FIRST NATIONAL CORP / VA / Management’s Discussion and Analysis of Financial Condition and Results of Operations (Form 10-Q)

Caution Regarding Forward-Looking Statements



First National Corporation (the Company) makes forward-looking statements in
this Form 10-Q that are subject to risks and uncertainties. These
forward-looking statements include, but are not limited to, statements regarding
profitability, liquidity, adequacy of capital, allowance for loan losses,
interest rate sensitivity, market risk, growth strategy, and the impact of the
Company's acquisitions of The Bank of Fincastle (Fincastle) and the SmartBank
loan portfolio, including the expected benefits of the acquisition of Fincastle
(Merger) and the potential impact of the acquisitions on the Company's and First
Bank's (the Bank) financial and other goals. The words "believes," "expects,"
"may," "will," "should," "projects," "contemplates," "anticipates," "forecasts,"
"intends," or other similar words or terms are intended to identify
forward-looking statements. These forward-looking statements are subject to
significant uncertainties because they are based upon or are affected by factors
including:


• the effects of the COVID-19 pandemic, including its potential adverse effects

on economic conditions and employees, customers, credit quality,

and financial performance;

• the general commercial conditions, as well as the conditions within

markets;

• general economic conditions, including unemployment levels, inflation and

slowdowns in economic growth;

• expansion of the Company’s branches and markets, technology and other initiatives

strategic initiatives?

• the impact of banking and non-banking competition, including financial

technology companies (Fintech)?

• the composition of the loan and deposit portfolio, including the types of

accounts and customers, may change, which could have an impact on the net amount

interest income and non-interest income in future periods, including income

    from service charges on deposits?


  • limited availability of financing or inability to raise capital?


  • reliance on third parties for key services?

• the Company’s credit standards and its ongoing credit assessment processes

might not protect against major credit losses?

• the quality of the loan portfolio and the value of the collateral guaranteed

    those loans?
  • demand for loan products;
  • deposit flows;

• the level of net write-offs on loans and the adequacy of the provision for

loan losses?

• the concentration of loans secured by real estate may negatively affect

    earnings due to changes in the real estate markets?


  • the value of securities held in the Company's investment portfolio?

• legislative or regulatory changes or actions, including the effects of the changes

in tax laws?

• the accounting principles, policies and guidelines and the choices made by the

    Company thereunder?


  • cyber threats, attacks or events?

• the ability to maintain adequate liquidity by retaining depositary clients and

secondary funding sources, especially if the Company’s reputation becomes

damaged?

• the monetary and fiscal policies of United States Governmentincluding the policies of

US Department of Treasury and the Federal Reserve Boardand the effect

these policies regarding interest rates and activity in the Company’s markets;

• variations in interest rates could have a negative impact on the Company’s net income

interest income and an adverse impact on the ability of the Company’s customers

repay loans?

geopolitical conditions, including acts or threats of terrorism,

• hostilities or actions undertaken by the WE or other governments in response to

acts or threats of terrorism and/or military conflict, which could

commercial and economic conditions in WE and abroad? and

• other factors identified in point 1A. Company Form 10-K Risk Factors

    for the year ending December 31, 2021.




Because of these and other uncertainties, actual results may be materially
different from the results indicated by these forward-looking statements. In
addition, past results of operations do not necessarily indicate future results.
The following discussion and analysis of the financial condition at June 30,
2022 and statements of income of the Company for the three andsix months ended
June 30, 2022 and 2021 should be read in conjunction with the consolidated
financial statements and related notes included in Part I, Item 1, of this
Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending
December 31, 2021. The statements of income for the three andsix months ended
June 30, 2022 may not be indicative of the results to be achieved for the year.

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  Table of Contents



Executive Overview



The Company


First National Society (the Company) is the bank holding company of:

First Bank (the Bank). The Bank owns:


  • First Bank Financial Services, Inc.Bank of Fincastle Services, Inc.ESF, LLCShen-Valley Land Holdings, LLCFirst National (VA) Statutory Trust II (Trust II)

National premiere (VA) Statutory Trust III (Trust III and, with Trust

    II, the Trusts)




First Bank Financial Services, Inc. invests in entities that provide title
insurance and investment services. Bank of Fincastle Services, Inc. owns an
entity that provides mortgage services.  Shen-Valley Land Holdings, LLC and ESF,
LLC were formed to hold other real estate owned and future office sites. The
Trusts were formed for the purpose of issuing redeemable capital securities,
commonly known as trust preferred securities and are not included in the
Company's consolidated financial statements in accordance with authoritative
accounting guidance because management has determined that the Trusts qualify as
variable interest entities.



Products, services, customers and locations



The Bank offers loan, deposit, and wealth management products and services. Loan
products and services include consumer loans, residential mortgages, home equity
loans, and commercial loans. Deposit products and services include checking
accounts, treasury management solutions, savings accounts, money market
accounts, certificates of deposit, and individual retirement accounts. Wealth
management services include estate planning, investment management of assets,
trustee under an agreement, trustee under a will, individual retirement
accounts, and estate settlement. Customers include small and medium-sized
businesses, individuals, estates, local governmental entities, and non-profit
organizations. The Bank's office locations are well-positioned in attractive
markets along the Interstate 81, Interstate 66, and Interstate 64 corridors in
the Shenandoah Valley, the Roanoke Valley, central regions of Virginia, and the
city of Richmond.  Within these markets, there are diverse types of industry
including medical and professional services, manufacturing, retail, warehousing,
Federal and local government, hospitality, and higher education. The Bank's
products and services are delivered through 20 bank branch offices, a loan
production office and customer service centers in two retirement villages. For
the location and general character of each of these offices, see Item 2 of the
Company's Form 10-K for the year ended December 31, 2021. Many of the Bank's
services are also delivered through the Bank's mobile banking platform, its
website, www.fbvirginia.com, and a network of ATMs located throughout its market
area.


Sources of income and factors of expenses



The primary source of revenue is from net interest income earned by the Bank.
Net interest income is the difference between interest income and interest
expense and typically represents between 70% and 80% of the Company's total
revenue. Interest income is determined by the amount of interest-earning assets
outstanding during the period and the interest rates earned on those assets. The
Bank's interest expense is a function of the amount of interest-bearing
liabilities outstanding during the period and the interest rates paid. In
addition to net interest income, noninterest income is the other source of
revenue for the Company. Noninterest income is derived primarily from service
charges on deposits, fee income from wealth management services, and ATM and
check card fees.



Primary expense categories are salaries and employee benefits, which comprised
58% of noninterest expenses for the six months ended June 30, 2022, followed by
occupancy and equipment expense, which comprised 13% of noninterest expenses.
The provision for loan losses is also typically a primary expense of the Bank.
The provision is determined by factors that include net charge-offs, asset
quality, economic conditions, and loan growth. Changing economic conditions
caused by inflation, recession, unemployment, or other factors beyond the
Company's control have a direct correlation with asset quality, net charge-offs,
and ultimately the required provision for loan losses.

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Overview of quarterly financial performance

The following items had the most significant impact on financial performance, when comparing the second quarter of 2022 to the same period in 2021.

? The acquisition of Fincastle Bank (fincastle) had a significant impact

on balance sheet growth. On July 1, 2021the date of acquisition, fincastle had

total assets of $267.9 millioninterest-bearing deposits in banks $43.5

million, total securities of $12.0 millionloans, net of the provision for

    loan losses, of $191.5 million, and total deposits of $236.3 million.



? The acquisition of the SmartBank loan portfolio from its richmond-regional branch

had an impact on the composition of the Bank’s earning assets. On September 30, 2021,

at the date of acquisition, the loan portfolio totaled $82.6 million. The bank

    funded the acquisition of the loan portfolio with cash, which decreased
    interest-bearing deposits in banks in the third quarter of 2021.



? The provision for loan losses amounts to $400,000 for the second quarter of

2022, which was a $1.4 million increase over loan recovery

    losses of $1.0 million in the second quarter of 2021.



? Total loans increased $43.7 millionin the three-month period ending in June

    30, 2022.



? The increase in PPP revenues, net of costs, decreased to $35,000 for the second

quarter of 2022, compared to $509,000 for the same period in the previous

    year.



? Accretion of discounts on purchased loans, net of premium amortization, totaled

$351,000 for the second quarter of 2022, compared to no credit purchased

    accretion for the same period in the prior year




Net income increased by $493 thousand, or 15%, to $3.8 million, or $0.61 per
diluted share, for the three months ended June 30, 2022, compared to $3.3
million, or $0.69 per diluted share, for the same period in 2021. Return on
average assets was 1.08% and return on average equity was 15.04% for the second
quarter of 2022, compared to 1.31% and 15.33%, respectively, for the same period
in 2021.



The increase in net income resulted primarily from a $3.8 million, or 51%,
increase in net interest income and a $345 thousand, or 14%, increase in total
noninterest income, which were partially offset by a $2.3 million, or 35%,
increase in total noninterest expense and an increase in the provision for loan
losses.  The provision for loan losses totaled $400 thousand for the second
quarter of 2022, compared to a recovery of loan losses of $1.0 million for the
same period of 2021.



The $3.8 million, or 51%, increase in net interest income resulted from an
increase in total interest income and no change in total interest expense. Net
interest income increased as the net interest margin expanded by 32 basis points
and average earning assets increased by 37%. The margin expansion resulted from
an increase in earning asset yields, a change in the earning asset composition,
and a decrease in the cost of funds. Earning asset yields increased by 25 basis
points from a higher interest rate environment during the second quarter of
2022, while the cost of funds decreased by 7 basis points, primarily from lower
interest rates paid on deposits and subordinated debt. The change in the earning
asset composition favorably impacted the net interest margin as average total
securities increased and average interest-bearing deposits in banks decreased.
The growth in earning assets resulted from both the acquisition of Fincastle and
from deposit growth.



The provision for loan losses totaled $400 thousand for the second quarter of
2022 in contrast to the second quarter of 2021 when the Bank recorded a $1.0
million recovery of loan losses. The allowance for loan losses totaled $6.2
million, or 0.70% of total loans on June 30, 2022, 0.69% of total loans on
December 31, 2021, and 0.89% of total loans on June 30, 2021.



The $345 thousand, or 14%, year-over-year quarterly increase in noninterest
income was primarily a result of a $251 thousand increase in service charges on
deposits, followed by increases in ATM and check card fees, wealth management
fees, and an increase in fees for other customer services. The merger with
Fincastle contributed to all increased income categories, except for wealth
management fees. The increases were partially offset by decreases in brokered
mortgage fees and other operating income.



Noninterest expense increased $2.3 million, or 35%, and was primarily
attributable to the increase in the number of employees, branch offices and
customers that resulted from the acquisition of Fincastle and the acquisition of
the SmartBank loan portfolio. Salaries and employee benefits increased by $1.4
million, followed by increases in occupancy, equipment, and other operating
expense.



For a more detailed discussion of the Company’s quarterly performance, see “Net Interest Income”, “Provision for Loan Losses”, “Non-Interest Income”, “Non-Interest Expenses” and “Income Taxes” below. below.

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The acquisition of Fincastle Bank



On July 1, 2021, the Company completed the acquisition of The Bank of Fincastle
for an aggregate purchase price of $33.8 million of cash and stock. The Company
paid cash consideration of $6.8 million and issued 1,348,065 shares of its
common stock to the shareholders of Fincastle. Upon completion of the
transaction, Fincastle was merged with and into First Bank. At the time of
closing of the acquisition, The Bank of Fincastle had six bank branch offices
operating in the Roanoke Valley region of Virginia and reported total assets of
$267.9 million, total loans of $194.5 million and total deposits of $236.3
million. After the merger, the former Fincastle branches continued to operate as
The Bank of Fincastle, a division of First Bank, until the systems were
converted on October 16, 2021. All branch offices have been operating as First
Bank since the system conversion. For the three and six months ended June 30,
2022, the Company recorded merger related expenses of $20 thousand in connection
with the acquisition of Fincastle.

Purchased performing loans were recorded at fair value, including a credit
discount. The fair value discount will be accreted as an adjustment to yield
over the estimated lives of the loans. A provision for loan losses on the
purchased loans is expected in future periods as the accretion decreases the
fair value discount amount. A provision may also be required for any
deterioration in these loans in future periods.

The Company expected to benefit from cost savings following the acquisition of
fincastle. Of the June 30, 2022the Company had substantially realized all anticipated cost savings related to the merger of fincastle with and in First bank.

Acquisition of SmartBank’s loan portfolio



On September 30, 2021, the Bank acquired $82.6 million of loans and certain
fixed assets from SmartBank related to its Richmond area branch, located in Glen
Allen, Virginia. First Bank paid cash consideration of $83.7 million for the
loans and fixed assets. Additionally, an experienced team of bankers based out
of the SmartBank location have transitioned to become employees of First Bank.
First Bank did not assume any deposit liabilities from SmartBank in connection
with the transaction, and SmartBank closed their branch operation on December
31, 2021. First Bank assumed the facility lease and acquired the remaining
assets at the branch on December 31, 2021 and now operates a loan production
office in the location of the former SmartBank branch. The Company incurred
expenses totaling $101 thousand related to the acquisition of loans and fixed
assets of SmartBank in the fourth quarter of 2021. There were no additional
expenses related to the acquisition for the three and six months ended June 30,
2022.



Non-GAAP Financial Measures



This report refers to the efficiency ratio, which is computed by dividing
noninterest expense, excluding amortization of intangibles, net gains on
disposal of premises and equipment, and merger related expenses, by the sum of
net interest income on a tax-equivalent basis and noninterest income, excluding
securities gains. This is a non-GAAP financial measure that the Company believes
provides investors with important information regarding operational efficiency.
Such information is not prepared in accordance with GAAP and should not be
construed as such. Management believes, however, such financial information is
meaningful to the reader in understanding operating performance, but cautions
that such information not be viewed as a substitute for GAAP. The Company, in
referring to its net income, is referring to income under GAAP. The components
of the efficiency ratio calculation are summarized in the following table
(dollars in thousands).



                                                                        Efficiency Ratio
                                                   Three Months Ended                       Six Months Ended
                                            June 30, 2022       June 30, 2021       June 30, 2022       June 30, 2021
Noninterest expense                        $         8,918     $         6,630     $        17,562     $        13,280
Add/(Subtract): other real estate owned
(expense), net                                         (41 )                 -                 (69 )                 -
Subtract: amortization of intangibles                   (5 )                (5 )                (9 )               (19 )
Add: gains on disposal of premises and
equipment, net                                           -                  14                   -                  26
Subtract: loss on disposal of premises
and equipment, net                                       -                   -                  (2 )                 -
Subtract: merger related expenses                        -                (277 )               (20 )              (682 )
                                           $         8,872     $         6,362     $        17,462     $        12,605
Tax-equivalent net interest income         $        11,372     $         7,560     $        22,008     $        15,128
Noninterest income                                   2,780               2,435               5,491               4,578
Subtract: securities gains, net                          -                   -                   -                 (37 )
                                           $        14,152     $         9,995     $        27,499     $        19,669
Efficiency ratio                                     62.69 %             63.65 %             63.50 %             64.09 %




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This report also refers to net interest margin, which is calculated by dividing
tax equivalent net interest income by total average earning assets. Because a
portion of interest income earned by the Company is nontaxable, the tax
equivalent net interest income is considered in the calculation of this ratio.
Tax equivalent net interest income is calculated by adding the tax benefit
realized from interest income that is nontaxable to total interest income then
subtracting total interest expense. The tax rate utilized in calculating the tax
benefit for both 2022 and 2021 is 21%. The reconciliation of tax equivalent net
interest income, which is not a measurement under GAAP, to net interest income,
is reflected in the table below (in thousands).

                                             Reconciliation of Net Interest 

Income versus net interest income equivalent to tax

                                                    Three Months Ended                           Six Months Ended
                                            June 30,                                     June 30,
                                              2022              June 30, 2021              2022              June 30, 2021
GAAP measures:
Interest income - loans                    $     9,963         $          7,074         $    19,459         $        14,217
Interest income - investments and other          1,876                      971               3,404                   1,923
Interest expense - deposits                       (413 )                   (328 )              (753 )                  (691 )
Interest expense - subordinated debt               (69 )                   (154 )              (138 )                  (308 )
Interest expense - junior subordinated
debt                                               (67 )                    (68 )              (134 )                  (134 )
Total net interest income                  $    11,290         $          7,495         $    21,838         $        15,007
Non-GAAP measures:
Tax benefit realized on non-taxable
interest income - loans                    $         -         $              8         $         7         $            16
Tax benefit realized on non-taxable
interest income - municipal securities              82                       57                 163                     105
Total tax benefit realized on
non-taxable interest income                $        82         $             65         $       170         $           121

Total tax equivalent net interest income $11,372 $7,560 $22,008 $15,128




Critical Accounting Policies



General



The Company's consolidated financial statements and related notes are prepared
in accordance with GAAP. The financial information contained within the
statements is, to a significant extent, financial information that is based on
measures of the financial effects of transactions and events that have already
occurred. A variety of factors could affect the ultimate value that is obtained
either when earning income, recognizing an expense, recovering an asset, or
relieving a liability. The Bank uses historical losses as one factor in
determining the inherent loss that may be present in the loan portfolio. Actual
losses could differ significantly from the historical factors used. In addition,
GAAP itself may change from one previously acceptable method to another.
Although the economics of transactions would be the same, the timing of events
that would impact transactions could change.



Presented below is a discussion of those accounting policies that management
believes are the most important (Critical Accounting Policies) to the portrayal
and understanding of the Company's financial condition and results of
operations. The Critical Accounting Policies require management's most
difficult, subjective, and complex judgments about matters that are inherently
uncertain. In the event that different assumptions or conditions were to
prevail, and depending upon the severity of such changes, the possibility of
materially different financial condition or results of operations is a
reasonable likelihood.



Allowance for Loan Losses



The allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. Loan losses
are charged against the allowance when management determines that the loan
balance is uncollectible. Subsequent recoveries, if any, are credited to the
allowance. For further information about the Company's loans and the allowance
for loan losses, see Notes 3 and 4 to the Consolidated Financial Statements
included in this Form 10-Q.



The allowance for loan losses is evaluated on a quarterly basis by management
and is based upon management's periodic review of the collectability of the
loans in light of historical experience, the nature and volume of the loan
portfolio, adverse situations that may affect the borrower's ability to repay,
estimated value of any underlying collateral, and prevailing economic
conditions. This evaluation is inherently subjective as it requires estimates
that are susceptible to significant revision as more information becomes
available.



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The Company performs regular credit reviews of the loan portfolio to review
credit quality and adherence to underwriting standards. The credit reviews
consist of reviews by its internal credit administration department and reviews
performed by an independent third party. Upon origination, each loan is assigned
a risk rating ranging from one to nine, with loans closer to one having less
risk. This risk rating scale is the Company's primary credit quality indicator.
The Company has various committees that review and ensure that the allowance for
loans losses methodology is in accordance with GAAP and loss factors used
appropriately reflect the risk characteristics of the loan portfolio.



The allowance represents an amount that, in management's judgment, will be
adequate to absorb any losses on existing loans that may become uncollectible.
Management's judgment in determining the level of the allowance is based on
evaluations of the collectability of loans while taking into consideration such
factors as trends in delinquencies and charge-offs, changes in the nature and
volume of the loan portfolio, current economic conditions that may affect a
borrower's ability to repay and the value of the collateral, overall portfolio
quality, and review of specific potential losses. The evaluation also considers
the following risk characteristics of each loan portfolio class:



• Residential mortgages for 1 to 4 families carry risks associated with the

the maintenance of the solvency of the borrower and the variations in the value of the

    collateral.



• Loans for building construction and land development involve risks that

the project may not be completed according to schedule, the project may not be

completed within budget, and the collateral value may, at any time

at any given time, be less than the principal amount of the loan. Construction

loans also carry the risk that the general contractor, who may or may not be a

loan customer, may be unable to complete construction project as planned

due to financial pressures or other non-project factors.

• Other home loans carry risks related to the success of the operation

of a business or a real estate project, in addition to the other risks related

with the ownership of real estate, because the repayment of these loans can be

depend on the profitability and cash flow of the business or project.

• Commercial and industrial loans have risks associated with success

operating a business, as the repayment of these loans may depend on

the company’s profitability and cash flow. Moreover, there is a risk

associated with the value of collateral other than real estate that may

    depreciate over time and cannot be appraised with as much reliability.




  • Consumer and other loans carry risk associated with the continued

the creditworthiness of the borrower and the value of the collateral, if any.

Consumer loans are generally either unsecured or secured by

depreciation of assets such as automobiles. These loans are also likely to be

immediately and negatively affected by job loss, divorce, illness,

bankruptcy or other changes in circumstances. Other loans included in this

    category include loans to states and political subdivisions.




The allowance for loan losses consists of specific and general components. The
specific component relates to loans that are classified as impaired, and is
established when the discounted cash flows, fair value of collateral less
estimated costs to sell, or observable market price of the impaired loan is
lower than the carrying value of that loan. For collateral dependent loans, an
updated appraisal is ordered if a current one is not on file. Appraisals are
typically performed by independent third-party appraisers with relevant industry
experience. Adjustments to the appraised value may be made based on recent sales
of like properties or general market conditions among other considerations.



The general component covers loans that are not considered impaired and is based
on historical loss experience adjusted for qualitative factors. The historical
loss experience is calculated by loan type and uses an average loss rate during
the preceding twelve quarters. The qualitative factors are assigned by
management based on delinquencies and asset quality, national and local economic
trends, effects of the changes in the value of underlying collateral, trends in
volume and nature of loans, effects of changes in the lending policy, the
experience and depth of management, concentrations of credit, quality of the
loan review system, and the effect of external factors such as competition and
regulatory requirements. The factors assigned differ by loan type. The general
allowance estimates losses whose impact on the portfolio has yet to be
recognized by a specific allowance. Allowance factors and the overall size of
the allowance may change from period to period based on management's assessment
of the above described factors and the relative weights given to each factor.
For further information regarding the allowance for loan losses, see Note 4 to
the Consolidated Financial Statements included in this Form 10-Q.



Loans acquired from Fincastle and SmartBank were recorded at fair value. There
was $254 thousand of allowance for loan losses attributable to purchased loans
at June 30, 2022.


Loans acquired as part of a business combination

Purchased loans are classified as either (i) purchased credit-impaired loans or (ii) purchased performing loans and are recorded at fair value at the acquisition date.



PCI loans are those for which there is evidence of credit deterioration since
origination and for which it is probable at the date of acquisition that the
Corporation will not collect all contractually required principal and interest
payments. When determining fair value, PCI loans are aggregated into pools of
loans based on common risk characteristics as of the date of acquisition such as
loan type, date of origination, and evidence of credit quality deterioration
such as internal risk grades and past due and nonaccrual status. The difference
between contractually required payments at acquisition and the cash flows
expected to be collected at acquisition is referred to as the "nonaccretable
difference." Any excess of cash flows expected at acquisition over the estimated
fair value is referred to as the "accretable yield" and is recognized as
interest income over the remaining life of the loan when there is a reasonable
expectation about the amount and timing of such cash flows.  There were no
acquired loans classified as PCI in the acquisition of the Fincastle and the
SmartBank loan portfolios.


Good will and other intangible assets



Goodwill arises from business combinations and is determined as the excess fair
value of the consideration transferred over the fair value of the net assets
acquired and liabilities assumed as of the acquisition date. Goodwill and
intangible assets acquired in a business combination and determined to have an
indefinite useful life are not amortized, but tested for impairment at least
annually or more frequently if events and circumstances exist that indicate that
a goodwill impairment test should be performed. The Company has selected June 30
as the date to perform the annual impairment test. Intangible assets with finite
useful lives are amortized over their estimated useful lives to their estimated
residual values. Goodwill is the only intangible asset with an indefinite life
on the balance sheet.



Other intangible assets consist of core deposit intangible assets arising from
whole bank and branch acquisitions and are amortized on an accelerated method
over their estimated useful lives, which range from 6 to 10 years.



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Lending Policies


There were no material changes to the company’s lending policies disclosed in the annual report on Form 10-K for the year ended December 31, 2021.


Results of Operations



General



Net interest income represents the primary source of earnings for the Company.
Net interest income equals the amount by which interest income on
interest-earning assets, predominantly loans and securities, exceeds interest
expense on interest-bearing liabilities, including deposits, other borrowings,
subordinated debt, and junior subordinated debt. Changes in the volume and mix
of interest-earning assets and interest-bearing liabilities, as well as their
respective yields and rates, are the components that impact the level of net
interest income. The net interest margin is calculated by dividing
tax-equivalent net interest income by average earning assets. The provision for
loan losses, noninterest income, and noninterest expense are the other
components that determine net income. Noninterest income and expense primarily
consists of income from service charges on deposit accounts, revenue from wealth
management services, ATM and check card income, revenue from other customer
services, income from bank owned life insurance, general and administrative
expenses, amortization expense, and other real estate owned expense.



Net Income


Three-month period ended June 30, 2022



Net income increased by $493 thousand, or 15%, to $3.8 million, or $0.61 per
diluted share, for the three months ended June 30, 2022, compared to $3.3
million, or $0.69 per diluted share, for the same period in 2021. Return on
average assets was 1.08% and return on average equity was 15.04% for the second
quarter of 2022, compared to 1.31% and 15.33%, respectively, for the same period
in 2021.



The increase in net income resulted primarily from a $3.8 million, or 51%,
increase in net interest income and a $345 thousand, or 14%, increase in total
noninterest income, which were partially offset by a $2.3 million, or 35%,
increase in total noninterest expense and an increase in the provision for loan
losses.  The provision for loan losses totaled $400 thousand for the second
quarter of 2022, compared to a recovery of loan losses of $1.0 million for the
same period of 2021.


Six-month period ended June 30, 2022



Net income increased by $1.8 million, or 31%, to $7.6 million, or $1.21 per
diluted share, for the six months ended June 30, 2022, compared to $5.8 million,
or $1.19 per diluted share, for the same period in 2021. Return on average
assets was 1.07% and return on average equity was 14.16% for the six months
ended June 30, 2022, compared to 1.15% and 13.44%, respectively, for the same
period in 2021.



The increase in net income resulted primarily from a $6.8 million, or 46%,
increase in net interest income and a $913 thousand, or 20%, increase in total
noninterest income, which were partially offset by a $4.3 million, or 32%,
increase in total noninterest expense and an increase in the provision for loan
losses.  The provision for loan losses totaled $400 thousand for the six months
ended June 30, 2022, compared to a recovery of loan losses of $1.0 million for
the same period of 2021.



Net Interest Income


Three-month period ended June 30, 2022



Net interest income increased $3.8 million, or 51%, comparing the second quarter
of 2022 to the same period of 2021, and was positively impacted by a higher
interest rate environment, a significant increase in average earning assets, and
a change in the Company's earning asset composition. During the second quarter
of 2022, the high-end of the Federal funds target increased from 0.50% to 1.75%,
compared to a Federal funds rate that remained at 0.25% throughout the second
quarter of 2021. The higher rate environment resulted in a 14-basis point
increase in the yield on loans and a 72-basis point increase in the yield on
interest-bearing deposits in other banks, while the total cost of
interest-bearing deposits decreased two basis points.  The cost of subordinated
debt decreased by 64-basis points from the redemption of $5.0 million of higher
rate subordinated debt on January 1, 2022.  Although the Federal funds rate
increased by 150 basis points, the Company's total cost of funds decreased seven
basis points, when comparing the periods. Average earning assets increased
$358.0 million, or 37%, as a result of the acquisition of Fincastle in the third
quarter of 2021 and growth of the Bank's deposit portfolio over the last twelve
months. Additionally, the composition of earning assets contributed to the
increase in total interest and dividend income as total average securities
increased from 20% to 27% of average earning assets, while average
interest-bearing deposits in other banks decreased from 16% to 9%. Average loans
were unchanged at 64% of average earning assets when comparing the same periods.



The $3.8 million increase in net interest income resulted from a $3.8 million,
or 47%, increase in total interest and dividend income, while total interest
expense was unchanged. The increase in total interest and dividend income was
attributable to a $2.9 million increase in interest income and fees on loans, a
$214 thousand increase in interest on deposits in banks, and a $691 thousand
increase in interest income and dividends on securities. There was no change in
total interest expense as an increase in interest expense on deposits was offset
by a decrease in interest expense on subordinated debt. The net interest margin
increased to 3.42%, a 32-basis point increase from 3.10% in the same period one
year ago.



Accretion of PPP income, net of costs, and accretion of discounts on purchased
loans, net of premiums, were included in interest and fees on loans. Net
accretion of PPP income totaled $35 thousand in the second quarter of 2022,
compared to $509 thousand for the same period of 2021. Net accretion of
discounts on purchased loans totaled $351 thousand in the second quarter of
2022. There were no purchased loans in the second quarter of 2021, and as a
result, there was no net accretion of discounts on purchased loans during the
period.


Six-month period ended June 30, 2022



Net interest income increased $6.8 million, or 46%, comparing the six months
ended June 30, 2022, to the same period of 2021, and was positively impacted by
a higher interest rate environment, a significant increase in average earning
assets, and a change in the Company's earning asset composition. During the six
months ended June 30, 2022, the high-end of the Federal funds target increased
from 0.25% to 1.75%, compared to a Federal funds rate that remained at 0.25%
throughout the same period of 2021. The higher rate environment resulted in a
11-basis point increase in the yield on loans and a 34-basis point increase in
the yield on interest-bearing deposits in other banks, while the cost of
interest-bearing deposits decreased six basis points.  The cost of subordinated
debt decreased by 133-basis points from the redemption of $5.0 million of higher
rate subordinated debt on January 1, 2022.  Although the Federal funds rate
increased by 150 basis points, the Company's total cost of funds decreased nine
basis points, when comparing the periods. Average earning assets increased
$353.8 million, or 37%, as a result of the acquisition of Fincastle in the third
quarter of 2021 and growth of the Bank's deposit portfolio over the last twelve
months. Additionally, the composition of earning assets contributed to the
increase in total interest and dividend income as total average securities
increased from 18% to 24% of average earning assets, while average
interest-bearing deposits in other banks decreased from 16% to 12% and average
loans decreased from 66% to 64%.



The $6.8 million increase in net interest income resulted from a $6.7 million,
or 42%, increase in total interest and dividend income, while total interest
expense decreased by $108 thousand. The increase in total interest and dividend
income was attributable to a $5.2 million increase in interest income and fees
on loans, a $251 thousand increase in interest on deposits in banks, and a $1.2
million increase in interest income and dividends on securities. The decrease in
total interest expense resulted from a $170 thousand decrease in interest
expense on subordinated debt, which was partially offset by a $62 thousand
increase in interest expense on deposits. The net interest margin increased to
3.39%, a 30-basis point increase from 3.19% in the same period one year ago.



Accretion of PPP income, net of costs, and accretion of discounts on purchased
loans, net of premiums, were included in interest and fees on loans. Net
accretion of PPP income totaled $358 thousand for the six months ended June 30,
2022, compared to $1.1 million for the same period of 2021. Net accretion of
discounts on purchased loans totaled $718 thousand for the six months ended June
30, 2022. There were no purchased loans in the six months ended June 30, 2021,
and as a result, there was no net accretion of discounts on purchased loans
during the period.



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The following tables show interest income on earning assets and related average
yields as well as interest expense on interest-bearing liabilities and related
average rates paid for the periods indicated (dollars in thousands):



  Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent
                                     Basis)



                                                                                         Three Months Ended
                                                              June 30, 2022                                               June 30, 2021
                                                                   Interest                                                    Interest
                                          Average Balance       Income/Expense       Yield/Rate       Average Balance       Income/Expense       Yield/Rate
Assets
Securities:
Taxable                                  $         296,318     $           1,295            1.75 %   $         147,285     $             697            1.90 %
Tax-exempt (1)                                      55,908                   391            2.81 %              42,712                   271            2.54 %
Restricted                                           1,908                    21            4.48 %               1,631                    22            5.37 %
Total securities                         $         354,134     $           1,707            1.93 %   $         191,628     $             990            2.07 %
Loans: (2)
Taxable                                  $         858,045     $           9,963            4.66 %   $         625,587     $           7,044            4.52 %
Tax-exempt (1)                                           -                     -               -                 3,400                    38            4.49 %
Total loans                              $         858,045     $           9,963            4.66 %   $         628,987     $           7,082            4.52 %
Federal funds sold                                       -                     -               -                     -                     -               -
Interest-bearing deposits with other
institutions                                       122,797                   251            0.82 %             156,317                    38            0.10 %
Total earning assets                     $       1,334,976     $          11,921            3.58 %   $         976,932     $           8,110            3.33 %
Less: allowance for loan losses                     (5,845 )                                                    (7,466 )
Total non-earning assets                            90,747                                                      57,117
Total assets                             $       1,419,878                                           $       1,026,583
Liabilities and Shareholders' Equity
Interest bearing deposits:
Checking                                 $         300,473     $             157            0.21 %   $         233,720     $             100            0.17 %
Regular savings                                    209,513                    26            0.05 %             134,266                    20            0.06 %
Money market accounts                              220,182                    75            0.14 %             160,462                    45            0.11 %
Time deposits:
$100,000 and over                                   62,346                    80            0.51 %              40,212                    83            0.83 %
Under $100,000                                      75,025                    75            0.40 %              55,485                    80            0.57 %
Brokered                                               553                     -            0.12 %                 578                     -            0.20 %
Total interest-bearing deposits          $         868,092     $             413            0.19 %   $         624,723     $             328            0.21 %
Federal funds purchased                                  2                     -               - %                   -                     -            0.00 %
Subordinated debt                                    4,994                    69            5.56 %               9,992                   155            6.20 %
Junior subordinated debt                             9,279                    67            2.91 %               9,279                    67            2.91 %
Total interest-bearing liabilities       $         882,367     $             549            0.25 %   $         643,994     $             550            0.34 %
Non-interest bearing liabilities
Demand deposits                                    431,995                                                     292,960
Other liabilities                                    3,247                                                       2,187
Total liabilities                        $       1,317,609                                           $         939,141
Shareholders' equity                               102,269                                                      87,442
Total liabilities and Shareholders'
equity                                   $       1,419,878                                           $       1,026,583
Net interest income                                            $          11,372                                           $           7,560
Interest rate spread                                                                        3.33 %                                                      2.99 %
Cost of funds                                                                               0.17 %                                                      0.24 %
Interest expense as a percent of
average earning assets                                                                      0.16 %                                                      0.23 %
Net interest margin                                                                         3.42 %                                                      3.10 %



(1) Income and returns are reported on an equivalent taxable basis assuming a

federal tax rate of 21%. The tax adjustment was $82 and $65

thousands for the three months ended June 30, 2022 and 2021, respectively.

(2) Unrecognized loans are reflected in balances.

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                                                                                          Six Months Ended
                                                              June 30, 2022                                               June 30, 2021
                                                                   Interest                                                    Interest
                                          Average Balance       Income/Expense       Yield/Rate       Average Balance       Income/Expense       Yield/Rate
Assets
Securities:
Taxable                                  $         257,529     $           2,427            1.90 %   $         135,305     $           1,413            2.11 %
Tax-exempt (1)                                      58,647                   777            2.67 %              38,856                   499            2.59 %
Restricted                                           1,867                    42            4.60 %               1,738                    44            5.12 %
Total securities                         $         318,043     $           3,246            2.06 %   $         175,899     $           1,956            2.24 %
Loans: (2)
Taxable                                  $         841,608     $          19,439            4.66 %   $         628,012     $          14,157            4.55 %
Tax-exempt (1)                                       1,106                    27            4.49 %               3,412                    76            4.49 %
Total loans                              $         842,714     $          19,466            4.66 %   $         631,424     $          14,233            4.55 %
Federal funds sold                                       -                     -               -                    67                     -            0.10 %
Interest-bearing deposits with other
institutions                                       150,222                   321            0.43 %             149,786                    70            0.09 %
Total earning assets                     $       1,310,979     $          23,033            3.54 %   $         957,176     $          16,259            3.43 %
Less: allowance for loan losses                     (5,806 )                                                    (7,475 )
Total non-earning assets                           120,409                                                      59,929
Total assets                             $       1,425,582                                           $       1,009,630
Liabilities and Shareholders' Equity
Interest bearing deposits:
Checking                                 $         295,005     $             256            0.17 %   $         230,723     $             217            0.19 %
Regular savings                                    208,163                    51            0.05 %             130,262                    39            0.06 %
Money market accounts                              233,496                   126            0.11 %             157,902                    88            0.11 %
Time deposits:
$100,000 and over                                   63,429                   163            0.52 %              41,392                   182            0.88 %
Under $100,000                                      76,566                   154            0.40 %              55,667                   164            0.60 %
Brokered                                               558                     3            1.03 %                 586                     1            0.43 %
Total interest-bearing deposits          $         877,217     $             753            0.17 %   $         616,532     $             691            0.23 %
Federal funds purchased                                  2                     -               -                     1                     -            0.47 %
Subordinated debt                                    5,708                   138            4.89 %               9,992                   308            6.22 %
Junior subordinated debt                             9,279                   134            2.91 %               9,279                   134            2.91 %
Other borrowings                                         -                     -               - %                   -                     -           

0.00% Total interest-bearing liabilities $892,206 $1,025

            0.23 %   $         635,804     $           1,133            0.36 %
Non-interest bearing liabilities
Demand deposits                                    421,785                                                     284,542
Other liabilities                                    3,904                                                       2,617
Total liabilities                        $       1,317,895                                           $         922,963
Shareholders' equity                               107,686                                                      86,667
Total liabilities and Shareholders'
equity                                   $       1,425,581                                           $       1,009,630
Net interest income                                            $          22,008                                           $          15,126
Interest rate spread                                                                        3.31 %                                                      3.07 %
Cost of funds                                                                               0.16 %                                                      0.25 %
Interest expense as a percent of
average earning assets                                                                      0.16 %                                                      0.24 %
Net interest margin                                                                         3.39 %                                                      3.19 %



(1) Income and returns are reported on an equivalent taxable basis assuming a

federal tax rate of 21%. The tax adjustment was $170 and $121

thousand for the six months ended June 30, 2022 and 2021, respectively.

(2) Unrecognized loans are reflected in balances.

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Provision for Loan Losses


Three-month period ended June 30, 2022



The provision for loan losses totaled $400 thousand for the second quarter of
2022, compared to a $1.0 million recovery of loan losses for the same period of
2021. The provision for loan losses resulted primarily from an increase in the
general reserve component of the allowance for loan losses, which was
attributable to loan growth during the quarter. There were no specific reserves
on impaired loans at June 30, 2022, compared to $78 thousand of specific
reserves at June 30, 2021. Net charge-offs totaled $26 thousand during the
second quarter of 2022, compared to $1.0 million of net charge-offs for the same
period of 2021.



The $1.0 million recovery of loan losses for the second quarter of 2021 resulted
from the resolution of a previously impaired loan and a related decrease of the
specific reserve component of the allowance for loan losses during the period.



The allowance for loan losses totaled $6.2 million, or 0.70% of total loans at
June 30, 2022, compared to $5.5 million, or 0.89% of total loans at June 30,
2021. The net discount on purchased loans totaled $2.9 million, or 0.33% of
total loans at June 30, 2022. There were no discounts on purchased loans at June
30, 2021.


Six-month period ended June 30, 2022



The provision for loan losses also totaled $400 thousand for the six months
ended June 30, 2022, compared to a $1.0 million recovery of loan losses for the
same period of 2021. Like the second quarter ended June 30, 2022, the provision
for loan losses for the six-month period resulted primarily from an increase in
the general reserve component of the allowance for loan losses and was
attributable to loan growth. There were net recoveries of previously charged-off
loans totaling $92 thousand for the first six months of 2022, compared to $1.0
of net charge-offs for the same period of 2021.



Noninterest Income


Three-month period ended June 30, 2022



Noninterest income increased $345 thousand, or 14%, to $2.8 million for the
second quarter of 2022, compared to the same period of 2021. Service charges on
deposits increased $251 thousand, or 56%, ATM and check card fees increased $115
thousand, or 17%, fees for other customer services increased $38 thousand, or
25%, and wealth management fees increased $103 thousand, or 16%. The increases
were partially offset by a $99 thousand, or 63%, decrease in brokered mortgage
fees, and a $77 thousand, or 34%, decrease in other operating income.



The increases in service charges on deposits, ATM and check card fees, and fees
for other customer services were favorably impacted by an increase in customer
transactions and additional deposit accounts that resulted from the acquisition
of Fincastle. The increase in wealth management income was attributable to an
increase in the number of client accounts. Brokered mortgage fees and net gains
on sale of loans held for sale decreased from a reduction in the number of
mortgage loans originated, as well as an increase in the number of mortgage
loans retained in the Bank's loan portfolio and not sold or brokered when
comparing the periods. The decrease in other operating income was a result of
income earned from an investment in a small business investment company
partnership in the second quarter of 2021.



Six-month period ended June 30, 2022



Noninterest income increased $913 thousand, or 20%, to $5.5 million for the six
months ended June 30, 2022, compared to the same period of 2021. Service charges
on deposits increased $418 thousand, or 47%, ATM and check card fees increased
$264 thousand, or 21%, fees for other customer services increased $90 thousand,
or 27%, and wealth management fees increased $263 thousand, or 20%. The
increases were partially offset by a $110 thousand, or 42%, decrease in brokered
mortgage fees and a $25 thousand decrease in gains on sale of loans held for
sale.



The increases in service charges on deposits, ATM and check card fees, and fees
for other customer services were favorably impacted by an increase in customer
transactions and additional deposit accounts that resulted from the acquisition
of Fincastle. The increase in wealth management income was attributable to an
increase in the number of client accounts. Brokered mortgage fees and net gains
on sale of loans held for sale decreased from a reduction in the number of
mortgage loans originated, as well as an increase in the number of mortgage
loans retained in the Bank's loan portfolio and not sold or brokered when
comparing the periods.



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Noninterest Expense


Three-month period ended June 30, 2022



Noninterest expense increased $2.3 million, or 35%, to $8.9 million for the
three-month period ended June 30, 2022, compared to the same period one year
ago. The increase was primarily attributable to a $1.4 million, or 38% increase
in salaries and employee benefits, a $146 thousand, or 37%, increase in
occupancy expense, a $187 thousand, or 43%, increase in equipment expense, an
$85 thousand, or 62%, increase in marketing, a $79 thousand, or 30%, increase in
ATM and check card expense, and a $280 thousand, or 42%, increase in other
operating expense. These increases were partially offset by a $102 thousand
decrease in legal and professional fees.



The increases were primarily attributable to the increase in the number of
employees, branch offices and customers that resulted from the acquisition of
Fincastle and the acquisition of the loan portfolio, branch assets and the
addition of employees from the SmartBank office. The increase in marketing was
also related to the timing of campaigns and promotion activities. The decrease
in legal and professional fees was primarily attributable to merger related
costs in the second quarter of 2021. Although there were no merger expenses in
the second quarter of 2022, merger expenses totaled $277 thousand in the second
quarter of 2021.


Six-month period ended June 30, 2022



Noninterest expense increased $4.3 million, or 32%, to $17.6 million for the
six-month period ended June 30, 2022, compared to the same period one year ago.
The increase was primarily attributable to a $3.0 million, or 41% increase in
salaries and employee benefits, a $315 thousand, or 36%, increase in equipment
expense, a $271 thousand, or 32%, increase in occupancy expense, a $151
thousand, or 30%, increase in ATM and check card expense, a $137 thousand, or
93%, increase in FDIC assessment, a $130 thousand, or 53%, increase in
marketing, a $114 thousand, or 34%, increase in bank franchise tax, and a $510
thousand, or 40%, increase in other operating expense. These increases were
partially offset by a $506 thousand, or 41%, decrease in legal and professional
fees.



The increases were primarily attributable to the increase in the number of
employees, branch offices and customers that resulted from the acquisition of
Fincastle and the acquisition of the loan portfolio, branch assets and the
addition of employees from the SmartBank office. The increase in marketing was
also related to the timing of campaigns and promotion activities. The decrease
in legal and professional fees was primarily attributable to merger related
costs during the first six months of 2021. Merger expenses totaled $20 thousand
for the first six months of 2022 compared to $682 thousand for the same period
of 2021.



Income Taxes


Three-month period ended June 30, 2022



Income tax expense decreased $41 thousand for the second quarter of 2022,
compared to the same period one year ago. The effective tax rate for the second
quarter of 2022 was 19.3% compared to 22.3% for the same period in 2021. The
reduced effective tax rate for 2022 was the result of lower non-deductible
expenses in 2022 compared to 2021. The Company's income tax expense differed
from the amount of income tax determined by applying the U.S. federal income tax
rate to pretax income for the three months ended June 30, 2022, and 2021. The
difference was a result of net permanent tax deductions, primarily comprised of
tax-exempt interest income, income from bank owned life insurance. A more
detailed discussion of the Company's tax calculation is contained in Note 11 to
the Consolidated Financial Statements included in the Company's Annual Report on
Form 10-K for the year ended December 31, 2021.



Six-month period ended June 30, 2022



Income tax expense increased $276 thousand, or 18%, for the first six months of
2022 compared with the same period in 2021.  The effective tax rate for the
first six months of 2022 was 19.2% compared with 20.9% for the same period in
2021. Like the three month period ended June 30, 2022, the reduced effective tax
rate for 2022 was also the result of lower non-deductible expenses in 2022
compared to 2021.







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Financial Condition



General



Total assets increased $25.3 million to $1.4 billion at June 30, 2022, compared
to December 31, 2021. The increase was primarily attributable to an $54.5
million, or 7.0%, increase in loans, net of allowance for loan losses, and a
$43.7 million, or 130.7%, increase in securities held to maturity.  These
increases were partially offset by a decrease in interest-bearing deposits in
banks of $52.8 million, or 33.5%, and a decrease in securities available for
sale of $24.7 million, or 8.5%, during the first quarter of 2022.



At June 30, 2022, total liabilities increased $42.0 million to
$1.3 billion compared to December 31, 2021. The increase was primarily
attributable to an increase in savings and interest-bearing demand deposits of
$41.1 million and in increase in noninterest-bearing deposits of $18.1
million. These increases were partially offset by a decrease in time deposits of
$11.8 million during the first six months of 2022 and the Company's repayment of
$5.0 million of subordinated debt on January 1, 2022.



Total shareholders' equity decreased $16.7 million to $100.3 million at June 30,
2022, compared to $117.0 million at December 31, 2021. This was primarily
attributable to a $23.0 million decrease in accumulated other comprehensive
(loss) income (AOCI).  The decrease in AOCI is related to unrealized losses in
the securities portfolio stemming from market rate increases during the first
quarter.  This decrease was partially offset by a $5.8 million increase in
retained earnings.  The Company's capital ratios continued to exceed the minimum
capital requirements for regulatory purposes.



Loans



Loans, net of the allowance for loan losses, increased $54.5 million to $873.9
million at June 30, 2022, compared to $819.4 million at December 31, 2021. This
change was primarily due to increases in residential real estate, commercial
real estate and commercial and industrial loans of $20.1 million, $36.1 million
and $9.7 million, respectively, during the first six months of
2022. Construction loans and consumer and other loans decreased by $6.6 million
and $4.4 million, respectively, during the first six months of 2022.



The Bank actively participated as a lender in the U.S. Small Business
Administration's ("SBA") Paycheck Protection Program ("PPP") to support local
small businesses and non-profit organizations by providing forgivable loans.
Loan fees received from the SBA are accreted by the Bank into income evenly over
the life of the loans, net of loan origination costs, through interest and fees
on loans. PPP loans totaled $845 thousand at June 30, 2022, with $32 thousand
scheduled to mature in the second and third quarters of 2022, and $813 thousand
scheduled to mature in the first and second quarters of 2026. The total amount
of deferred PPP income, net of origination costs, that has not yet been
recognized through interest and fees on loans totaled $8 thousand at June 30,
2022. The Company believes the majority of these loans will ultimately be
forgiven and repaid by the SBA in accordance with the terms of the program. It
is the Company's understanding that loans funded through the PPP program are
fully guaranteed by the U.S. government. Should those circumstances change, the
Company could be required to establish additional allowance for loan losses
through additional provision for loan losses charged to earnings.



During the fourth quarter of 2020, the Bank modified terms of certain loans for
customers that continued to be negatively impacted by the pandemic. The loan
modifications lowered borrower loan payments by allowing interest only payments
for periods ranging between 6 and 24 months. All loans modified were in the
lodging sector of the Bank's commercial real estate loan portfolio and totaled
$4.7 million at June 30, 2022. All modified loans were performing under their
modified terms at June 30, 2022.





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Loans that management has the intent and ability to hold for the foreseeable
future or until maturity or pay-off generally are reported at their outstanding
unpaid principal balances less the allowance for loan losses and any deferred
fees or costs on originated loans. Interest income is accrued and credited to
income based on the unpaid principal balance. Loan origination fees, net of
certain origination costs, are deferred and recognized as an adjustment of the
related loan yield using the interest method. Interest income includes
amortization of purchase premiums and discounts, recognized evenly over the life
of the loans.


A loan's past due status is based on the contractual due date of the most
delinquent payment due. Loans are generally placed on non-accrual status when
the collection of principal or interest is 90 days or more past due, or earlier,
if collection is uncertain based on an evaluation of the net realizable value of
the collateral and the financial strength of the borrower. Loans greater than 90
days past due may remain on accrual status if management determines it has
adequate collateral to cover the principal and interest. Loans greater than 90
days past due and still accruing totaled $92 thousand at June 30, 2022.  There
were no loans greater than 90 days past due and still accruing at December 31,
2021. For those loans that are carried on non-accrual status, payments are first
applied to principal outstanding. A loan may be returned to accrual status if
the borrower has demonstrated a sustained period of repayment performance in
accordance with the contractual terms of the loan and there is reasonable
assurance the borrower will continue to make payments as agreed. These policies
are applied consistently across the loan portfolio.

All interest accrued but not collected for loans that are placed on non-accrual
or charged off is reversed against interest income. The interest on these loans
is accounted for on the cost-recovery method, until qualifying for return to
accrual. Loans are returned to accrual status when all the principal and
interest amounts contractually due are brought current and future payments are
reasonably assured. When a loan is returned to accrual status, interest income
is recognized based on the new effective yield to maturity of the loan.

Any unsecured loan deemed uncollectible is written off in full. Any secured loans deemed by management to be uncollectible are partially written off and recorded at the fair value of the collateral less estimated costs to sell. This charging policy applies to all loan segments.

Impaired Loans



A loan is considered impaired when, based on current information and events, it
is probable that the Company will be unable to collect all scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement. Factors considered by management in determining impairment include
payment status, collateral value (net of selling costs), and the probability of
collecting scheduled principal and interest payments when due. Additionally,
management generally evaluates substandard and doubtful loans greater than
$250 thousand for impairment. Loans that experience insignificant payment delays
and payment shortfalls generally are not classified as impaired. Management
determines the significance of payment delays and payment shortfalls on a
case-by-case basis, taking into consideration all of the circumstances
surrounding the loan and the borrower, including the length of the delay, the
reasons for the delay, the borrower's prior payment record, and the amount of
the shortfall in relation to the principal and interest owed. Impairment is
measured on a loan-by-loan basis by either the present value of expected future
cash flows discounted at the loan's effective interest rate, the loan's
obtainable market price, or the fair market value of the collateral, net of
selling costs, if the loan is collateral dependent. Large groups of smaller
balance homogeneous loans are collectively evaluated for impairment.
Accordingly, the Company typically does not separately identify individual
consumer, residential, and certain small commercial loans that are less than
$250 thousand for impairment disclosures, except for troubled debt
restructurings (TDRs) as noted below. The recorded investment in impaired loans
totaled $586 thousand and $2.3 million at June 30, 2022 and December 31, 2021,
respectively.


Troubled Debt Restructurings (TDR)



In situations where, for economic or legal reasons related to a borrower's
financial condition, management grants a concession to the borrower that it
would not otherwise consider, the related loan is classified as a TDR. TDRs are
considered impaired loans. Upon designation as a TDR, the Company evaluates the
borrower's payment history, past due status, and ability to make payments based
on the revised terms of the loan. If a loan was accruing prior to being modified
as a TDR and if the Company concludes that the borrower is able to make such
payments, and there are no other factors or circumstances that would cause it to
conclude otherwise, the loan will remain on an accruing status. If a loan was on
non-accrual status at the time of the TDR, the loan will remain on non-accrual
status following the modification and may be returned to accrual status based on
the policy for returning loans to accrual status as noted above. There were $116
thousand in loans classified as TDRs as of June 30, 2022 and $1.6 million as
of December 31, 2021.



Asset Quality



Management classifies non-performing assets as non-accrual loans and OREO. OREO
represents real property taken by the Bank when its customers do not meet the
contractual obligation of their loans, either through foreclosure or through a
deed in lieu thereof from the borrower and properties originally acquired for
branch operations or expansion but no longer intended to be used for that
purpose. OREO is recorded at the lower of cost or fair value, less estimated
selling costs, and is marketed by the Bank through brokerage channels. The Bank
had $1.7 million and $1.8 million in assets classified as OREO at June 30,
2022 and December 31, 2021, respectively.



Non-performing assets totaled $2.1 million and $4.2 million at June 30, 2022 and
December 31, 2021, representing approximately 0.15% and 0.30% of total assets,
respectively. Non-performing assets consisted of OREO and non-accrual loans at
June 30, 2022 and December 31, 2021. Non-performing assets included $1.7 million
in properties formerly classified as bank premises by The Bank of Fincastle
which are now classified as held for sale.



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At June 30, 2022, 4% of non-performing assets were commercial real estate
loans and 21% were residential real estate loans.  Additionally, 79% was related
to bank-owned properties acquired from The Bank of Fincastle which will not be
used in the Company's operations and are classified as held for sale.
Non-performing assets could increase due to other loans identified by management
as potential problem loans. Other potential problem loans are defined as
performing loans that possess certain risks, including the borrower's ability to
pay and the collateral value securing the loan, that management has identified
that may result in the loans not being repaid in accordance with their terms.
Other potential problem loans totaled $308 thousand and $1.1 million at June 30,
2022 and December 31, 2021, respectively. The amount of other potential problem
loans in future periods may be dependent on economic conditions and other
factors influencing a customers' ability to meet their debt requirements.


Total loans over 90 days past due and still accrued $92,000 at
June 30, 2022. There were no loans over 90 days past due and still outstanding December 31, 2021.

The allowance for loan losses represents management's analysis of the existing
loan portfolio and related credit risks. The provision for loan losses is based
upon management's current estimate of the amount required to maintain an
adequate allowance for loan losses reflective of the risks in the loan
portfolio. The allowance for loan losses totaled $6.2 million at June 30, 2022
and $5.7 million December 31, 2021, representing 0.70% and 0.69% of total loans,
respectively. For further discussion regarding the allowance for loan losses,
see "Provision for Loan Losses" above.

Recoveries of loan losses of $9 thousand and $40 thousand were recorded in the
construction and land development and 1-4 family residential loans classes
respectively, during the six months ended June 30, 2022.  This recovery was
offset by provision for loan losses totaling $334 thousand, $20 thousand, and
$95 thousand in the other real estate, commercial and industrial, and consumer
and other loan classes, respectively. For more detailed information regarding
the (recovery of) provision for loan losses, see Note 4 to the Consolidated
Financial Statements.



Impaired loans totaled $586 thousand and $2.3 million at June 30, 2022 and
December 31, 2021, respectively. There was no related allowance for loan losses
recorded for these loans at June 30, 2022. The related allowance for loan losses
provided for these loans totaled $55 thousand at December 31, 2021. The average
recorded investment in impaired loans during the six months ended June 30, 2022
and the year ended December 31, 2021 was $1.9 million and $4.5 million,
respectively. Included in the impaired loans total are loans classified as TDRs
totaling $116 thousand and $1.6 million at June 30, 2022 and December 31, 2021,
respectively. Loans classified as TDRs represent situations in which a
modification to the contractual interest rate or repayment structure has been
granted to address a financial hardship. As of June 30, 2022, none of these TDRs
were performing under the restructured terms and all were considered
non-performing assets.

Management believes, based upon its review and analysis, that the Bank has
sufficient reserves to cover losses inherent within the loan portfolio. For each
period presented, the provision for loan losses charged to expense was based on
management's judgment after taking into consideration all factors connected with
the collectability of the existing portfolio. Management considers economic
conditions, historical loss factors, past due percentages, internally generated
loan quality reports, and other relevant factors when evaluating the loan
portfolio. There can be no assurance, however, that an additional provision for
loan losses will not be required in the future, including as a result of changes
in the qualitative factors underlying management's estimates and judgments,
changes in accounting standards, adverse developments in the economy, on a
national basis or in the Company's market area, loan growth, or changes in the
circumstances of particular borrowers. For further discussion regarding the
allowance for loan losses, see "Critical Accounting Policies" above.



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Securities



The securities portfolio plays a primary role in the management of the Company's
interest rate sensitivity and serves as a source of liquidity. The portfolio is
used as needed to meet collateral requirements, such as those related to secure
public deposits and balances with the Reserve Bank. The investment portfolio
consists of held to maturity, available for sale, and restricted securities.
Securities are classified as available for sale or held to maturity based on the
Company's investment strategy and management's assessment of the intent and
ability to hold the securities until maturity. Management determines the
appropriate classification of securities at the time of purchase. If management
has the intent and the Company has the ability at the time of purchase to hold
the investment securities to maturity, they are classified as investment
securities held to maturity and are stated at amortized cost, adjusted for
amortization of premiums and accretion of discounts using the interest method.
Investment securities which the Company may not hold to maturity are classified
as investment securities available for sale, as management has the intent and
ability to hold such investment securities for an indefinite period of time, but
not necessarily to maturity. Securities available for sale may be sold in
response to changes in market interest rates, changes in prepayment risk,
increases in loan demand, general liquidity needs and other similar factors and
are carried at estimated fair value. Restricted securities, including Federal
Home Loan Bank, Federal Reserve Bank, and Community Bankers' Bank stock, are
generally viewed as long-term investments because there is minimal market for
the stock and are carried at cost.



Securities at June 30, 2022 totaled $343.8 million, an increase of $18.9
million, or 6.0%, from $324.7 million at December 31, 2021. Investment
securities are comprised of U.S. Treasury securities, U.S. agency and
mortgage-backed securities, obligations of state and political subdivisions,
corporate debt securities, and restricted securities. As of June 30, 2022,
neither the Company nor the Bank held any derivative financial instruments in
their respective investment security portfolios. Gross unrealized gains in the
available for sale portfolio totaled $147 thousand and $2.0 million at June 30,
2022 and December 31, 2021, respectively. Gross unrealized losses in the
available for sale portfolio totaled $31.1 million and $2.6 million at June 30,
2022 and December 31, 2021, respectively. Gross unrealized gains in the held to
maturity portfolio totaled $2 thousand and $242 thousand at June 30, 2022 and
December 31, 2021, respectively.  Gross unrealized losses in the held to
maturity portfolio totaled $6.7 million and $66 thousand at June 30,
2022 and December 31, 2021. Investments in an unrealized loss position were
considered temporarily impaired at June 30, 2022 and December 31, 2021. The
change in the unrealized gains and losses of investment securities from December
31, 2021 to June 30, 2022 was related to changes in market interest rates and
was not related to credit concerns of the issuers.



At June 30, 2022, the securities portfolio was comprised of $264.8 million of
securities available for sale and $77.2 million of securities held to maturity
compared to $289.5 million and $33.4 million at December 31, 2021,
respectively.  Securities held to maturity increased by $43.8 million during the
first six months of 2022 from new purchases as a part of the Company's strategy
to mitigate the risk of potential fluctuations in value and the related impact
on shareholders' equity.  The Company has not transferred any securities from
available for sale to held to maturity during the first six months of 2022.



Deposits



At June 30, 2022, deposits totaled $1.3 billion, an increase of $47.4 million,
from $1.2 billion at December 31, 2021. There was a slight change in the deposit
mix when comparing the periods. At June 30, 2022, noninterest-bearing demand
deposits, savings and interest-bearing demand deposits, and time deposits
composed 33%, 57%, and 10% of total deposits, respectively, compared to 33%,
57%, and 10% at December 31, 2021.



Liquidity



Liquidity represents the ability to meet present and future financial
obligations through either the sale or maturity of existing assets or with
borrowings from correspondent banks or other deposit markets. The Company
classifies cash, interest-bearing and noninterest-bearing deposits with banks,
federal funds sold, investment securities, and loans maturing within one year as
liquid assets. As part of the Bank's liquidity risk management, stress tests and
cash flow modeling are performed quarterly.


As a result of the Bank's management of liquid assets and the ability to
generate liquidity through liability funding, management believes that the Bank
maintains overall liquidity sufficient to satisfy its depositors' requirements
and to meet its customers' borrowing needs.

At June 30, 2022, cash, interest-bearing and noninterest-bearing deposits with
banks, securities, and loans maturing within one year totaled $210.8 million. At
June 30, 2022, 9.5% or $83.7 million of the loan portfolio matured within one
year. Non-deposit sources of available funds totaled $385.0 million at June 30,
2022, which included $287.8 million of secured funds available from Federal Home
Loan Bank of Atlanta (FHLB), $46.2 million of secured funds available through
the Federal Reserve Discount Window, and $51.0 million of unsecured federal
funds lines of credit with other correspondent banks.

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Capital Resources



The adequacy of the Company's capital is reviewed by management on an ongoing
basis with reference to the size, composition, and quality of the Company's
asset and liability levels and consistent with regulatory requirements and
industry standards. Management seeks to maintain a capital structure that will
assure an adequate level of capital to support anticipated asset growth and
absorb potential losses. The Company meets eligibility criteria of a small bank
holding company in accordance with the Federal Reserve Board's Small Bank
Holding Company Policy Statement issued in February 2015 and is not obligated to
report consolidated regulatory capital.

Effective January 1, 2015, the Bank became subject to capital rules adopted by
federal bank regulators implementing the Basel III regulatory capital reforms
adopted by the Basel Committee on Banking Supervision (the Basel Committee), and
certain changes required by the Dodd-Frank Act.

The minimum capital level requirements applicable to the Bank under the final
rules are as follows: a new common equity Tier 1 capital ratio of 4.5%; a Tier 1
capital ratio of 6%; a total capital ratio of 8%; and a Tier 1 leverage ratio of
4% for all institutions. The final rules also established a "capital
conservation buffer" above the new regulatory minimum capital requirements. The
capital conservation buffer was phased-in over four years and, as fully
implemented effective January 1, 2019, requires a buffer of 2.5% of
risk-weighted assets. This results in the following minimum capital ratios
beginning in 2019: a common equity Tier 1 capital ratio of 7.0%, a Tier 1
capital ratio of 8.5%, and a total capital ratio of 10.5%. Under the final
rules, institutions are subject to limitations on paying dividends, engaging in
share repurchases, and paying discretionary bonuses if its capital level falls
below the buffer amount. These limitations establish a maximum percentage of
eligible retained income that could be utilized for such actions. Management
believes, as of June 30, 2022 and December 31, 2021, that the Bank met all
capital adequacy requirements to which it is subject, including the capital
conservation buffer.


The following table presents the Bank’s regulatory capital ratios as at June 30, 2022:



                                                        First Bank
Total capital to risk-weighted assets                         14.23 %
Tier 1 capital to risk-weighted assets                        13.56 %

Common Equity Tier 1 capital to risk-weighted assets 13.56% Common Equity Tier 1 capital to average assets

                               8.87 %
Capital conservation buffer ratio(1)                           6.23 %




(1) Calculated by subtracting regulatory minimum capital ratio requirements

of the Company’s actual ratio for Common Equity Tier 1, Tier 1 and total

risk-based capital. The lowest of the three measurements represents the

    capital conservation buffer ratio.




The prompt corrective action framework is designed to place restrictions on
insured depository institutions if their capital levels begin to show signs of
weakness. Under the prompt corrective action requirements, which are designed to
complement the capital conservation buffer, insured depository institutions are
required to meet the following capital level requirements in order to qualify as
"well capitalized:" a common equity Tier 1 capital ratio of 6.5%; a Tier 1
capital ratio of 8%; a total capital ratio of 10%; and a Tier 1 leverage ratio
of 5%. The Bank met the requirements to qualify as "well capitalized" as of June
30, 2022 and December 31, 2021.

On September 17, 2019 the FDIC finalized a rule that introduces an optional
simplified measure of capital adequacy for qualifying community banking
organizations (i.e., the community bank leverage ratio (CBLR) framework), as
required by the Economic Growth Act. The CBLR framework is designed to reduce
burden by removing the requirements for calculating and reporting risk-based
capital ratios for qualifying community banking organizations that opt into the
framework.

In order to qualify for the CBLR framework, a community banking organization
must have a tier 1 leverage ratio greater than 9%, less than $10 billion in
total consolidated assets, and limited amounts of off-balance sheet exposures
and trading assets and liabilities. The CARES Act temporarily lowered the tier 1
leverage ratio requirement to 8% until December 31, 2020. A qualifying community
banking organization that opts into the CBLR framework and meets all
requirements under the 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.
Although, the Company did not opt into the CBLR framework at June 30, 2022, it
may opt into the CBLR framework in a future quarterly period.

During the fourth quarter of 2019, the Board of Directors of the Company
authorized a stock repurchase plan pursuant to which the Company was authorized
to repurchase up to $5.0 million of the Company's outstanding common stock
through December 31, 2020. During 2020, the Company repurchased and retired
129,035 shares at an average price paid per share of $16.05, for a total of $2.1
million. The Company's stock repurchase plan was suspended in the second quarter
of 2020, and remained suspended until it ended on December 31, 2020.  The
Company has not authorized another stock repurchase plan as of June 30, 2022.

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Contractual Obligations



There have been no material changes outside the ordinary course of business to
the contractual obligations disclosed in the Company's Annual Report on Form
10-K for the year ended December 31, 2021.



Off-balance sheet arrangements



The Company, through the Bank, is a party to credit related financial
instruments with risk not reflected in the consolidated financial statements in
the normal course of business to meet the financing needs of its customers.
These financial instruments include commitments to extend credit, standby
letters of credit, and commercial letters of credit. Such commitments involve,
to varying degrees, elements of credit and interest rate risk in excess of the
amount recognized in the consolidated balance sheets. The Bank's exposure to
credit loss is represented by the contractual amount of these commitments. The
Bank follows the same credit policies in making commitments as it does for
on-balance sheet instruments.


Commitments to extend credit, which amounted to $161.3 million at June 30, 2022,
and $161.4 million at December 31, 2021, 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. The commitments for lines of credit may expire
without being drawn upon. Therefore, the total commitment amounts do not
necessarily represent future cash requirements. The amount of collateral
obtained, if it is deemed necessary by the Bank, is based on management's credit
evaluation of the customer.

Unfunded commitments under commercial lines of credit, revolving credit lines,
and overdraft protection agreements are commitments for possible future
extensions of credit to existing customers. These lines of credit are
collateralized as deemed necessary and may or may not be drawn upon to the total
extent to which the Bank is committed.

Commercial and standby letters of credit are conditional commitments issued by
the Bank to guarantee the performance of a customer to a third party. Those
letters of credit are primarily issued to support public and private borrowing
arrangements. Essentially all letters of credit issued have expiration dates
within one year. The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending loan facilities to customers.
The Bank generally holds collateral supporting those commitments if deemed
necessary. At June 30, 2022 and December 31, 2021, the Bank had $18.1 million
and $18.9 million in outstanding standby letters of credit, respectively.

On April 21, 2020, the Company entered into interest rate swap agreements
related to its outstanding junior subordinated debt. The Company uses
derivatives to manage exposure to interest rate risk through the use of interest
rate swaps. Interest rate swaps involve the exchange of fixed and variable rate
interest payments between two parties, based on a common notional principal
amount and maturity date with no exchange of underlying principal amounts.

The interest rate swaps qualified and are designated as cash flow hedges. The
Company's cash flow hedges effectively modify the Company's exposure to interest
rate risk by converting variable rates of interest on $9.0 million of the
Company's junior subordinated debt to fixed rates of interest. The cash flow
hedges end and the junior subordinated debt matures between June 2034 and
October 2036. The cash flow hedges' total notional amount is $9.0 million. At
June 30, 2022, the cash flow hedges had a fair value of $2.2 million, which is
recorded in other assets. The net gain/loss on the cash flow hedges is
recognized as a component of other comprehensive (loss) income and reclassified
into earnings in the same period(s) during which the hedged transactions affect
earnings. The Company's derivative financial instruments are described more
fully in Note 16 to the Consolidated Financial Statements.

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