valuation allowance and can be reversed. The standard also requires expanded credit quality disclosures. In April 2019, the FASB issued ASU 2019-04 "Codification Improvements to Topic 326, Financial Instruments-Credit Losses; Topic 815, Derivatives and Hedging; and Topic 825, Financial Instruments," which clarifies that the estimate of expected credit losses should include expected recoveries of financial assets, and that contractual extension or renewal options that are not unconditionally cancellable by the lender are considered when determining the contractual term over which expected credit losses are measured. The Company's loan terms for contractual extensions and renewal options are unconditionally cancellable by the Company (that is, the Company has no obligation to extend or renew existing loans), and therefore are not considered in measuring expected credit losses. In May 2019, the FASB issued ASU 2019-05 "Targeted Transition Relief," which allows entities to irrevocably elect the fair value option for certain financial assets measured at amortized cost, not including held-to-maturity investment securities which will continue to be measured at amortized cost. This will apply to those institutions that elect the fair value option on newly originated or purchased financial assets, to avoid the possibility of dual measurement methodologies for identical or similar financial assets.
As permitted by the Coronavirus Aid, Relief, and Economic Security ("CARES") Act, Arrow deferred the adoption of the Current Expected Credit Losses ("CECL") methodology in determining credit losses until January 1, 2021. The initial adjustment to the allowance for credit losses and unfunded commitments recorded as other liabilities was not reported in earnings, but as the cumulative effect of a change in accounting principle and the adoption will require additional disclosures in future periods. To prepare for the adoption of CECL, (a) the Company held CECL working group meetings that included individuals from various functional areas relevant to the implementation of CECL; (b) the CECL working group developed accounting policies for credit losses including, among other things, management’s decisions regarding portfolio segmentation, life of loan considerations, and a reasonable and supportable forecasting methodology; (c) the Company established a CECL governance and approval process, and completed an analysis of the results from a third-party model validation and the results from an internal model validation; and (d) the Company established an internal control framework and finalized the testing of controls related to the adoption of CECL. The CECL pronouncement describes several acceptable methodologies for calculating expected losses on a loan or a pool of loans. Arrow identified the discounted cash flow method for determining losses for the commercial loan portfolios and the residential real estate portfolios, and the vintage method for the consumer indirect loan portfolio. As a result of analyses performed, including the availability of future economic data, the Company will utilize an 18-month reasonable and supportable forecast period, and revert to an historic net loss rate using the straight-line method over a two year reversion period. The Company has identified the economic data that it believes best correlate with expected credit losses through the use of various regression analyses of historical economic information and loan losses. The Company has developed a qualitative factor framework in accordance with this standard that has changed how qualitative factors are determined as compared to the current incurred loss allowance for loan losses model, and has developed a methodology to determine unfunded loan commitments that are recorded as other liabilities. The Company has continued to monitor updates to financial reporting requirements and regulatory guidance, and evaluated the impact on the consolidated financial statements, disclosures, processes and internal controls.
The Company has performed parallel CECL reserve estimated calculations for each quarterly period beginning December 31, 2019 and is completing its final review of the most recent model run including an evaluation of model back-testing and sensitivity analysis results and finalizing certain assumptions primarily related to qualitative factor adjustments. The Company does not expect to incur a material adjustment to the stockholders' equity balance as of January 1, 2021 related to the adoption of CECL for held-to-maturity securities, loans carried at amortized cost and unfunded commitments recorded as other liabilities. In addition, the Company has also evaluated the composition of the available-for-sale investment securities portfolio and determined that the changes in ASU 2016-13 will not have a significant effect on the current portfolio.
With the adoption of CECL on January 1, 2021, Arrow expects to remain a well-capitalized financial institution. Regulators have developed a deferral option related to the adoption of CECL and the resulting computation of regulatory capital ratios, the 2019 CECL Rule, which allows a financial institution to elect a three year deferral of the initial CECL adoption amount for the computation of regulatory capital. Arrow is in the process of evaluating this deferral method.
In December 2019, the FASB issued ASU 2019-12 "Simplifying the Accounting for Income Taxes" (Topic 740), which removes certain exceptions to the general principles in Topic 740 and improves consistent application of and simplifies GAAP for other areas of Topic 740 by clarifying and amending existing guidance. This ASU is effective for fiscal years beginning after December 15, 2020 and interim periods within those fiscal years, with early adoption permitted. Arrow adopted this standard on January 1, 2021. The Company does not expect that the adoption of this standard will have a material impact on its financial position or the results of operations in periods subsequent to its adoption.
I. FOURTH QUARTER RESULTS
Arrow reported net income of $12.5 million for the fourth quarter of 2020, an increase of $2.8 million, or 28.3%, from the net income of $9.7 million reported for the fourth quarter of 2019. Diluted earnings per common share for the fourth quarter of 2020 were $0.81, up from $0.63 during the fourth quarter of 2019. The net change in earnings between the two quarters was due to the following: (a) a $2.9 million increase in net interest income, (b) a $2.0 million increase in noninterest income, (c) a $602 thousand increase in the provision for loan losses, (d) a $1.1 million increase in noninterest expense, and (e) a $1.1 million increase in the provision for income taxes. The principal factors contributing to these quarter-to-quarter changes are included in the discussion of the year-to-year changes in net income set forth elsewhere in this Item 7, specifically, in Section B, "Results of Operations," above, as well as in Arrow's Current Report on Form 8-K, as filed with the SEC on January 28, 2021, incorporating by reference Arrow's earnings release for the year ended December 31, 2020.
SELECTED FOURTH QUARTER FINANCIAL INFORMATION
(Dollars In Thousands, Except Per Share Amounts)
SUMMARY OF QUARTERLY FINANCIAL DATA (Unaudited)
The following quarterly financial information for 2020 and 2019 is unaudited, but, in the opinion of management, fairly presents the results of Arrow.
SELECTED QUARTERLY FINANCIAL DATA
(Dollars In Thousands, Except Per Share Amounts)
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
In addition to credit risk in the loan portfolio and liquidity risk, discussed earlier, the Company's business activities also generate market risk. Market risk is the possibility that changes in future market rates (interest rates) or prices (market value of financial instruments) will make the Company's position (i.e. assets and operations) less valuable. The Company's primary market risk is interest rate volatility. The ongoing monitoring and management of interest rate risk is an important component of the asset/liability management process, which is governed by policies that are reviewed and approved annually by the Board of Directors. The Board of Directors delegates responsibility for carrying out asset/liability oversight and control to management's Asset/Liability Committee ("ALCO"). In this capacity ALCO develops guidelines and strategies impacting the asset/liability profile based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends.
Changes in market interest rates, whether increases or decreases, can trigger repricing and changes in the pace of payments for both assets and liabilities (prepayment risk). This may individually or in combination affect net interest income, net interest margin, and ultimately net income, either positively or negatively. ALCO utilizes the results of a detailed and dynamic simulation model to quantify this interest rate risk by projecting net interest income in various interest rate scenarios.
The Company's standard simulation model applies a parallel shift in interest rates, ramped over a 12-month period, to capture the impact of changing interest rates on net interest income. The results are compared to ALCO policy limits which specify a maximum tolerance level for net interest income exposure over one and two year periods, assuming no balance sheet growth and a 200 basis point upward and a 100 basis point downward shift in interest rates. Additional tools to monitor potential longer-term interest rate risk, including periodic stress testing involving hypothetical sudden and significant interest rate spikes are also evaluated.
The following table summarizes the percentage change in net interest income as compared to the base scenario, which assumes no change in market interest rates as generated from the standard simulation model. The results are presented for each of the first two years of the simulation period for the 200 basis point increase in interest rate scenario and the 100 basis point decrease in interest rate scenario. These results are well within the ALCO policy limits as shown.
As of December 31, 2020:
Historically, there has existed an inverse relationship between changes in prevailing rates and the Company's net interest income, suggesting that liabilities and sources of funds generally reprice more quickly than earning assets. (near-term liability sensitivity). However, when net interest income is simulated over a longer time frame, this exposure is limited, and actually reverses, as asset yields continue to reprice while the cost of funding reaches assumed ceilings or floors (long-term asset sensitivity).
The simulated results underlying the sensitivity analysis are based upon numerous assumptions including: the nature and timing of changes in interest rates including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurance as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.
Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate changes on caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, unanticipated shifts in the yield curve and other internal/external variables. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates.
Item 8.
Item 8. Financial Statements and Supplementary Data
The following audited Consolidated Financial Statements and unaudited supplementary data are submitted herewith:
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2020 and 2019
Consolidated Statements of Income for the Years Ended December 31, 2020, 2019 and 2018
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2020, 2019 and 2018
Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 2020, 2019 and 2018
Consolidated Statements of Cash Flows for the Years Ended December 31, 2020, 2019 and 2018
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors
Arrow Financial Corporation:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Arrow Financial Corporation and
subsidiaries (the Company) as of December 31, 2020 and 2019, the related consolidated statements of
income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the
three-year period ended December 31, 2020, and the related notes (collectively, the consolidated financial
statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the
financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its
cash flows for each of the years in the three-year period ended December 31, 2020, in conformity with
U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board
(United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2020,
based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of
Sponsoring Organizations of the Treadway Commission, and our report dated March 10, 2021 expressed an
unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these consolidated financial statements based on our audits. We are
a public accounting firm registered with the PCAOB and are required to be independent with respect to the
Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the
Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements
are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to
assess the risks of material misstatement of the consolidated financial statements, whether due to error or
fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test
basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits
also included evaluating the accounting principles used and significant estimates made by management, as
well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits
provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the
consolidated financial statements that was communicated or required to be communicated to the audit
committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial
statements and (2) involved our especially challenging, subjective, or complex judgments. The communication
of a critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as
a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the
critical audit matter or on the accounts or disclosures to which it relates.
Allowance for loan losses related to loans collectively evaluated for impairment
As discussed in Notes 2 and 5 to the consolidated financial statements, the Company’s allowance for loan
losses related to loans collectively evaluated for impairment (ALL) was $29.2 million as of December 31,
2020. The Company estimates the ALL by applying historical net loss rates to pools of loans with similar
risk characteristics. For commercial, commercial construction and commercial real estate loans, the pools
of loans are further segmented by internal credit risk profile grades. The historical net loss rates are
calculated by using a rolling average annual twelve quarter look-back period of the respective segment that
have occurred within each pool of loans over the loss emergence period. The Company adjusts the
historical net loss rates for applicable qualitative factors to reflect incurred risk of losses that are not fully
captured in the historical net loss rates.
We identified the assessment of the ALL as a critical audit matter. A high degree of audit effort, including
specialized skills and knowledge, and subjective and complex auditor judgment was involved in the
assessment of the ALL due to significant measurement uncertainty This assessment of the ALL
encompassed the evaluation of the ALL methodology used to estimate 1) the historical net loss rates for
each pool of loans and their key factors and assumptions, including the lookback period, the loss
emergence periods, and how loans with similar characteristics are pooled, 2) the internal credit risk profile
grades for commercial loans, and 3) the qualitative factors. In addition, auditor judgment was required to
evaluate the sufficiency of audit evidence obtained.
The following are the primary procedures we performed to address this critical audit matter. We evaluated
the design and tested the operating effectiveness of certain internal controls related to the Company’s ALL,
including controls related to the:
• development and approval of the ALL methodology, including key factors and assumptions
• development of the qualitative factors, including key assumptions
• periodic testing of internal credit risk profile grades for commercial loans
• analysis of the ALL results, trends, and ratios.
We evaluated the Company’s process to develop the ALL estimate by testing certain sources of data and
assumptions that the Company used and considered the relevance and reliability of such data and
assumptions, and whether additional factors and alternative assumptions should have been used. We
assessed the qualitative factors by:
• evaluating the maximum qualitative factor based on the peer groups highest annual losses over the
recent full credit cycle
• evaluating the metrics used to determine the qualitative factors by comparing them to the Company’s
business environment and credit risk factors
• evaluating trends in the ALL, including the qualitative factors, for consistency with trends in the loan
portfolio and credit performance.
We involved credit risk professionals with specialized industry knowledge and experience, who assisted in:
• evaluating the Company’s ALL methodology for compliance with U.S. generally accepted accounting
principles
• evaluating the lookback period assumption used in calculating the historical net loss rates to evaluate
the length of the period
• determining whether loans are pooled by similar risk characteristics by comparing to the Company’s
business environment and relevant industry practices
• evaluating the methodology used to develop the loss emergence periods by comparing them to specific
portfolio risk characteristics and trends
• evaluating the methodology used to develop the resulting qualitative factors and the effect of those
adjustments on the ALL compared with relevant credit risk factors and consistency with credit trends
• evaluating the determination of each qualitative factor by comparing it to the Company’s business
environment and credit risk
• testing individual internal credit risk profile grades for a selection of commercial loans by evaluating the
financial performance of the borrower, sources of repayment, and any relevant guarantees or
underlying collateral.
We also assessed the sufficiency of the audit evidence obtained related to the Company’s ALL by
evaluating the:
• cumulative results of the audit procedures
• qualitative aspects of the Company’s accounting practices
• potential bias in the accounting estimate.
/s/ KPMG LLP
We have served as the Company’s auditor since 1990.
Albany, New York
March 10, 2021
Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors
Arrow Financial Corporation:
Opinion on Internal Control Over Financial Reporting
We have audited Arrow Financial Corporation and subsidiaries’ (the Company) internal control over financial
reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework
(2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the
Company maintained, in all material respects, effective internal control over financial reporting as of
December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by
the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board
(United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2020 and
2019, the related consolidated statements of income, comprehensive income, changes in stockholders’ equity,
and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes
collectively, the consolidated financial statements, and our report dated March 10, 2021 expressed an
unqualified opinion on those consolidated financial statements.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial reporting, included in the
accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to
express an opinion on the Company’s internal control over financial reporting based on our audit. We are a
public accounting firm registered with the PCAOB and are required to be independent with respect to the
Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the
Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective internal control over financial
reporting was maintained in all material respects. Our audit of internal control over financial reporting included
obtaining an understanding of internal control over financial reporting, assessing the risk that a material
weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on
the assessed risk. Our audit also included performing such other procedures as we considered necessary in
the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process 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. A company’s internal control over financial reporting
includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements
in accordance with generally accepted accounting principles, and that receipts and expenditures of the
company are being made only in accordance with authorizations of management and directors of the company;
and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use,
or disposition of the company’s assets that could have a material effect on the financial statements.
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.
/s/ KPMG LLP
Albany, New York
March 10, 2021
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars In Thousands, Except Share and Per Share Amounts)
See Notes to Consolidated Financial Statements.
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars In Thousands, Except Per Share Amounts)
Share and Per Share Amounts have been restated for the September 25, 2020 3% stock dividend.
See Notes to Consolidated Financial Statements.
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars In Thousands)
See Notes to Consolidated Financial Statements.
1 Cash dividends paid per share have been adjusted for the September 25, 2020 3% stock dividend.
2 Included in the shares issued for the 3% stock dividend in 2020 were treasury shares of 137,041
See Notes to Consolidated Financial Statements.
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1:RISKS AND UNCERTAINTIES
Nature of Operations - Arrow Financial Corporation, a New York corporation, was incorporated on March 21, 1983 and is registered as a bank holding company within the meaning of the Bank Holding Company Act of 1956. The banking subsidiaries are Glens Falls National Bank and Trust Company (Glens Falls National or GFNB) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (Saratoga National or SNB) whose main office is located in Saratoga Springs, New York. The two banks provide a full range of services to individuals and small to mid-size businesses in northeastern New York State from Albany, the State's capitol, to the Canadian border. Both banks have wealth management departments which provide investment management and administrative services. An active subsidiary of Glens Falls National is Upstate Agency LLC, offering insurance services including property, and casualty insurance, group health insurance and individual life insurance products. North Country Investment Advisers, Inc., a registered investment adviser that provides investment advice to our proprietary mutual funds, and Arrow Properties, Inc., a real estate investment trust, or REIT, are subsidiaries of Glens Falls National. Arrow also owns directly two subsidiary business trusts, organized in 2003 and 2004 to issue trust preferred securities (TRUPs), which are still outstanding.
Concentrations of Credit - Virtually all of Arrow's loans are with borrowers in upstate New York. Although the loan portfolios of the subsidiary banks are well diversified, tourism has a substantial impact on the northeastern New York economy. The commitments to extend credit are fairly consistent with the distribution of loans presented in Note 5, "Loans," generally have the same credit risk and are subject to normal credit policies. Generally, the loans are secured by assets and are expected to be repaid from cash flow or the sale of selected assets of the borrowers. Arrow evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by Arrow upon extension of credit, is based upon management's credit evaluation of the counterparty. The nature of the collateral varies with the type of loan and may include: residential real estate, cash and securities, inventory, accounts receivable, property, plant and equipment, income producing commercial properties and automobiles.
Note 2:SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation - The financial statements of Arrow and its wholly owned subsidiaries are consolidated and all material inter-company transactions have been eliminated. In the “Parent Company Only” financial statements in Note 21, the investment in wholly owned subsidiaries is carried under the equity method of accounting. When necessary, prior years’ Consolidated Financial Statements have been reclassified to conform to the current-year financial statement presentation.
The Company determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a variable interest entity under GAAP. Voting interest entities are entities in which the total equity investment at risk is sufficient to enable the entity to finance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. The Company consolidates voting interest entities in which it has all, or at least a majority of, the voting interest. As defined in applicable accounting standards, variable interest entities (VIE) are entities that lack one or more of the characteristics of a voting interest entity. A controlling financial interest in a VIE is present when the Company has both the power and ability to direct the activities of the VIE that most significantly impact the VIE's economic performance and an obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE. The Company’s wholly owned subsidiaries Arrow Capital Statutory Trust II and Arrow Capital Statutory Trust III are VIEs for which the Company is not the primary beneficiary. Accordingly, the accounts of these entities are not included in the Company’s Consolidated Financial Statements.
Segment Reporting - Arrow operations are primarily in the community banking industry, which constitutes Arrow’s only segment for financial reporting purposes. Arrow provides other services, such as trust administration, retirement plan administration, advice to the Company's proprietary mutual funds and insurance products, but these services do not rise to the quantitative thresholds for separate disclosure. Arrow operates primarily in the northeastern region of New York State in Warren, Washington, Saratoga, Essex, Clinton, Rensselaer, Albany, and Schenectady counties and surrounding areas.
Cash and Cash Equivalents - Cash and cash equivalents include the following items: cash at branches, due from bank balances, cash items in the process of collection, interest-bearing bank balances and federal funds sold.
Securities - Management determines the appropriate classification of securities at the time of purchase. Securities reported as held-to-maturity are those debt securities which Arrow has both the positive intent and ability to hold to maturity and are stated at amortized cost. Securities available-for-sale are reported at fair value, with unrealized gains and losses reported in accumulated other comprehensive income or loss, net of taxes. Equity securities with readily determinable fair values are stated at fair value with realized and unrealized gains and losses reported in income.
Realized gains and losses are based upon the amortized cost of the specific security sold. A decline in the fair value of any available-for-sale or held-to-maturity security below cost that is deemed to be other-than-temporary results in an impairment to reduce the carrying amount to fair value. To determine whether an impairment is other-than-temporary, all available information relevant to the collectability of the security is considered, including past events, current conditions, and reasonable and supportable forecasts when developing an estimate of cash flows expected to be collected. Evidence considered in this assessment includes the reasons for impairment, the severity and duration of the impairment, changes in value subsequent to year-end, forecasted performance of the investee, and the general market condition in the geographic area or industry the investee operates in. When an other-than-temporary impairment has occurred on a debt security, the amount of the other-than-temporary impairment recognized in earnings depends on whether the Company intends to sell the debt security or if it is more likely than not that the Company will be required to sell the debt security before recovery of its amortized cost basis less any current-period credit loss. If it is more likely than not that the Company will be required to sell the debt security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If the Company does not intend to sell the debt security and it is not more likely than not that the Company will be required to sell the debt security before recovery of its amortized cost basis, the other-than-temporary impairment is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to other factors is recognized in other comprehensive income, net of applicable income taxes. Investments in Federal Reserve Bank and Federal Home Loan Bank (“FHLB”) stock are required for membership in those organizations and are carried at cost since there is no market value available. The FHLB New York continues to pay dividends and repurchase stock. As such, the Company has not recognized any impairment on its holdings of Federal Reserve Bank and FHLB stock.
Loans and Allowance for Loan Losses - Loans are reported at their principal outstanding balance, net of deferred fees and costs, and unearned income. Arrow has the intent and ability to hold to maturity. Interest income on loans is accrued and credited to income based upon the principal amount outstanding. Loan fees and costs directly associated with loan originations are deferred and amortized/accreted as an adjustment to yield over the lives of the loans originated.
Arrow originated loans to commercial borrowers under the PPP during 2020. PPP loans have an interest rate of 1% and include an origination and servicing fee as a result of originating these loans. The original term on the PPP loans is two years, however the borrower will have the option to apply for forgiveness. Subsequent to the funding of the loans, additional guidance was provided permitting the term of a PPP loan to be extended to five years if both parties agree to the revised terms. Arrow is recognizing the fees earned over the life of the loan and will accelerate recognition of the fees if the loan is forgiven by the Small Business Administration.
From time-to-time, Arrow has sold (most with servicing retained) residential real estate loans at or shortly after origination. Any gain or loss on the sale of loans, along with the value of the servicing right, is recognized at the time of sale as the difference between the recorded basis in the loan and net proceeds from the sale. Loans held for sale are recorded at the lower of cost or fair value on an aggregate basis.
Loans are placed on nonaccrual status either due to the delinquency status of principal and/or interest or a judgment by management that the full repayment of principal and interest is unlikely. Unless already placed on nonaccrual status, loans secured by home equity lines of credit are put on nonaccrual status when 120 days past due; residential real estate loans when 150 days past due; commercial and commercial real estate loans are evaluated on a loan-by-loan basis and are placed on nonaccrual status when 90 days past due if the full collection of principal and interest is uncertain; all other loans are to be moved to nonaccrual status upon the earliest occurrence of repossession, bankruptcy, delinquency of 90 days or more unless the loan is secured and in the process of collection with no loss anticipated or when full collection of principal and interest is in doubt.
The balance of any accrued interest deemed uncollectible at the date the loan is placed on nonaccrual status is reversed, generally against interest income. A loan is returned to accrual status at the later of the date when the past due status of the loan falls below the threshold for nonaccrual status or management deems that it is likely that the borrower will repay all interest and principal. For payments received while the loan is on nonaccrual status, Arrow may recognize interest income on a cash basis if the repayment of the remaining principal and accrued interest is deemed likely.
The allowance for loan losses is maintained by charges to operations based upon the Company's best estimate of the probable amount of loans that will not be able to collected based on current information. Provisions to the allowance for loan losses are offset by actual loan charge-offs (net of any recoveries). The loan portfolio is evaluated for potential charge-offs on a monthly basis. In general, automobile and other consumer loans are charged-off when 120 days delinquent. Residential real estate loans are charged-off when a loss becomes known or based on a new appraisal at the earlier of 180 days past due or repossession. Commercial and commercial real estate loans are evaluated early in their delinquency status and are charged-off when management concludes that not all principal will be repaid from on-going cash flows or liquidation of collateral. An evaluation of estimated proceeds from the liquidation of the loan’s collateral is compared to the loan carrying amount and a charge to the allowance for loan losses is taken for any deficiency. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions in Arrow's market area. In addition, various Federal regulatory agencies, as an integral part of their examination process, review Arrow's allowance for loan losses. Such agencies may require Arrow to recognize additions to the allowance in future periods, based on their judgments about information available to them at the time of their examination, which may not be currently available to management.
All nonaccrual loans over $250 thousand and all troubled debt restructured loans are considered to be impaired loans and these loans are evaluated individually to determine the amount of impairment, if any. The amount of impairment, if any, related
to individual impaired loans is measured based on either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Arrow determines impairment for collateral dependent loans based on the fair value of the collateral less estimated costs to sell. Any excess of the recorded investment in the collateral dependent impaired loan over the estimated collateral value, less costs to sell, is typically charged off. For impaired loans which are not collateral dependent, impairment is measured by comparing the recorded investment in the loan to the present value of the expected cash flows, discounted at the loan’s effective interest rate. If this amount is less than the recorded investment in the loan, an impairment reserve is recognized as part of the allowance for loan losses, or based upon the judgment of management all or a portion of the excess of the recorded investment in the loan over the present value of the estimated future cash flow may be charged off.
The allowance for loan losses on the remaining loans is primarily determined based upon consideration of the historical net loss factor incorporating a rolling average annual twelve quarter look-back period of the respective segment that have occurred within each pool of loans over the loss emergence period (LEP), adjusted as necessary based upon consideration of qualitative considerations impacting the inherent risk of loss in the respective loan portfolios. The LEP is an estimate of the average amount of time from the point at which a loss is incurred on a loan to the point at which the loss is recognized in the financial statements. Since the LEP may change under various economic environments, the LEP calculation is updated on an annual basis. In addition to historical net loss factors, qualitative factors that impact the inherent risk of loss associated with the loan categories within total loan portfolio are evaluated. These include:
•Changes in the volume and severity of past due, nonaccrual and adversely classified loans
•Changes in the nature and volume of the portfolio and in the terms of loans
•Changes in the value of the underlying collateral for collateral dependent loans
•Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating loan losses
•Changes in the quality of the loan review system
•Changes in the experience, ability, and depth of lending management and other relevant staff
•Changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio
•The existence and effect of any concentrations of credit, and changes in the level of such concentrations
•The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated loan losses in the existing portfolio or pool
In management’s opinion, the balance of the allowance for loan losses, at each balance sheet date, is sufficient to provide for probable loan losses inherent in the corresponding loan portfolio.
Comprehensive Income (Loss) - For the Company, comprehensive income (loss) represents net income plus unrealized net securities holding gains or losses arising during the year (net of taxes), net retirement plan gain or loss (net of taxes), net retirement plan prior service cost (net of taxes), amortization of net retirement plan actuarial gain or loss (net of taxes) and amortization of net retirement plan prior service credit or cost (net of taxes) and is presented in the Consolidated Statements of Comprehensive Income (Loss) and Consolidated Statements of Changes in Shareholders’ Equity. Accumulated other comprehensive income (loss) represents the unrealized net securities holding gains or losses arising during the year (net of taxes), net retirement plan gain or loss (net of taxes), net retirement plan prior service cost (net of taxes), amortization of net retirement plan actuarial gain or loss (net of taxes) and amortization of net retirement plan prior service credit or cost (net of taxes) in the Company’s defined-benefit retirement and pension plan, supplemental employee retirement plan, and post-retirement life and healthcare benefit plan.
Revenue Recognition - The following is a description of principal activities from which the Company generates its revenue from noninterest income sources.
Income from Fiduciary Activities: represents revenue derived mainly through the management of client investments which is based on the market value of the covered assets and the fee schedule contained in the applicable account management agreement. Since the revenue is mainly based on the market value of assets, this amount can be volatile as financial markets increase and decrease based on various economic factors. The terms of the account management agreements generally specify that the performance obligations are completed each quarter. Accordingly, the Company mainly recognizes revenue from fiduciary activities on a quarterly basis.
Fees for Other Services to Customers: represents general service fees for monthly deposit account maintenance and account activity plus fees from other deposit-based services. Revenue is recognized when the performance obligation is completed, which is generally on a monthly basis for account maintenance services, or upon the completion of a deposit-related transaction. Payment for these performance obligations is generally received at the time the performance obligations are satisfied.
Insurance Commissions: represents commissions and fees paid by insurance carriers for both property and casualty insurance policies, and for services performed for employment benefits clients. Revenue from the property and casualty insurance business is recognized when the performance obligation is satisfied, which is generally the effective date of the bound coverage since there are no significant performance obligations remaining. Revenue from the employment benefit brokerage business is recognized when the benefit servicing performance obligations are satisfied, generally on a monthly basis.
Other Real Estate Owned and Repossessed Assets - Real estate acquired by foreclosure and assets acquired by repossession are recorded at the fair value of the property less estimated costs to sell at the time of repossession. Subsequent declines in fair value, after transfer to other real estate owned and repossessed assets are recognized through a valuation
allowance. Such declines in fair value along with related operating expenses to administer such properties or assets are charged directly to operating expense.
Premises and Equipment - Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization included in operating expenses are computed largely on the straight-line method. Depreciation is based on the estimated useful lives of the assets (buildings and improvements 20-40 years; furniture and equipment 7-10 years; data processing equipment 5-7 years) and, in the case of leasehold improvements, amortization is computed over the terms of the respective leases or their estimated useful lives, whichever is shorter. Gains or losses on disposition are reflected in earnings.
Leases - The Company recognizes right-of-use assets and lease liabilities on the balance sheet for all leases with terms longer than 12 months, and has elected not to separate lease and non-lease components, but accounts for the resulting combined component as a single lease component. The Company also elected to account for short-term leases, those leases with a "lease term" of twelve months or less, as an operating lease. Since the Company has not been able to determine the rate implicit in its leases, the secured borrowing rate from the Federal Home Loan Bank of New York is utilized to determine the lease discount rate. The expected expiration date of each new lease is determined on a lease-by-lease basis based on certain criteria, such as the availability of renewal options in the lease contracts, the amount of leasehold improvements required in addition to the feasibility of growth potential.
Investments in Real Estate Limited Partnerships - These limited partnerships acquire, develop and operate low and moderate-income housing. As a limited partner in these projects, Arrow receives low income housing tax credits and tax deductions for losses incurred by the underlying properties. The proportional amortization method allowed in Accounting Standards Update 2014-01 "Investments - Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects" is applied. The proportional amortization method permits an entity to amortize the initial cost of the investment in proportion to the amount of the tax credits and other tax benefits received and to recognize the net investment performance in the income statement as a component of income tax expense.
Investments in Historical Tax Credits - Arrow accounts for historic rehabilitation tax credits using the deferral method of accounting under which the tax benefit generated from an investment tax credit is recorded as a reduction to the GAAP asset basis. Accordingly, Arrow recognized a current tax receivable and a deferred tax asset and corresponding reduction in the basis of Arrow's historic tax credit investment.
Bank-Owned Life Insurance - Arrow has purchased life insurance policies on certain employees, key executives and directors. Bank-owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Derivative Instruments and Hedging Activities - Arrow enters into interest rate swap agreements that are not designated as hedges for accounting purposes. As the interest rate swap agreements have substantially equivalent and offsetting terms, they do not present any material exposure to Arrow's consolidated statements of income. Arrow records its interest rate swap agreements at fair value and is presented on a gross basis within other assets and other liabilities on the consolidated balance sheets. Changes in the fair value of assets and liabilities arising from these derivatives are included, net, in other income in the consolidated statement of income.
In addition, Arrow has entered into interest rate swaps to synthetically fix the variable rate interest payments in outstanding subordinated trust securities. These agreements are designated as cash flow hedges. For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in Accumulated Other Comprehensive Income and subsequently reclassified into interest expense in the same period during which the hedge transaction affects earnings.
Income Taxes - Arrow accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date. Arrow’s policy is that deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
Goodwill and Other Intangible Assets - Identifiable intangible assets acquired in a business combination are capitalized and amortized. Any remaining unidentifiable intangible asset is classified as goodwill, for which amortization is not required but which must be evaluated for impairment. Arrow tests for impairment of goodwill on an annual basis, or when events and circumstances indicate potential impairment. In evaluating goodwill for impairment, Arrow first assesses certain qualitative factors to determine if it is more likely than not that the fair value of the reporting unit is less than its carrying value. If it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any.
The carrying amounts of other recognized intangible assets that meet recognition criteria and for which separate accounting records have been maintained (mortgage servicing rights and customer intangibles), have been included in the consolidated balance sheet as “Other Intangible Assets, Net.”
Arrow has sold residential real estate loans, primarily to Freddie Mac, with servicing retained. Mortgage servicing rights are recognized as an asset when loans are sold with servicing retained, by allocating the cost of an originated mortgage loan between the loan and servicing right based on estimated relative fair values. The cost allocated to the servicing right is capitalized as a separate asset and amortized in proportion to, and over the period of, estimated net servicing income. Capitalized mortgage servicing rights are evaluated for impairment by comparing the asset’s carrying value to its current estimated fair value. Fair values are estimated using a discounted cash flow approach, which considers future servicing income and costs, current market interest rates, and anticipated prepayment, and default rates. Impairment losses are recognized through a valuation allowance for servicing rights having a current fair value that is less than amortized cost on an aggregate basis. Adjustments to increase or decrease the valuation allowance are charged or credited to income as a component of other operating income.
Pension and Postretirement Benefits - Arrow maintains a non-contributory, defined benefit pension plan covering substantially all employees, a supplemental pension plan covering certain executive officers selected by the Board of Directors, and certain post-retirement medical, dental and life insurance benefits for employees and retirees. The costs of these plans, based on actuarial computations of current and future benefits for employees, are charged to current operating expenses. The cost of post-retirement benefits other than pensions is recognized on an accrual basis as employees perform services to earn the benefits. Arrow recognizes the overfunded or underfunded status of our single employer defined benefit pension plan as an asset or liability on its consolidated balance sheet and recognizes changes in the funded status in comprehensive income in the year in which the change occurred.
Prior service costs or credits are amortized on a straight-line basis over the average remaining service period of active participants. Gains and losses in excess of 10% of the greater of the benefit obligation or the fair value of assets are amortized over the average remaining service period of active participants.
The discount rate assumption is determined by preparing an analysis of the respective plan’s expected future cash flows and high-quality fixed-income investments currently available and expected to be available during the period to maturity of the pension benefits.
Stock-Based Compensation Plans - Arrow has three stock-based compensation plans, which are described more fully in Note 12, Stock Based Compensation. The Company expenses the grant date fair value of stock options and restricted stock units granted. For stock options and restricted stock units, the expense is recognized over the vesting period of the grant, typically four years for stock options and three years for restricted stock units, on a straight-line basis. Shares are generally issued from treasury for the exercise of stock options.
Arrow sponsors an Employee Stock Purchase Plan ("ESPP") under which employees may purchase Arrow’s common stock at a 5% discount below market price at the time of purchase. This stock purchase plan is not considered a compensatory plan.
Arrow maintains an employee stock ownership plan (“ESOP”). Substantially all employees of Arrow and its subsidiaries are eligible to participate upon satisfaction of applicable service requirements. The ESOP borrowed funds from one of Arrow’s subsidiary banks to purchase outstanding shares of Arrow’s common stock. The notes required annual payments of principal and interest through 2019. As the debt was repaid, shares were released from collateral based on the proportion of debt paid to total debt outstanding for the year and allocated to active employees. At December 31, 2020, there was no outstanding balance remaining on the loans and therefore no remaining unallocated shares. In addition, Arrow makes additional cash contributions to the Plan each year.
Securities Sold Under Agreements to Repurchase - In securities repurchase agreements, Arrow receives cash from a counterparty in exchange for the transfer of securities to a third party custodian’s account that explicitly recognizes Arrow’s interest in the securities. These agreements are accounted for by Arrow as secured financing transactions, since it maintains effective control over the transferred securities, and meets other criteria for such accounting. Accordingly, the cash proceeds are recorded as borrowed funds, and the underlying securities continue to be carried in Arrow’s securities available-for-sale portfolio.
Earnings Per Share (“EPS”) - Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity (such as Arrow’s stock options), computed using the treasury stock method. Unallocated common shares held by Arrow’s ESOP are not included in the weighted average number of common shares outstanding for either the basic or diluted EPS calculation.
Financial Instruments - Arrow is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Commitments to extend credit include home equity lines of credit, commitments for residential and commercial construction loans and other personal and commercial lines of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of the involvement Arrow has in particular classes of financial instruments. Arrow's policy is to record such instruments when funded. Fair value estimates are made at a specific point in time,
based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time Arrow's entire holdings of a particular financial instrument. Because no market exists for a significant portion of Arrow's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, Arrow has a wealth management department that contributes net fee income annually. The value of the wealth management department customer relationships is not considered a financial instrument of the Company, and therefore this value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial assets or liabilities include deferred taxes, premises and equipment, the value of low-cost, long-term core deposits and goodwill. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.
The fair value for loans is disclosed using the "exit price" notion which is a reasonable estimate of what another party might pay in an orderly transaction. Fair values for loans are calculated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, indirect auto and other consumer loans. Each loan category is further segmented into fixed and adjustable interest rate terms and by performing and nonperforming categories. The fair value of performing loans is calculated by determining the estimated future cash flow, which is the contractual cash flow adjusted for estimated prepayments. The discount rate is determined by starting with current market yields, and adjusting for a discount spread. The discount spread is applied separately for each loan type based on market information. A liquidity premium is determined for each loan type based on market inefficiencies associated with the sale of a financial instrument. Finally, a credit loss component is determined utilizing the credit loss assumptions used in the allowance for loan and lease loss model.
The carrying amount of short-term assets and liabilities is a reasonable estimate of fair value: cash and due from banks, federal funds sold and purchased, securities sold under agreements to repurchase, demand deposits, savings, N.O.W. and money market deposits, brokered money market deposits and time deposits, other short-term borrowings, accrued interest receivable and accrued interest payable. The fair value estimates of other on- and off-balance sheet financial instruments, as well as the method of arriving at fair value estimates, are included in the related footnotes and summarized in Note 17.
Fair Value Measures - Arrow determines the fair value of financial instruments under the following hierarchy:
•Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
•Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability;
•Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).
A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
Management’s Use of Estimates -The preparation of the Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements and the reported amounts of income and expenses during the reporting period. Our most significant estimates are the allowance for loan losses, the evaluation of other-than-temporary impairment of investment securities, goodwill impairment, pension and other postretirement liabilities and an analysis of a need for a valuation allowance for deferred tax assets. Actual results could differ from those estimates.
A material estimate that is particularly susceptible to significant change in the near term is the allowance for loan losses. In connection with the determination of the allowance for loan losses, management obtains appraisals for properties. The allowance for loan losses is management’s best estimate of probable loan losses incurred as of the balance sheet date. While management uses available information to recognize losses on loans, future adjustments to the allowance for loan losses may be necessary based on changes in economic conditions.
The following accounting standards were adopted in 2020:
In August 2018, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2018-13 "Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement" as part of its disclosure framework, and pursuant to which FASB has eliminated, amended and added disclosure requirements for fair value measurements. For Arrow, the standard became effective, on a prospective basis, on January 1, 2020. The adoption of this change in fair value disclosure did not have a material impact on its financial position or the results of operations in the period subsequent to its adoption.
In August 2018, the FASB issued ASU 2018-14 "Disclosure Framework-Changes to the Disclosure Requirements for Defined Benefit Plans" which applies to all companies that provide defined benefit pension or other postretirement benefit plans for their employees. Certain disclosure requirements have been eliminated such as reporting the amounts in accumulated other comprehensive income expected to be recognized as components of net periodic benefit cost over the next year, and reporting
the effects of a one-percentage-point change in the assumed healthcare cost trend rate on the aggregate of the service cost and interest cost components of net periodic benefit cost and on the benefit obligation for postretirement healthcare benefits. New required disclosures for reporting the weighted-average interest rate used to credit cash balance and similar plans that have a promised interest credit, the reasons for significant gains and losses affecting benefit obligations and other requirements for reporting aggregate information related to pension plans. For Arrow, the standard was adopted on December 31, 2020. The adoption of this standard affecting defined benefit plan disclosures did not have a material impact on its financial position or the results of operations.
In August 2018, the FASB issued ASU 2018-15 "Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract" which will require companies to defer potentially significant, specified implementation costs incurred in a cloud computing arrangement that are currently often expensed under US GAAP. For Arrow, the standard was adopted, on a prospective basis, on January 1, 2020. The adoption of this standard did not have a material impact on its financial position or the results of operations in the period subsequent to its adoption.
In October 2018, the FASB issued ASU No. 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities ("ASU 2018-17"). ASU 2018-17 provides that indirect interests held through related parties in common control arrangements should be considered on a proportional basis for determining whether fees paid to decision makers and service providers are variable interests. For Arrow, the standard was effective on January 1, 2020 and the adoption of this standard did not have a material impact on its financial position or the results of operations in the period subsequent to its adoption.
In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting ("ASU 2020-04"). ASU 2020-04 provides companies with optional guidance to ease the potential accounting burden associated with transitioning away from reference rates that are expected to be discontinued, such as LIBOR. Companies can apply the ASU immediately. However, the guidance will only be available for a limited time (generally through December 31, 2022), and provides optional relief for contract modifications, hedge accounting and Held-to-maturity debt securities. For Arrow, this standard was effective January 1, 2020 and can be applied prospectively beginning January 1, 2020 for contract modifications and hedging relationships. The one-time election to sell and/or transfer securities classified as Held-to-maturity may be made at any point after March 12, 2020. Arrow is evaluating the impact of this standard as it will provide relief for contracts currently tied to LIBOR and hedge accounting relationships.
Note 3:CASH AND CASH EQUIVALENTS (Dollars In Thousands)
During 2019 and until March 2020, the Company was required to maintain reserve balances with the Federal Reserve Bank of New York. The required reserve was calculated on a fourteen day average and the amount presented in the table above represents the average for the period that includes December 31, 2019. In March 2020, the Federal Reserve Board reduced reserve requirement ratios to zero percent to free up liquidity in the banking industry to support lending to households and businesses.
Note 4. INVESTMENT SECURITIES (Dollars In Thousands)
The following table is the schedule of Available-For-Sale Securities at December 31, 2020 and 2019:
The following table is the schedule of Held-To-Maturity Securities at December 31, 2020 and 2019:
In the tables above, maturities of mortgage-backed securities are included based on their expected average lives. Actual maturities will differ because issuers may have the right to call or prepay obligations with or without prepayment penalties.
Securities in a continuous loss position, in the tables above for December 31, 2020 and December 31, 2019 do not reflect any deterioration of the credit worthiness of the issuing entities. U.S. agency issues, including mortgage-backed securities, are all rated AAA by Moody's and AA+ by Standard and Poor's. The state and municipal obligations are general obligations supported by the general taxing authority of the issuer, and in some cases are insured. Obligations issued by school districts are supported by state aid. For any non-rated municipal securities, credit analysis is performed in-house based upon data that has been submitted by the issuers to the NY State Comptroller. That analysis shows no deterioration in the credit worthiness of the municipalities. Subsequent to December 31, 2020, there were no securities downgraded below investment grade.
Because Arrow expects to recover the entire cost basis according to the contractual terms of each debt security, there is no current intention to sell any of our temporarily impaired securities, and because it is not more likely than not that it would be required to sell the securities prior to recovery, the impairment is considered temporary.
Pledged securities, in the tables above, are primarily used to collateralize state and municipal deposits, as required under New York State law. A small portion of the pledged securities are used to collateralize repurchase agreements and pooled deposits of our trust customers.
The following table is the schedule of Equity Securities at December 31, 2020 and 2019.
The following is a summary of realized and unrealized gains and losses recognized in net income on equity securities during the years ended December 31, 2020 and 2019 :
Schedule of Federal Reserve Bank and Federal Home Loan Bank Stock (at cost)
Note 5:LOANS (Dollars In Thousands)
Loan Categories and Past Due Loans
The following table presents loan balances outstanding as of December 31, 2020 and December 31, 2019 and an analysis of the recorded investment in loans that are past due at these dates. Loans held-for-sale of $11,085 and $150 as of December 31, 2020, and December 31, 2019, respectively, are included in the residential real estate balances for current loans.
The Company disaggregates its loan portfolio into the following four categories:
Commercial - The Company offers a variety of loan options to meet the specific needs of our commercial customers including term loans, time notes and lines of credit. Such loans are made available to businesses for working capital needs such as inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment or other assets owned by the borrower. Generally, these loans carry a higher risk than commercial real estate loans due to the nature of the underlying collateral, which can be business assets such as equipment and accounts receivable and generally have a lower liquidation value than real estate. In the event of default by the borrower, the Company may be required to liquidate collateral at deeply discounted values. To reduce the risk, management usually obtains personal guarantees to support the borrowing, as permitted by applicable law.
Commercial Real Estate - The Company offers commercial real estate loans to finance real estate purchases, refinancings, expansions and improvements to commercial properties. Commercial real estate loans are made to finance the purchases of real property which generally consists of real estate with completed structures. These commercial real estate loans are typically secured by first liens on the real estate, which may include apartments, commercial structures, housing businesses, healthcare facilities, and both owner and non owner-occupied facilities. These loans are typically less risky than commercial loans, since they are secured by real estate and buildings, and are generally originated in amounts of no more than 80% of the appraised value of the property. However, the Company also offers commercial construction and land development loans to finance projects. Many projects will ultimately be used by the borrowers' businesses, while others are developed for resale. These real estate loans are also typically secured by first liens on the real estate, which may include apartments, commercial structures, housing businesses, healthcare facilities and both owner-occupied and non-owner-occupied facilities. There is enhanced risk during the construction period, since the loan is secured by an incomplete project. Many of the commercial and commercial real estate loans are in industries that have been heavily impacted by the COVID-19 pandemic. In 2020, Arrow originated $142.7 million of PPP loans.
Consumer Loans - This category is primarily comprised of automobile loans. Arrow primarily finances the purchases of automobiles indirectly through dealer relationships located throughout upstate New York and Vermont. Most automobile loans
carry a fixed rate of interest with principal repayment terms typically ranging from three to seven years. Automobile loans are underwritten on a secured basis using the underlying collateral being financed. Arrow also offers a variety of consumer installment loans to finance other personal expenditures. Most of these loans carry a fixed rate of interest with principal repayment terms typically ranging from one to five years, based upon the nature of the collateral and size of the loan. In addition to installment loans, Arrow also offers personal lines of credit and overdraft protection. Several of these consumer loans are unsecured, which carry a higher risk of loss.
Residential - Residential real estate loans consist primarily of loans secured by first or second mortgages on primary residences. The Company originates adjustable-rate and fixed-rate one-to-four-family residential real estate loans for the construction, purchase of real estate, or refinancing of an existing mortgage. These loans are collateralized primarily by owner-occupied properties generally located in the Company’s market area. Loans for one-to-four-family residential real estate are generally originated in amounts of no more than 80% of the purchase price or appraised value (whichever is lower), or have private mortgage insurance. Arrow's underwriting analysis for residential mortgage loans typically includes credit verification, independent appraisals, and a review of the borrower’s financial condition. Mortgage title insurance and hazard insurance are normally required. It is Arrow's general practice to underwrite residential real estate loans to secondary market standards. Construction loans have a unique risk, because they are secured by an incomplete dwelling. This risk is reduced through periodic site inspections, including one at each loan draw period. In addition, the Company offers fixed home equity loans, as well as home equity lines of credit to consumers to finance home improvements, debt consolidation, education and other uses. The Company's policy allows for a maximum loan to value ratio of 80%, although periodically higher advances are allowed. The Company originates home equity lines of credit and second mortgage loans (loans secured by a second junior lien position on one-to-four-family residential real estate). Risk is generally reduced through underwriting criteria, which include credit verification, appraisals, a review of the borrower's financial condition, and personal cash flows. A security interest, with title insurance when necessary, is taken in the underlying real estate.
Schedule of Supplemental Loan Information
Allowance for Loan Losses
The following table presents a roll forward of the allowance for loan losses and other information pertaining to the allowance for loan losses:
Through the provision for loan losses, an allowance for loan losses is maintained that reflects Arrow's best estimate of the inherent risk of loss in the Company’s loan portfolio as of the balance sheet date. Additions are made to the allowance for loan losses through a periodic provision for loan losses. Actual loan losses are charged against the allowance for loan losses when loans are deemed uncollectible and recoveries of amounts previously charged off are recorded as credits to the allowance for loan losses.
Loan officers and risk managers meet at least quarterly to discuss and review the conditions and risks associated with certain criticized and classified commercial-related relationships. In addition, the Company's independent internal loan review department performs periodic reviews of the credit quality indicators on individual loans in the commercial loan portfolio.
The Company uses a two-step process to determine the provision for loan losses and the amount of the allowance for loan losses. An evaluation of impaired loans is performed on a quarterly basis. Impaired loans are generally nonaccrual loans over $250 thousand and all troubled debt restructured loans. Specific reserves on individually identified impaired loans that are not collateral dependent are measured based on the present value of expected future cash flows discounted at the original effective interest rate of each loan. For loans that are collateral-dependent, impairment is measured based on the fair value of the collateral less estimated selling costs, and such impaired amounts are generally charged off. In general, Arrow's impaired loans are collateral-dependent impaired loans that have limited exposure or require limited specific reserves because of collateral support with respect to these loans. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis.
The remainder of the portfolio is evaluated on a pooled basis, as described below. For each homogeneous loan pool, a total loss factor is estimated based on the historical net loss rates adjusted for applicable qualitative factors. The total loss factors assigned to each loan category are updated on a quarterly basis. For the commercial, commercial construction, and commercial real estate categories, the loan categories are further segregated by credit risk profile (pools of loans graded pass, special mention and accruing substandard). Additional description of the credit risk classifications is detailed in the Credit Quality Indicators section of this note.
The historical net loss rate is determined for each loan category using a rolling average annual twelve quarter look-back period of the respective segment that have occurred within each pool of loans over the loss emergence period (LEP). While historical net loss experience provides a reasonable starting point for the analysis, historical net losses, or even recent trends in net losses, do not by themselves form a sufficient basis to determine the appropriate level of the allowance for loan losses. Therefore, historical net loss factors are considered and adjusted for qualitative factors that impact the incurred risk of loss associated with the loan categories within the total loan portfolio. These include:
•Changes in the volume and severity of past due, nonaccrual and adversely classified loans
•Changes in the nature and volume of the portfolio and in the terms of loans
•Changes in the value of the underlying collateral for collateral dependent loans
•Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating loan losses
•Changes in the quality of the loan review system
•Changes in the experience, ability, and depth of lending management and other relevant staff
•Changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio
•The existence and effect of any concentrations of credit, and changes in the level of such concentrations
•The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated loan losses in the existing portfolio or pool
Loan Credit Quality Indicators
The following table presents the credit quality indicators by loan category at December 31, 2020 and December 31, 2019:
For the purposes of the table above, nonperforming consumer and residential loans are those loans on nonaccrual status or are 90 days or more past due and still accruing interest.
The recorded investment in consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process is $660 thousand.
For the allowance calculation, an internally developed system of five credit quality indicators to rate the credit worthiness of each commercial loan defined as follows:
1) Satisfactory - "Satisfactory" borrowers have acceptable financial condition with satisfactory record of earnings and sufficient historical and projected cash flow to service the debt. Borrowers have satisfactory repayment histories and primary and secondary sources of repayment can be clearly identified;
2) Special Mention - Loans in this category have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. "Special mention" assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. Loans which might be assigned this credit quality indicator include loans to borrowers with deteriorating financial strength and/or earnings record and loans with potential for problems due to weakening economic or market conditions;
3) Substandard - Loans classified as “substandard” are inadequately protected by the current sound net worth or paying capacity of the borrower or the collateral pledged, if any. Loans in this category have well defined weaknesses that jeopardize the repayment. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. “Substandard” loans may include loans which are likely to require liquidation of collateral to effect repayment, and other loans where character or ability to repay has become suspect. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard;
4) Doubtful - Loans classified as “doubtful” have all of the weaknesses inherent in those classified as “substandard” with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of current existing facts, conditions, and values highly questionable and improbable. Although possibility of loss is extremely high, classification of these loans as “loss” has been deferred due to specific pending factors or events which may strengthen
the value (i.e. possibility of additional collateral, injection of capital, collateral liquidation, debt restructure, economic recovery, etc). Loans classified as “doubtful” need to be placed on non-accrual; and
5) Loss - Loans classified as “loss” are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. As of the date of the balance sheet, all loans in this category have been charged-off to the allowance for loan losses.
Commercial loans are generally evaluated on an annual basis depending on the size and complexity of the loan relationship, unless the credit related quality indicator falls to a level of "special mention" or below, when the loan is evaluated quarterly. The credit quality indicator is one of the factors used in assessing the level of inherent risk of loss in our commercial related loan portfolios.
Impaired Loans
The following table presents information on impaired loans based on whether the impaired loan has a recorded allowance or no recorded allowance:
At December 31, 2020, all impaired loans were considered to be collateral dependent and were therefore evaluated for impairment based on the fair value of collateral less estimated cost to sell. Interest income recognized in the table above, represents income earned after the loans became impaired and includes restructured loans in compliance with their modified terms and nonaccrual loans where we have recognized interest income on a cash basis.
Loans Modified in Trouble Debt Restructurings
The following table presents information on loans modified in trouble debt restructurings during the periods indicated:
In general, prior to the novel coronavirus (COVID-19) pandemic, loans requiring modification were restructured to accommodate the projected cash-flows of the borrower. Such modifications may have involved a reduction of the interest rate, a significant deferral of payments or forgiveness of a portion of the outstanding principal balance. As indicated in the table above, no loans modified during the preceding twelve months subsequently defaulted as of December 31, 2020 or December 31, 2019. In accordance with the Coronavirus Aid, Relief, and Economic Security (CARES) Act and ASC Subtopic 310-40, if a qualifying loan modification was made for a borrower as the result of the COVID-19 pandemic, this modification was not considered a troubled debt restructuring (TDR).
Note 6:PREMISES AND EQUIPMENT (Dollars In Thousands)
A summary of premises and equipment at December 31, 2020 and 2019 is presented below:
Amounts charged to expense for depreciation totaled $3,080, $2,211 and $1,891 in 2020, 2019 and 2018, respectively.
Note 7:OTHER INTANGIBLE ASSETS (Dollars In Thousands)
The following table presents information on Arrow’s other intangible assets (other than goodwill) as of December 31, 2020, 2019 and 2018:
1 Amortization of mortgage servicing rights is reported in the Consolidated Statements of Income as a reduction of mortgage servicing fee income, which is included with fees for other services to customers.
2 Amortization of customer intangibles are reported in the Consolidated Statements of Income as a component of other operating expense.
The following table presents the remaining estimated annual amortization expense for Arrow's intangible assets as of December 31, 2020:
Note 8:COMMITMENTS AND CONTINGENCIES (Dollars In Thousands)
The following table presents the notional amount and fair value of Arrow's off-balance sheet commitments to extend credit and commitments under standby letters of credit as of December 31, 2020 and 2019:
Arrow is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Commitments to extend credit include home equity lines of credit, commitments for residential and commercial construction loans and other personal and commercial lines of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of the involvement Arrow has in particular classes of financial instruments.
Arrow's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. Arrow uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
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 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. Arrow evaluates each customer's creditworthiness on a case-by-case basis. Home equity lines of credit are secured by residential real estate. Construction lines of credit are secured by underlying real estate. For other lines of credit, the amount of collateral obtained, if deemed necessary by Arrow upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Most of the commitments are variable rate instruments.
Arrow does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit.
Arrow has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit at December 31, 2020 and 2019 represent the maximum potential future payments Arrow could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Company policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios will generally range from 50% for movable assets, such as inventory, to 100% for liquid assets, such as bank CD's. Fees for standby letters of credit range from 1% to 3% of the notional amount. Fees are collected upfront and amortized over the life of the commitment. The carrying amount and fair value of Arrow's standby letters of credit at December 31, 2020 and 2019 were insignificant. The fair value of standby letters of credit is based on the fees currently charged for similar agreements or the cost to terminate the arrangement with the counterparties.
The fair value of commitments to extend credit is determined by estimating the fees to enter into similar agreements, taking into account the remaining terms and present creditworthiness of the counterparties, and for fixed rate loan commitments, the difference between the current and committed interest rates. Arrow provides several types of commercial lines of credit and standby letters of credit to its commercial customers. The pricing of these services is not isolated as Arrow considers the customer's complete deposit and borrowing relationship in pricing individual products and services. The commitments to extend credit also include commitments under home equity lines of credit, for which Arrow charges no fee. The carrying value and fair value of commitments to extend credit are not material and Arrow does not expect to incur any material loss as a result of these commitments.
Note 9:TIME DEPOSITS (Dollars In Thousands)
The following summarizes the contractual maturities of time deposits during years subsequent to December 31, 2020:
Note 10:DEBT (Dollars in Thousands)
Schedule of Short-Term Borrowings:
The securities sold under agreements to repurchase ("repo accounts") shown above represent collateralized borrowings with certain commercial customers located primarily within the Company's service area. All repo accounts at December 31, 2020 and 2019 have overnight maturities. Repo accounts are not covered by federal deposit insurance and are secured by Arrow's own qualified investment securities. The Company retains the right to substitute similar type securities and has the right to withdraw all excess collateral applicable to repo accounts whenever the collateral values are in excess of the related repurchase liabilities. However, as a means of mitigating market risk, the Company maintains excess collateral to cover normal changes in the repurchase liability by monitoring daily usage. At December 31, 2020, there were no material amounts of securities at risk with any one customer. The Company maintains control of these securities through the use of third-party safekeeping arrangements. Investment securities with a fair value of $19.2 million and $62.4 million were pledged as collateral for the securities sold under agreements to repurchase at December 31, 2020 and 2019, respectively, and are presented in the table below:
Arrow's subsidiary banks have in place unsecured federal funds lines of credit with two correspondent banks. As a member of the FHLBNY, Arrow participates in the advance program which allows for overnight and term advances up to the limit of pledged collateral, including FHLBNY stock, residential real estate and home equity loans (see Note 4, "Investment Securities" and Note 5, "Loans"). The investment in FHLBNY stock is proportional to the total of Arrow's overnight and term advances (see the Schedule of Federal Reserve Bank and Federal Home Loan Bank Stock in Note 4, Investment Securities, to the notes to the Consolidated Financial Statements). Arrow's bank subsidiaries have also established borrowing facilities with the Federal Reserve Bank of New York for potential “discount window” advances, pledging certain consumer loans as collateral (see Note 5, Loans, to the notes to the Consolidated Financial Statements).
Long Term Debt - FHLBNY Term Advances
In addition to overnight advances, Arrow also borrows longer-term funds from the FHLBNY.
Maturity Schedule of FHLBNY Term Advances:
Long Term Debt - Guaranteed Preferred Beneficial Interests in Corporation's Junior Subordinated Debentures
During 2020, there were outstanding two classes of financial instruments issued by two separate subsidiary business trusts of Arrow, identified as “Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts” on the Consolidated Balance Sheets and the Consolidated Statements of Income.
The first of the two classes of trust-issued instruments outstanding at year-end was issued by Arrow Capital Statutory Trust II ("ACST II"), a Delaware business trust established on July 16, 2003, upon the filing of a certificate of trust with the Delaware Secretary of State. In July 2003, ACST II issued all of its voting (common) stock to Arrow and issued and sold to an unaffiliated purchaser 30-year guaranteed preferred beneficial interests in the trust's assets ("ACST II trust preferred securities"). The rate on the securities is variable, adjusting quarterly to the 3-month LIBOR plus 3.15%. ACST II used the proceeds of the sale of its trust preferred securities to purchase an identical amount of junior subordinated debentures issued by Arrow that bear an interest rate identical at all times to the rate payable on the ACST II trust preferred securities. The ACST II trust preferred securities became redeemable after July 23, 2008 and mature on July 23, 2033.
The second of the two classes of trust-issued instruments outstanding at year-end was issued by Arrow Capital Statutory Trust III ("ACST III"), a Delaware business trust established on December 23, 2004, upon the filing of a certificate of trust with the Delaware Secretary of State. On December 28, 2004, the ACST III issued all of its voting (common) stock to Arrow and issued and sold to an unaffiliated purchaser 30-year guaranteed preferred beneficial interests in the trust's assets ("ACST III"). The rate on the ACST III trust preferred securities is a variable rate, adjusted quarterly, equal to the 3-month LIBOR plus 2.00%. ACST III used the proceeds of the sale of its trust preferred securities to purchase an identical amount of junior subordinated debentures issued by Arrow that bear an interest rate identical at all times to the rate payable on the ACST III trust preferred securities. The ACST III trust preferred securities became redeemable on or after March 31, 2010 and mature on December 28, 2034. Arrow has entered into interest rate swaps to synthetically fix the variable rate interest payments associated with $20 million in outstanding subordinated trust securities. These agreements are designated as cash flow hedges.
The primary assets of the two subsidiary trusts having trust preferred securities outstanding at year-end, ACST II and ACST III (the “Trusts”), are Arrow's junior subordinated debentures discussed above, and the sole revenues of the Trusts are payments received by them from Arrow with respect to the junior subordinated debentures. The trust preferred securities issued by the Trusts are non-voting. All common voting securities of the Trusts are owned by Arrow. Arrow used the net proceeds from its sale of junior subordinated debentures to the Trusts, facilitated by the Trust’s sale of their trust preferred securities to the purchasers thereof, for general corporate purposes. The trust preferred securities and underlying junior subordinated debentures, with associated expense that is tax deductible, qualify as Tier I capital under regulatory definitions.
Arrow's primary source of funds to pay interest on the debentures that are held by the Trusts are current dividends received by Arrow from its subsidiary banks. Accordingly, Arrow's ability to make payments on the debentures, and the ability of the Trusts to make payments on their trust preferred securities, are dependent upon the continuing ability of Arrow's subsidiary banks to pay dividends to Arrow. Since the trust preferred securities issued by the subsidiary trusts and the underlying junior subordinated debentures issued by Arrow at December 31, 2020, 2019 and 2018 are classified as debt for financial statement purposes, the expense associated with these securities is recorded as interest expense in the Consolidated Statements of Income for the three years.
Schedule of Guaranteed Preferred Beneficial Interests in Corporation's Junior Subordinated Debentures
Note 11:COMPREHENSIVE INCOME (LOSS), NET OF TAX (Dollars In Thousands)
The following table presents the components of other comprehensive income (loss) for the years ended December 31, 2020, 2019 and 2018:
The following table presents the changes in accumulated other comprehensive income by component:
(1) All amounts are net of tax. Amounts in parentheses indicate debits.
The following table presents the reclassifications out of accumulated other comprehensive income:
Reclassifications Out of Accumulated Other Comprehensive Income (1)
Amounts Reclassified
Details about Accumulated Otherfrom Accumulated OtherAffected Line Item in the Statement
Comprehensive Income ComponentsComprehensive IncomeWhere Net Income Is Presented
December 31, 2018
Unrealized gains and losses on available-for-sale securities$- Gain on Securities Transactions, Net
- Total before tax
- Provision for Income Taxes
$- Net of tax
Amortization of defined benefit pension items
Prior-service credit$(108)(2)
Salaries and Employee Benefits
Actuarial Loss(325)(2)
Salaries and Employee Benefits
(433)Total before tax
111 Provision for Income Taxes
$(322)Net of tax
Total reclassifications for the period$(322)Net of tax
(1) Amounts in parentheses indicate debits to profit/loss.
(2) These accumulated other comprehensive income components are included in the computation of net periodic pension cost (see retirement benefit plans footnote for additional details).
Note 12:STOCK BASED COMPENSATION (Dollars In Thousands, Except Share and Per Share Amounts)
Arrow has established three stock-based compensation plans: an Incentive and Non-qualified Stock Option Plan (Long Term Incentive Plan), an Employee Stock Purchase Plan (ESPP) and an Employee Stock Ownership Plan (ESOP). All share and per share data have been adjusted for the September 25, 2020 3% stock dividend.
Long Term Incentive Plan
The Long Term Incentive Plan provides for the grant of incentive stock options, non-qualified stock options, restricted stock, restricted stock units, performance units and performance shares. The Compensation Committee of the Board of Directors administers the Long Term Incentive Plan.
Stock Options - Options may be granted at a price no less than the greater of the par value or fair market value of such shares on the date on which such option is granted, and generally expire ten years from the date of grant. The options usually vest over a four-year period.
The following table summarizes information about stock option activity for the year ended December 31, 2020.
The following is the Schedule of Stock Options Granted Under the Long Term Incentive Plan by Exercise Price Range.
The following is the Schedule of Other Information on Stock Options Granted.
Restricted Stock Units - The Company grants restricted stock units which gives the recipient the right to receive shares of Company stock upon vesting. The fair value of each restricted stock unit is the market value of Company stock on the date of grant. 100% of the restricted stock unit awards vest three years from the grant date. Once vested, the restricted stock units become vested units and are no longer forfeitable. Vested units settle upon retirement of the recipient. Unvested restricted stock unit awards will generally be forfeited if the recipient ceases to be employed by the Company, with limited exceptions.
The following table summarizes information about restricted stock unit activity for the year ended December 31, 2020. The Company started granting restricted stock units in 2018.
The following table presents information on the amounts expensed related to Restricted Stock Units awarded pursuant to the Long Term Incentive Plan for the year ended December 31, 2020.
Employee Stock Purchase Plan
Arrow sponsors an ESPP under which employees purchase Arrow's common stock at a 5% discount below market price. Under current accounting guidance, a stock purchase plan with a discount of 5% or less is not considered a compensatory plan.
Employee Stock Ownership Plan
Arrow maintains an employee stock ownership plan (“ESOP”). Substantially all employees of Arrow and its subsidiaries are eligible to participate upon satisfaction of applicable service requirements. The ESOP borrowed funds from one of Arrow’s subsidiary banks to purchase outstanding shares of Arrow’s common stock. The notes required annual payments of principal and interest through 2019. As the debt was repaid, shares were released from collateral based on the proportion of debt paid to total debt outstanding for the year and allocated to active employees. At December 31, 2020, there was no outstanding balance remaining on the loans and therefore no remaining unallocated shares. In addition, the Company makes additional cash contributions to the Plan each year.
Schedule of ESOP Compensation Expense
Prior to December 31, 2019, shares pledged as collateral were reported as unallocated ESOP shares in stockholders’ equity. As shares were released from collateral, Arrow reported compensation expense equal to the current average market price of the shares, and the shares become outstanding for earnings per share computations. During the year ended December 31, 2019, all remaining unallocated shares were released.
Note 13: RETIREMENT BENEFIT PLANS (Dollars in Thousands)
Arrow sponsors qualified and nonqualified defined benefit pension plans and other postretirement benefit plans for its employees. Arrow maintains a non-contributory pension plan, which covers substantially all employees. Effective December 1, 2002, all active participants in the qualified defined benefit pension plan were given a one-time irrevocable election to continue participating in the traditional plan design, for which benefits were based on years of service and the participant’s final compensation (as defined), or to begin participating in the new cash balance plan design. All employees who participate in the plan after December 1, 2002 automatically participate in the cash balance plan design. The interest credits under the cash balance plan are based on the 30-year U.S. Treasury rate in effect for November of the prior year with a minimum interest credit of 3.0%. The service credits under the cash balance plan are equal to 6.0% of eligible salaries for employees who become participants on or after January 1, 2003. For employees in the plan prior to January 1, 2003, the service credits are scaled based on the age of the participant, and range from 6.0% to 12.0%. The funding policy is to contribute up to the maximum amount that can be deducted for federal income tax purposes and to make all payments required under ERISA. Arrow also maintains a supplemental non-qualified unfunded retirement plan to provide eligible employees of Arrow and its subsidiaries with benefits in excess of qualified plan limits imposed by federal tax law.
Arrow has multiple non-pension postretirement benefit plans. The health care, dental and life insurance plans are contributory, with participants’ contributions adjusted annually. Arrow’s policy is to fund the cost of postretirement benefits based on the current cost of the underlying policies. However, the health care plan provision allows for grandfathered participants to receive automatic increases of Company contributions each year based on the increase in inflation and limited to a maximum of 5%.
As of December 31, 2020, Arrow uses the sex-distinct amount-weighted Pri-2012 mortality tables for employees, healthy annuitants and contingent survivors, adjusted for mortality improvements with the Scale MP-2020 mortality improvement scale on a generational basis for the Pension Plan and the sex-distinct amount-weighted White Collar tables for employees and healthy annuitants, adjusted for mortality improvements with the scale MP-2020 mortality improvement scale on a generational basis for the Select Executive Retirement Plan. As of December 31, 2020, Arrow updated its mortality assumption used for the Postretirement Plan to the sex-distinct Pri.H-2012 headcount-weighted mortality tables for employees and healthy annuitants, adjusted for mortality improvements with the Scale MP-2020 mortality improvement scale on a generational basis. The change in mortality tables resulted in a decrease in liabilities for the Employees' Pension Plan, the Select Executive Retirement Plan and the Postretirement Benefit Plan.
The interest rates used in determining the present value of a lump sum payment/annuitizing cash balance accounts were changed to the segment rates in effect for the January 1, 2020 plan year (0.53%,2.31%, 3.09%) as of December 31, 2020.
Effective January 1, 2021, Glens Falls National Bank and Trust Company amended the Arrow Financial Corporation Employees' Pension Plan. The plan change was adopted January 1, 2021 and the amendment was valued as of December 31, 2020. The plan amendment is the following:
Effective January 1, 2021, the benefit payable to or on behalf of each participant:
•whose employment with the Employer (or any predecessor Employer, except as noted below) terminated on or before January 1, 2016;
•who satisfied the requirements for early, normal, or late retirement as of such termination;
•who never participated in the United Vermont Bancorporation Plan and;
•who is, or whose Beneficiary is, receiving monthly benefit payments from the Plan as of January 1, 2021 (including a Participant or Beneficiary who shall commence receiving benefits from the Plan as of January 1, 2021), shall be increased by three percent (3%).
The foregoing increase shall be applied to the monthly benefit actually payable to the Participant, or to the Participant's Beneficiary, as of January 1, 2021, determined after all applicable adjustments, regardless of whether such benefit had been determined under the Company's plan or the plan of a predecessor employer that had been merged into the Plan.
The plan amendment caused a $351,638 increase in the Projected Benefit Obligation creating a positive service cost which will be amortized over 9.70 years (the average expected future service of active plan participants.)
Effective January 1, 2021, Glens Falls National Bank and Trust Company amended the Arrow Financial Corporation Employees' Select Executive Retirement Plan. The plan change was adopted January 1, 2021 and the amendment was valued as of December 31, 2020. The plan amendment provides a special adjustment to the monthly benefit payment for certain retirees. The plan amendment caused a $122,797 increase in the Projected Benefit Obligation creating a positive prior service cost which will be amortized over 12.5 years.
The following tables set forth changes in the plans’ benefit obligations (projected benefit obligation for pension benefits and accumulated benefit obligation for postretirement benefits) and changes in the plans’ assets and the funded status of the pension plans and other postretirement benefit plan at December 31:
Schedule of Defined Benefit Plan Disclosures
Footnotes:
1.Included in Salaries and Employee Benefits on the Consolidated Statements of Income
2.Included in Other Operating Expense on the Consolidated Statements of Income
Schedule of Defined Benefit Plan Disclosures
Information about Defined Benefit Plan Assets - Employees' Pension Plan
Footnotes:
1 Payment for the acquisition of Arrow Financial Corporation common stock was under 10% of the total fair value of the employee's pension plan assets at the time of acquisition.
2 The North Country Funds - Equity and the North Country Funds - Fixed Income are publicly traded mutual funds advised by Arrow's subsidiary, North Country Investment Advisers, Inc.
Schedule of Defined Benefit Plan Disclosures
Fair Value of Plan Assets (Defined Benefit Plan):
For information on fair value measurements, including descriptions of level 1, 2 and 3 of the fair value hierarchy and the valuation methods employed by Arrow, see Note 2, Summary of Significant Accounting Policies, and Note 17, Fair Values.
The fair value of level 1 financial instruments in the table above are based on unadjusted, quoted market prices from exchanges in active markets.
In accordance with ERISA guidelines, the Board authorized the purchase of Arrow common stock up to 10% of the fair market value of the plan's assets at the time of acquisition.
Pension Plan Investment Policies and Strategies:
The Company maintains a non-contributory pension benefit plan covering substantially all employees for the purpose of rewarding long and loyal service to the Company. The pension assets are held in trust and are invested in a prudent manner for the exclusive purpose of providing benefits to participants. The investment objective is to achieve an inflation-protected rate of return that meets the actuarial assumption which is used for funding purposes. The investment strategy attempts to maximize the investment return on assets at a level of risk deemed appropriate by the Company while complying with ERISA and any applicable regulations and laws. The investment strategy utilizes asset allocation as a principal determinant for establishing the risk/reward profile of the assets. Asset allocation ranges are established, periodically reviewed, and adjusted as funding levels, and participant benefit characteristics change. Active and passive investment management is employed to help enhance the risk/return profile of the assets.
The plan’s assets are invested in a diversified portfolio of equity securities comprised of companies with small, mid, and large capitalizations. Both domestic and international equities are allowed to provide further diversification and opportunity for return in potentially higher growth economies with lower correlation of returns. Growth and value styles of investment are employed to increase the diversification and offer varying opportunities for appreciation. The fixed income portion of the plan may be invested in U.S. dollar denominated debt securities that shall be rated within the top four ratings categories by nationally recognized ratings agencies. The fixed income portion will be invested without regard to industry or sector based on analysis of each target security’s structural and repayment features, current pricing and trading opportunities as well as credit quality of the issuer. Individual bonds with ratings that fall below the Plan’s rating requirements will be sold only when it is in the best interests of the Plan. Hybrid investments, such as convertible bonds, may be used to provide growth characteristics while offering some protection to declining equity markets by having a fixed income component. Alternative investments such as Treasury Inflation Protected Securities, commodities, and REITs may be used to further enhance diversification while offering opportunities for return. In accordance with ERISA guidelines, common stock of the Company may be purchased up to 10% of the fair market value of the Plan’s assets at the time of acquisition. Derivative investments are prohibited in the plan.
The return on assets assumption was developed through review of historical market returns, historical asset class volatility and correlations, current market conditions, the Plan’s past experience, and expectations on potential future market returns. The assumption represents a long-term average view of the performance of the assets in the Plan, a return that may or may not be achieved during any one calendar year. The assumption is based on the return of the Plan using the historical 15 year return adjusted for the potential for lower than historical returns due to low interest rates.
Cash Flows - We were not required to and we did not make any contribution to our qualified pension plan in 2020. Arrow makes contributions for its postretirement benefits in an amount equal to actual expenses for the year.
Note 14:OTHER EXPENSES (Dollars In Thousands)
Other operating expenses included in the Consolidated Statements of Income are as follows:
Note 15:INCOME TAXES (Dollars In Thousands)
The provision for income taxes is summarized below:
The provisions for income taxes differed from the amounts computed by applying the U.S. Federal Income Tax Rate of 21% to pre-tax income as a result of the following:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2020 and 2019 are presented below:
Management believes that the realization of the recognized gross deferred tax assets at December 31, 2020 and 2019 is more likely than not, based on historic earnings and expectations as to future taxable income.
Interest and penalties are recorded as a component of the provision for income taxes, if any. There are no current examinations of our Federal or state income tax returns, nor have we been notified of any upcoming examinations. Tax years 2017 through 2020 are subject to Federal and New York State examination. Management annually conducts an analysis of its tax positions and has concluded that it has no uncertain tax positions as of December 31, 2020.
Note 16: EARNINGS PER SHARE (Dollars In Thousands, Except Per Share Amounts)
The following table presents a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per common share ("EPS") for each of the years in the three-year period ended December 31, 2020. All share and per share amounts have been adjusted for the September 25, 2020 3% stock dividend.
Note 17:FAIR VALUES (Dollars In Thousands)
FASB ASC Subtopic 820-10 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP) and requires certain disclosures about fair value measurements. There are no nonfinancial assets or liabilities measured at fair value on a recurring basis. The only assets or liabilities that Arrow measured at fair value on a recurring basis at December 31, 2020 and 2019 were securities available-for-sale, equity securities and derivatives. Arrow held no securities or liabilities for trading on such dates. For information on fair value measurements, including descriptions of level 1, 2 and 3 of the fair value hierarchy and the valuation methods employed by Arrow, see Note 2, Summary of Significant Accounting Policies.
The table below presents the financial instrument's fair value and the amounts within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement:
The fair value of financial instruments is determined under the following hierarchy:
•Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
•Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability;
•Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).
There were no transfers between Levels 1, 2 and 3 for the years ended December 31, 2020 or 2019.
Fair Value Methodology for Assets and Liabilities Measured on a Recurring Basis
The fair value of level 1 securities available-for-sale are based on unadjusted, quoted market prices from exchanges in active markets. The fair value of level 2 securities available-for-sale are based on an independent bond and equity pricing service for identical assets or significantly similar securities and an independent equity pricing service for equity securities not actively traded. The pricing services use a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models. Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows. The fair value of Level 2 derivatives is determined using inputs that are observable in the market place obtained from third parties including yield curves, publicly available volatilities, and floating indexes.
Fair Value Methodology for Assets and Liabilities Measured on a Nonrecurring Basis
The fair value of collateral dependent impaired loans and other real estate owned was based on third-party appraisals less estimated cost to sell. The appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses. Other assets which might have been included in this table include mortgage servicing rights, goodwill and other intangible assets. Arrow evaluates each of these assets for impairment on an annual basis, with no impairment recognized for these assets at December 31, 2020 and 2019.
Fair Value Methodology for Financial Instruments Not Measured on a Recurring or Nonrecurring Basis
The fair value for securities held-to-maturity is determined utilizing an independent bond pricing service for identical assets or significantly similar securities. The pricing service uses a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models. Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows.
ASU 2016-01 "Recognition and Measurement of Financial Assets and Financial Liabilities" requires that the fair value for loans must be disclosed using the "exit price" notion which is a reasonable estimate of what another party might pay in an orderly transaction. Fair values for loans are calculated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, indirect auto and other consumer loans. Each loan category is further segmented into fixed and adjustable interest rate terms and by performing and nonperforming categories. The fair value of performing loans is calculated by determining the estimated future cash flow, which is the contractual cash flow adjusted for estimated prepayments. The discount rate is determined by starting with current market yields, and first adjusting for a liquidity premium. This premium is separately determined for each loan type. Then a credit loss component is determined utilizing the credit loss assumptions used in the allowance for loan and lease loss model. Finally, a discount spread is applied separately for consumer loans vs. commercial loans based on market information and utilization of the swap curve.
The fair value of time deposits is calculated using the replacement cost of funds approach, which is based on the discounted value of contractual cash flows. The discount rates are estimated using the Federal Home Loan Bank of New York ("FHLBNY") yield curve, which is considered representative of Arrow’s replacement cost of funds. A cash flow is generated separately to
represent the functional cost of maintaining each account; this cash flow is discounted to FHLBNY yield curve, in conjunction with the contractual cash flows.
The fair value of all other deposits is equal to the carrying value. The fair value of FHLBNY advances are as calculated by the FHLBNY. The carrying amount of FHLBNY and FRB stock approximates fair value. If the stock was redeemed, the Company will receive an amount equal to the par value of the stock.
The fair value of the outstanding trust preferred securities (Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts) are equal to book value with adjustments for the fair market value of their associated interest rate swaps. The fair value is determined by starting with book value as these outstanding securities have a floating rate coupon that is tied to 3-month LIBOR. Through the use of interest rate swaps, the coupons are synthetically fixed, so an adjustment for market value of swap is applied. The market value of interest rate swaps are provided by a third party counterparty.
Fair Value by Balance Sheet Grouping
The following table presents a summary of the carrying amount, the fair value or an amount approximating fair value and the fair value hierarchy of Arrow’s financial instruments:
Note 18:LEASES (Dollars In Thousands)
The Company is a lessee in its leases, which are mainly for financial services locations in addition to leases for corporate vehicles. These leases generally require the Company to pay third-party expenses on behalf of the Lessor, which are referred to as variable payments. Under some leases, the Company pays the variable payments to the lessor, and in other leases, the Company pays the variable payments directly to the applicable third party. None of the Company's current leases include any residual value guarantees or any subleases, and there are no significant rights or obligations of the Company for leases that have not commenced as of the reporting date.
Arrow leases four of its branch offices, at market rates, from Stewart’s Shops Corp. Mr. Gary C. Dake, President of Stewart’s Shops Corp., serves as a director on the board of directors of each of Arrow and Saratoga National Bank and Trust Company. Additional information regarding this relationship can be found in Arrow's Proxy Statement for its Annual Meeting of Shareholders to be held May 6, 2020 under the caption "Corporate Governance - Related Party Transactions."
The following includes quantitative data related to the Company's leases as of and for the twelve months ended December 31, 2020 and December 31, 2019:
Note 19. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES (In Thousands)
Arrow is exposed to certain risks arising from both its business operations and economic conditions. Arrow principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. Arrow manages economic risks, including interest rate, primarily by managing the amount, sources and duration of its assets and liabilities and through the use of derivative instruments. Specifically, Arrow enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Arrow's derivative financial instruments are used to manage differences in the amount, timing and duration of known or expected cash receipts and its known or expected cash payments principally related to certain fixed rate borrowings. Arrow also has interest rate derivatives that result from a service provided to certain qualifying customers and, therefore, are not used to manage interest rate risk in the Company’s assets or liabilities. The Company manages a matched book with respect to its derivative instruments in order to minimize its net risk exposure resulting from such transactions.
Derivatives Not Designated as Hedging Instruments
Arrow enters into interest rate swap agreements with its commercial customers to provide them with a long-term fixed rate, while simultaneously entering into offsetting interest rate swap agreements with a counterparty to swap the fixed rate to a variable rate to manage interest rate exposure.
These interest rate swap agreements are not designated as hedges for accounting purposes. As the interest rate swap agreements have substantially equivalent and offsetting terms, they do not present any material exposure to Arrow's consolidated statements of income. Arrow records its interest rate swap agreements at fair value and is presented on a gross basis within other assets and other liabilities on the consolidated balance sheets. Changes in the fair value of assets and liabilities arising from these derivatives are included, net, in other income in the consolidated statement of income.
The following table depicts the fair value adjustment recorded related to the notional amount of derivatives outstanding as well as the notional amount of the interest rate swap agreements.
Derivatives Designated as Hedging Instruments
Arrow has entered into interest rate swaps to synthetically fix the variable rate interest payments associated with $20 million in outstanding subordinated trust securities. These agreements are designated as cash flow hedges.
For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in Accumulated Other Comprehensive Income ("AOCI") and subsequently reclassified into interest expense in the same period during which the hedge transaction affects earnings. Amounts reported in AOCI related to derivatives will be reclassified to interest expense as interest payments are made on Arrow's Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts borrowings.
The following table indicates the effect of cash flow hedge accounting on AOCI and on the consolidated statement of income.
Note 20:REGULATORY MATTERS (Dollars in Thousands)
In the normal course of business, Arrow and its subsidiaries operate under certain regulatory restrictions, such as the extent and structure of covered inter-company borrowings and maintenance of reserve requirement balances.
The principal source of the funds for the payment of stockholder dividends by Arrow has been from dividends declared and paid to Arrow by its bank subsidiaries. As of December 31, 2020, the maximum amount that could have been paid by subsidiary banks to Arrow, without prior regulatory approval, was approximately $71.8 million.
Under current Federal Reserve regulations, Arrow is prohibited from borrowing from the subsidiary banks unless such borrowings are secured by specific obligations. Additionally, the maximum of any such borrowings from any one subsidiary bank (aggregated with all other "covered transactions" between the bank and Arrow) is limited to 10% of that bank’s capital and surplus. Loans and other covered transactions between any one subsidiary bank and all of its affiliates cannot exceed 20% of that bank's capital and surplus.
Arrow and its subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory--and possibly additional discretionary--actions by regulators that, if undertaken, could have a direct material effect on an institution’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Arrow and its subsidiary banks must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Current quantitative measures established by regulation to ensure capital adequacy require Arrow and its subsidiary banks to maintain minimum capital amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2020 and 2019, that Arrow and both subsidiary banks meet all capital adequacy requirements to which they are subject. The regulatory capital requirements incorporate a capital concept, the so-called "capital conservation buffer" (set at 2.5%, after full phase-in), which must be added to each of the minimum required risk-based capital ratios (i.e., the minimum CET1 ratio, the minimum Tier 1 risk-based capital ratio and the minimum total risk-based capital ratio). As of January 1, 2019, the capital conservation buffer increased to 2.50% of risk weighted assets.
The federal bank regulators have issued a final rule to implement the Community Bank Leverage Ratio ("CBLR"), introducing an optional simplified measure of capital adequacy for qualifying community banks that satisfy certain requirements, including having a leverage ratio of greater than 9%, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community bank that opts into the CBLR framework and meets all requirements under the CBLR framework will be considered to have met the well-capitalized ratio requirements under the “prompt corrective action” regulations and will not be required to report or calculate risk-based capital ratios. The CBLR is calculated as the ratio of “tier 1 capital” divided by “average total consolidated assets.” This final rule was effective as of January 1, 2020, and qualifying community banks can utilize the CBLR framework for purposes of filing their call reports or Form FR Y-9C, as applicable, for the first quarter of 2020 (i.e., as of March 31, 2020). Arrow elected to opt out of utilizing the CBLR framework. The Capital Rules promulgated under Dodd-Frank will remain applicable to Arrow.
As of December 31, 2020, Arrow and both subsidiary banks qualified as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as “well-capitalized,” Arrow and its subsidiary banks must maintain minimum total risk-based, Tier I risk-based, Tier I leverage, and CET1 risk-based ratios as set forth in the table below. There are no conditions or events that management believes have changed Arrow’s or its subsidiary banks’ categories. The actual capital amounts and ratios for Arrow and its subsidiary banks, Glens Falls National Bank and Trust Company (“Glens Falls National”) and Saratoga National Bank and Trust Company (“Saratoga National”), are presented in the table below as of December 31, 2020 and 2019:
Note 21:PARENT ONLY FINANCIAL INFORMATION (Dollars In Thousands)
Condensed financial information for Arrow Financial Corporation is as follows:
The Statement of Changes in Stockholders’ Equity is not reported because it is identical to the Consolidated Statement of Changes in Stockholders’ Equity.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure - None.
Item 9A.
Item 9A. Controls and Procedures
Senior management maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods provided in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, senior management has recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and therefore has been required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Senior management, including the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13(a)-15(e) under the Exchange Act) as of December 31, 2020. Based upon that evaluation, senior management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective on that date. There were no changes made in our internal controls or in other factors that could significantly affect these internal controls subsequent to the date of the evaluation performed by the Chief Executive Officer and Chief Financial Officer.
Management’s Report on Internal Control Over Financial Reporting
Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2020. In May 2013, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) published an updated Internal Control-Integrated Framework and related illustrative documents. We adopted the 2013 framework in 2015. Accordingly, in making its assessment of the effectiveness of our internal control over financial reporting as of December 31, 2020, management used the criteria established in the 2013 framework. Based on our assessment, our management concluded that our internal control over financial reporting was effective as of December 31, 2020.
Item 9B.
Item 9B. Other Information - None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this item regarding directors, nominees for director, and the committees of the Company's Board is set forth under the captions "Voting Item 1: Election of Directors" and “Corporate Governance” of Arrow's Proxy Statement for its Annual Meeting of Shareholders to be held May 5, 2021 (the Proxy Statement), which sections are incorporated herein by reference. Information regarding Compliance with Section 16(a) of the Exchange Act is set forth in the Company's Proxy Statement under the caption "Delinquent Section 16(a) Reports” and is incorporated herein by reference. Certain required information regarding our Executive Officers is contained in Part I, Item 1.G. of this Report, "Executive Officers of the Registrant." Arrow has adopted a Financial Code of Ethics applicable to our principal executive officer, principal financial officer and principal accounting officer, a copy of which can be found on our website at www.arrowfinancial.com under the link "Corporate Governance" on the header tab "Corporate."
Item 11.
Item 11. Executive Compensation
The information required by this item is set forth under the captions “Corporate Governance - Director Independence,” "Compensation Discussion and Analysis” including the “Compensation Committee Report” thereof, “Executive Compensation,” “Agreements with Named Executive Officers” including the "Potential Payments Upon Termination or Change of Control” and “Potential Payments Table” sections thereof, and “Voting Item 1: Election of Directors - Director Compensation” of the Proxy Statement, which sections are incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Certain information required by this item is set forth under the caption "Stock Ownership Information" of the Proxy Statement, which section is incorporated herein by reference, and under the caption "Equity Compensation Plan Information" in Part II, item 5 of this Report.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this item is set forth under the captions “Corporate Governance - Related Party Transactions” and “Corporate Governance - Director Independence” of the Proxy Statement, which sections are incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this item is set forth under the captions "Voting Item 4, Ratification of Independent Registered Public Accounting Firm - Independent Registered Public Accounting Firm Fees," and “Corporate Governance - Board Committees” of the Proxy Statement, which sections are incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
1. Financial Statements
The following financial statements, the notes thereto, and the independent auditors’ report thereon are filed in Part II, Item 8 of this Report. See the index to such financial statements at the beginning of Item 8.
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2020 and 2019
Consolidated Statements of Income for the Years Ended December 31, 2020, 2019 and 2018
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2020, 2019 and 2018
Consolidated Statements of Changes in Stockholders’ Equity for the Years Ended December 31, 2020, 2019 and 2018
Consolidated Statements of Cash Flows for the Years Ended December 31, 2020, 2019 and 2018
Notes to Consolidated Financial Statements
2. Schedules
All schedules are omitted as the required information is either not applicable or not required or is contained in the respective financial statements or in the notes thereto.
3. Exhibits:
See Exhibit Index on page 119.
Item 16. Form 10-K Summary - None
EXHIBIT INDEX
The following exhibits are incorporated by reference herein.
The following exhibits are submitted herewith:
* Management contracts or compensation plans required to be filed as an exhibit.
Pursuant to the requirements of Section 13 or 15(d) 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.
ARROW FINANCIAL CORPORATION
Date:March 10, 2021By: /s/ Thomas J. Murphy
Thomas J. Murphy
President and Chief Executive Officer
(Principal Executive Officer)
Date:March 10, 2021By: /s/ Edward J. Campanella
Edward J. Campanella
Senior Vice President, Treasurer and
Chief Financial Officer
(Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below on March 10, 2021 by the following persons in the capacities indicated.
/s/ Mark L. Behan
Mark L. Behan
Director
/s/ Elizabeth A. Miller
Elizabeth A. Miller
Director
/s/ Tenée R. Casaccio
Tenée R. Casaccio
Director
/s/ Thomas J. Murphy
Thomas J. Murphy
Director
/s/ Michael B. Clarke
Michael B. Clarke
Director
/s/ Raymond F. O'Conor
Raymond F. O'Conor
Director
/s/ Gary C. Dake
Gary C. Dake
Director
/s/ William L. Owens
William L. Owens
Director
/s/ Thomas L. Hoy
Thomas L. Hoy
Director and Chairman
/s/ Colin L. Read
Colin L. Read
Director
/s/ David G. Kruczlnicki
David G. Kruczlnicki
Director
/s/ Richard J. Reisman, D.M.D.
Richard J. Reisman, D.M.D.
Director