General




As the holding company for the Bank, the Company conducts its business primarily
through the Bank. The Bank's results of operations depend primarily on net
interest income, which is the difference between the income earned on its
interest-earning assets, such as loans and investments, and the cost of its
interest-bearing liabilities, consisting primarily of deposits, retail
repurchase agreements and borrowings from the FHLB. The Bank's net income is
also affected by, among other things, fee income, provisions for loan losses,
operating expenses and income tax provisions. The Bank's results of operations
are also significantly affected by general economic and competitive conditions,
particularly changes in market interest rates, government legislation and
policies concerning monetary and fiscal affairs, housing and financial
institutions and the intended actions of the regulatory authorities.



Management uses various indicators to evaluate the Company’s financial condition
and results of operations. Indicators include the following:

· Net income and earnings per share – Net income attributable to the Company was

$10.3 million, or $3.09 per diluted share for 2019 compared to $9.3 million, or

$2.77 per diluted share for 2018 and $7.4 million, or $2.23 per diluted share

   for 2017.



· Return on average assets and return on average equity – Return on average

assets for 2019 was 1.26% compared to 1.19% for 2018 and 0.99% for 2017, and

return on average equity for 2019 was 11.13% compared to 11.46% for 2018 and

   9.37% for 2017.



· Efficiency ratio – The Company’s efficiency ratio (defined as noninterest

expenses divided by net interest income plus noninterest income) was 62.9% for

   2019 compared to 64.6% for 2018 and 63.8% for 2017.



· Asset quality – Net loan charge-offs decreased from $667,000 for 2017 and

$737,000 for 2018 to $429,000 for 2019, and the ratio of net charge-offs to

average loans outstanding decreased from 0.17% for both 2017 and 2018 to 0.09%

for 2019. In addition, total nonperforming assets (consisting of nonperforming

loans and foreclosed real estate) decreased from $6.2 million, or 0.78% of

total assets, at December 31, 2018 to $1.9 million, or 0.24% of total assets,

at December 31, 2019. The allowance for loan losses was 1.08% of total

outstanding loans and 284.6% of nonperforming loans at December 31, 2019

compared to 0.93% of total outstanding loans and 133.0% of nonperforming loans

   at December 31, 2018.



· Shareholder return – Total shareholder return, including the increase in the

Company’s stock price from $42.48 at December 31, 2018 to $73.00 at December

31, 2019 and dividends of $0.95 per share, was 74.1% for 2019 compared to 18.1%

   for 2018 and 16.0% for 2017.



Management's discussion and analysis of financial condition and results of
operations is intended to assist in understanding the financial condition and
results of operations of the Company and the Bank. The information contained in
this section should be read in conjunction with the consolidated financial
statements and the accompanying Notes to Consolidated Financial Statements
included in this report.



                                       42



Operating Strategy



The Company is the parent company of an independent community-oriented financial
institution that delivers quality customer service and offers a wide range of
deposit, loan and investment products to its customers. The commitment to
customer needs, the focus on providing consistent customer service, and
community service and support are the keys to the Bank's past and future
success. The Company has no other material income other than that generated by
the Bank and its subsidiaries.



The Bank's primary business strategy is attracting deposits from the general
public and using those funds to originate residential mortgage loans,
multi-family residential loans, commercial real estate and business loans and
consumer loans. The Bank invests excess liquidity primarily in interest-bearing
deposits with the FHLB and other financial institutions, federal funds sold,
U.S. government and agency securities, local municipal obligations and
mortgage-backed securities.



In recent years, the Company's operating strategy has also included strategies
designed to enhance profitability by increasing sources of noninterest income
and improving operating efficiency while managing its capital and limiting its
credit risk and interest rate risk exposures. To accomplish these objectives,
the Company has focused on the following:



· Monitoring asset quality and credit risk in the loan and investment portfolios,

with an emphasis on reducing nonperforming assets and originating high-quality

commercial and consumer loans. In 2020, management will continue to focus on

   maintaining the reduced level of nonperforming assets through improved
   collection efforts and underwriting on nonperforming loans.



· Being active in the local community, particularly through our efforts with

local schools, to uphold our high standing in our community and marketing to

   our next generation of customers.



· Improving profitability by expanding our product offerings to customers and

leveraging recent investments in technology to increase the productivity and

   efficiency of our staff.



· Continuing to emphasize commercial real estate and other commercial business

lending as well as consumer lending. The Bank will also continue to focus on

increasing secondary market lending as a source of noninterest income.

Management intends to continue to focus on growth in the loan portfolio and the

secondary market lending programs in and around the newest markets entered,

   Bullitt County, Kentucky and Clark County, Indiana.



· Growing commercial and personal demand deposit accounts which provide a

   low-cost funding source.



· Continuing to evaluate vendor contracts for potential cost savings and

   efficiencies.



· Continuing our capital management strategy to enhance shareholder value through

   the repurchase of Company stock and the payment of dividends.



· Evaluating growth opportunities to expand the Bank’s market area and market

share through acquisitions of other financial institutions or branches of other

institutions. The acquisition of Peoples in December 2015 expanded our market

area into Bullitt County, Kentucky, where Peoples was the leader in deposit

account market share among FDIC-insured institutions. We opened our new River

Ridge office in Clark County, Indiana in May 2017. Our focus in 2020 will be to

continue the enhancement and expansion of our customer relationships in these

   new markets.



· Ensuring that the Company attracts and retains talented personnel and that an

optimal level of performance and customer service is promoted at all levels of

   the Company.




                                       43


Critical Accounting Policies and Estimates

The accounting and reporting policies of the Company comply with U.S. GAAP and
conform to general practices within the banking industry. The preparation of
financial statements in conformity with U.S. GAAP requires management to make
estimates and assumptions. The financial position and results of operations can
be affected by these estimates and assumptions, which are integral to
understanding reported results. Critical accounting policies are those policies
that require management to make assumptions about matters that are highly
uncertain at the time an accounting estimate is made; and different estimates
that the Company reasonably could have used in the current period, or changes in
the accounting estimate that are reasonably likely to occur from period to
period, would have a material impact on the Company's financial condition,
changes in financial condition or results of operations. Most accounting
policies are not considered by management to be critical accounting policies.
Several factors are considered in determining whether or not a policy is
critical in the preparation of financial statements. These factors include,
among other things, whether the estimates are significant to the financial
statements, the nature of the estimates, the ability to readily validate the
estimates with other information including third parties or available prices,
and sensitivity of the estimates to changes in economic conditions and whether
alternative accounting methods may be utilized under U.S. GAAP.



Significant accounting policies, including the impact of recent accounting
pronouncements, are discussed in Note 1 of the accompanying Notes to
Consolidated Financial Statements. Those policies considered to be critical
accounting policies are described below.




Allowances for Loan Losses. The allowance for loan losses is the amount
estimated by management as necessary to cover losses inherent in the loan
portfolio at the balance sheet date. The allowance is established through the
provision for loan losses, which is charged to income. Determining the amount of
the allowance for loan losses necessarily involves a high degree of judgment.
Among the material estimates required to establish the allowance are: loss
exposure at default; the amount and timing of future cash flows on impacted
loans; value of collateral; and determination of loss factors to be applied to
the various elements of the portfolio. All of these estimates are susceptible to
significant change. Management reviews the level of the allowance at least
quarterly and establishes the provision for loan losses based upon an evaluation
of the portfolio, past loss experience, current economic conditions and other
factors related to the collectability of the loan portfolio. Although we believe
that we use the best information available to establish the allowance for loan
losses, future adjustments to the allowance may be necessary if economic or
other conditions differ substantially from the assumptions used in making the
evaluation. In addition, the IDFI and FDIC, as an integral part of their
examination process, periodically reviews our allowance for loan losses and may
require us to recognize adjustments to the allowance based on its judgments
about information available to it at the time of its examination. A large loss
could deplete the allowance and require increased provisions to replenish the
allowance, which would adversely affect earnings. Note 1 and Note 4 of the
accompanying Notes to Consolidated Financial Statements describe the methodology
used to determine the allowance for loan losses. The Company has not made any
substantive changes to its methodology for determining the allowance for loan
losses during the year ended December 31, 2019, but management does review (and
modify as necessary) the qualitative factors used in the estimate of the
allowance for loan losses on a quarterly basis.



Valuation Methodologies. In the ordinary course of business, management applies
various valuation methodologies to assets and liabilities that often involve a
significant degree of judgment, particularly when active markets do not exist
for the items being valued. Generally, in evaluating various assets for
potential impairment, management compares the fair value to the carrying value.
Quoted market prices are referred to when estimating fair values for certain
assets, such as certain investment securities. For investment securities for
which quoted market prices are not available, the Company obtains fair value
measurements from an independent pricing service. However, for those items for
which market-based prices do not exist and an independent pricing service is not
readily available, management utilizes significant estimates and assumptions to
value such items. Examples of these items include goodwill and other intangible
assets, acquired loans and deposits, foreclosed and other repossessed assets,
impaired loans, stock-based compensation and certain other financial
investments. The use of different assumptions could produce significantly
different results, which could have material positive or negative effects on the
Company's results of operations. Note 19 of the accompanying Notes to
Consolidated Financial Statements describes the methodologies used to determine
the fair value of investment securities, impaired loans, loans held for sale and
foreclosed real estate. There were no changes in the valuation techniques and
related inputs used during the year ended December 31, 2019.



                                       44


Results of Operations for the Year Ended December 31, 2019 Compared to the Year
Ended December 31, 2018

Net Income.Net income attributable to the Company was $10.3 million ($3.09 per
share diluted; weighted average common shares outstanding of 3,344,072, as
adjusted) for the year ended December 31, 2019 compared to $9.3 million ($2.77
per share diluted; weighted average common shares outstanding of 3,335,394, as
adjusted) for the year ended December 31, 2018.



Net Interest Income. Net interest income increased $2.8 million, or 10.3%, from
$27.3 million for 2018 to $30.1 million for 2019 primarily due to increases in
the average balance of interest-earning assets and the interest rate spread, the
difference between the average tax-equivalent yield on interest-earning assets
and the average cost of interest-bearing liabilities.



Total interest income increased $3.2 million for 2019 as compared to 2018. This
increase was primarily a result of increases in the tax-equivalent yield on
interest-earning assets from 4.01% for 2018 to 4.28% for 2019 and in the average
balance of interest-earning assets from $730.5 million for 2018 to $760.8
million for 2019. The increase in the average balance of interest-earning assets
in 2019 was primarily attributable to continued growth in loans and partially
offset by continued declining balances in investment securities. Interest on
loans increased $2.9 million as a result of the average balance of loans
increasing from $423.6 million for 2018 to $465.4 million for 2019 and the
average tax-equivalent yield on loans increasing from 5.39% for 2018 to 5.54%
for 2019. Interest and dividends on investment securities (including FHLB stock)
increased $144,000 for 2019 compared to 2018 due to an increase in the tax
equivalent yield on investment securities from 2.13% in 2018 to 2.29% in 2019,
partially offset by a decrease in the average balance of investment securities
from $267.4 million for 2018 to $258.0 million for 2019. Other interest income
increased $96,000 for 2019 as compared to 2018 primarily due to the tax
equivalent yield of federal funds sold and interest-bearing deposits with banks
increasing from 1.92% to 2.29% when comparing the two periods.



Total interest expense increased $349,000, from $1.6 million for 2018 to $2.0
million for 2019, due to increases in the average balance of interest-bearing
liabilities from $552.2 million for 2018 to $567.6 million for 2019 and in the
average cost of interest-bearing liabilities from 0.29% for 2018 to 0.35% for
2019. Included in the interest-bearing liabilities were borrowed funds with an
average balance of $1.2 million for 2018 and an average cost of 1.78%. There
were no borrowed funds during 2019. For further information, see "Average
Balances and Yields" below. The changes in interest income and interest expense
resulting from changes in volume and changes in rates for 2019 and 2018 are
shown in the schedule captioned "Rate/Volume Analysis" included herein.



Provision for Loan Losses. The provision for loan losses was $1.4 million for
2019 compared to $1.2 million for 2018. The consistent application of
management's allowance methodology resulted in an increase in the provision for
loan losses for 2019, primarily due to the loan portfolio growth during the
year. Total outstanding loans increased by $33.2 million during 2019 as compared
to an increase of $25.0 million during 2018. Net charge-offs decreased from
$737,000 for 2018 to $429,000 for 2019, and nonperforming loans decreased from
$3.1 million at December 31, 2018 to $1.8 million at December 31, 2019. The
provisions were recorded to bring the allowance to the level determined in
applying the allowance methodology after reduction for net charge-offs during
the year.



Provisions for loan losses are charges to earnings to maintain the total
allowance for loan losses at a level considered reasonable by management to
provide for probable known and inherent loan losses based on management's
evaluation of the collectability of the loan portfolio, including the nature of
the portfolio, credit concentrations, trends in historical loss experience,
specified impaired loans and economic conditions. Although management uses the
best information available, future adjustments to the allowance may be necessary
due to changes in economic, operating, regulatory and other conditions that may
be beyond the Bank's control. While the Bank maintains the allowance for loan
losses at a level that it considers adequate to provide for estimated losses,
there can be no assurance that further additions will not be made to the
allowance for loan losses and that actual losses will not exceed the estimated
amounts.



                                       45



Noninterest income.Noninterest income increased $758,000 to $6.9 million for
2019 due to increases in ATM and debit card fees and unrealized gains on equity
securities of $248,000 and $239,000, respectively. There was also a loss on a
tax credit investment of $270,000 recorded in 2018. Those changes were partially
offset by an $89,000 decrease in service charges on customer accounts during
2019.



Noninterest expense.Noninterest expense increased $1.7 million, to $23.3 million
for 2019 primarily due to increases in compensation and benefits expense of $1.4
million and data processing expense of $458,000 when comparing the two periods.
Compensation and benefits expense increased primarily due to normal salaries and
benefits increases and an increase in stock compensation expense. A significant
factor in the increase in data processing expense during 2019 was the rollout of
the Bank's new digital platform in the fourth quarter of 2019 and the associated
costs, including termination fees from the previous platform provider.



Income tax expense. Tax expense increased $593,000 for 2019 to $2.0 million
primarily due to an increase in taxable income and a reduction in benefits from
a tax credit entity. As a result, the effective tax rate increased from 13.1%
for 2018 to 16.1% for 2019. See Note 12 of the accompanying Notes to
Consolidated Financial Statements for additional details on the Company's income
tax expense.


Results of Operations for the Year Ended December 31, 2018 Compared to the Year
Ended December 31, 2017




Net Income.Net income attributable to the Company was $9.3 million ($2.77 per
share diluted; weighted average common shares outstanding of 3,335,394, as
adjusted) for the year ended December 31, 2018 compared to $7.4 million ($2.23
per share diluted; weighted average common shares outstanding of 3,329,563, as
adjusted) for the year ended December 31, 2017.



Net Interest Income. Net interest income increased $2.2 million, or 9.0%, from
$25.0 million for 2017 to $27.3 million for 2018 primarily due to increases in
the average balance of interest-earning assets and the interest rate spread, the
difference between the average tax-equivalent yield on interest-earning assets
and the average cost of interest-bearing liabilities.



Total interest income increased $2.5 million for 2018 as compared to 2017. This
increase was primarily a result of increases in the tax-equivalent yield on
interest-earning assets from 3.84% for 2017 to 4.01% for 2018 and in the average
balance of interest-earning assets from $708.4 million for 2017 to $730.5
million for 2018. The increase in the average balance of interest-earning assets
in 2018 was primarily attributable to growth in loans and partially offset by
declining balances in investment securities. Interest on loans increased $2.1
million as a result of the average balance of loans increasing from $399.8
million for 2017 to $423.6 million for 2018 and the average tax-equivalent yield
on loans increasing from 5.19% for 2017 to 5.39% for 2018. Interest and
dividends on investment securities (including FHLB stock) decreased $42,000 for
2018 compared to 2017 due to a decrease in the average balance of investment
securities from $275.8 million for 2017 to $267.4 million for 2018. The tax
equivalent yield on investment securities decreased from 2.21% for 2017 to 2.13%
for 2018 primarily due to the effect of the Tax Cuts and Jobs Act ("TCJA")
signed into law on December 22, 2017 which resulted in a decrease in the
tax-effective yield on tax-exempt securities. Other interest income increased
$388,000 for 2018 as compared to 2017 primarily due to the tax equivalent yield
of federal funds sold and interest-bearing deposits with banks increasing from
1.13% to 1.92% when comparing the two periods as a result of increases in
short-term market interest rates.



Total interest expense increased $219,000, from $1.4 million for 2017 to $1.6
million for 2018, due to increases in the average balance of interest-bearing
liabilities from $541.5 million for 2017 to $552.2 million for 2018 and in the
average cost of interest-bearing liabilities from 0.26% for 2017 to 0.29% for
2018. Included in the interest-bearing liabilities were borrowed funds with an
average balance of $1.2 million for both 2018 and 2017 and an average cost 1.78%
and 1.52%, respectively, for 2018 and 2017. For further information, see
"Average Balances and Yields" below. The changes in interest income and interest
expense resulting from changes in volume and changes in rates for 2018 and 2017
are shown in the schedule captioned "Rate/Volume Analysis" included herein.


                                       46



Provision for Loan Losses. The provision for loan losses was $1.2 million for
2018 compared to $915,000 for 2017. The consistent application of management's
allowance methodology resulted in an increase in the provision for loan losses
for 2018, primarily due to the loan portfolio growth during the year and
increased net charge-offs. Total outstanding loans increased by $25.0 million
during 2018 as compared to an increase of $28.5 million during 2017. Net
charge-offs increased from $667,000 for 2017 to $737,000 for 2018 when comparing
the two periods, and nonperforming loans increased from $2.8 million at December
31, 2017 to $3.1 million at December 31, 2018. The provisions were recorded to
bring the allowance to the level determined in applying the allowance
methodology after reduction for net charge-offs during the year.



Provisions for loan losses are charges to earnings to maintain the total
allowance for loan losses at a level considered reasonable by management to
provide for probable known and inherent loan losses based on management's
evaluation of the collectability of the loan portfolio, including the nature of
the portfolio, credit concentrations, trends in historical loss experience,
specified impaired loans and economic conditions. Although management uses the
best information available, future adjustments to the allowance may be necessary
due to changes in economic, operating, regulatory and other conditions that may
be beyond the Bank's control. While the Bank maintains the allowance for loan
losses at a level that it considers adequate to provide for estimated losses,
there can be no assurance that further additions will not be made to the
allowance for loan losses and that actual losses will not exceed the estimated
amounts.



Noninterest income.Noninterest income decreased $530,000 to $6.2 million for
2018 due to decreases in gains on the sale of loans and gains on the sale of
securities of $285,000 and $149,000, respectively, as well as a loss on equity
securities of $207,000 and an impairment loss on a tax credit investment of
$270,000 recorded in 2018. Those charges were partially offset by a $235,000
increase in ATM and debit card fees during 2018.



Noninterest expense.Noninterest expense increased $1.4 million, to $21.6 million
for 2018 primarily due to increases in compensation and benefits expense of
$534,000 and data processing expense of $351,000 when comparing the two periods.
Net loss on foreclosed real estate and occupancy and equipment expense also
increased $160,000 and $117,000, respectively, when comparing the two periods.
Compensation and benefits expense increased primarily due to normal salaries and
benefits increases and an increase in stock compensation expense. Data
processing expense increased primarily due to increased customer activity,
particularly related to ATM and electronic banking usage.



Income tax expense. Tax expense decreased from $3.1 million for 2017 to $1.4
million for 2018 primarily due to the TCJA and the Bank's investments in tax
credit entities during 2018. In addition, the Company recognized an additional
$290,000 in income tax expense during 2017 related to the revaluation of the
Company's net deferred tax assets at the new federal corporate tax rate of 21%.
As a result, the effective tax rate decreased from 29.4% for 2017 to 13.1%
for
2018.



                                       47



Average Balances and Yields. The following table sets forth certain information
for the periods indicated regarding average balances of assets and liabilities,
as well as the total dollar amounts of interest income from average
interest-earnings assets and interest expense on average interest-bearing
liabilities and average yields and costs. Such yields and costs for the periods
indicated are derived by dividing income or expense by the average historical
cost balances of assets or liabilities, respectively, for the periods presented
and do not give effect to changes in fair value that are included as a separate
component of stockholders' equity. Average balances are derived from daily
balances. Tax-exempt income on loans and investment securities has been adjusted
to a tax equivalent basis using the federal marginal tax rate of 21% for 2019
and 2018 and 34% for 2017.



                                                                               Year Ended December 31,
                                                2019                                    2018                                    2017
                                                            Average                                 Average                                 Average
(Dollars in thousands)            Average                    Yield/       Average                    Yield/       Average                    Yield/
                                  Balance      Interest       Cost        Balance      Interest       Cost        Balance      Interest       Cost
Interest-earning assets:
Loans (1) (2)(3):
Taxable                         $ 461,191$ 25,635         5.56 %   $ 418,800$ 22,693         5.42 %   $ 396,898$ 20,625         5.20 %
Tax-exempt                          4,190          141         3.37 %       4,810          157         3.26 %       2,914          114         3.91 %
Total loans                       465,381       25,776         5.54 %     423,610       22,850         5.39 %     399,812       20,739         5.19 %

Investment securities:
Taxable (4)                       192,567        3,746         1.95 %     207,901        3,853         1.85 %     217,072        3,913         1.80 %
Tax-exempt                         65,441        2,159         3.30 %     

59,496 1,842 3.10 % 58,720 2,177 3.71 %
Total investment securities 258,008 5,905 2.29 % 267,397 5,695 2.13 % 275,792 6,090 2.21 %


Other interest-earning assets
(5)                                37,387          856         2.29 %      39,485          760         1.92 %      32,799          372         1.13 %
Total interest-earning assets     760,776       32,537         4.28 %     730,492       29,305         4.01 %     708,403       27,201         3.84 %

Noninterest-earning assets         55,844                                  48,613                                  46,512
Total assets                    $ 816,620$ 779,105$ 754,915

Interest-bearing liabilities:
Interest-bearing demand
deposits                        $ 321,647$    912         0.28 %   $ 307,052$    784         0.26 %   $ 296,345$    599         0.20 %
Savings accounts                  177,648          305         0.17 %     173,693          321         0.18 %     164,859          339         0.21 %
Time deposits                      68,276          743         1.09 %      70,251          485         0.69 %      79,098          436         0.55 %
Total deposits                    567,571        1,960         0.35 %     550,996        1,590         0.29 %     540,302        1,374         0.25 %

Borrowed funds                          0            0         0.00 %       1,178           21         1.78 %       1,185           18         1.52 %
Total interest-bearing
liabilities                       567,571        1,960         0.35 %     552,174        1,611         0.29 %     541,487        1,392         0.26 %

Noninterest-bearing
liabilities:
Noninterest-bearing deposits      150,426                                 141,422                                 131,260
Other liabilities                   5,834                                   4,736                                   2,798
Total liabilities                 723,831                                 698,332                                 675,545
Stockholders' equity (6)           92,789                                  80,773                                  79,370

Total liabilities and
stockholders' equity            $ 816,620$ 779,105$ 754,915

Net interest income (tax
equivalent basis)                             $ 30,577$ 27,694$ 25,809
Less: tax equivalent
adjustment                                        (483 )                                  (419 )                                  (779 )
Net interest income                           $ 30,094$ 27,275$ 25,030

Interest rate spread (tax
equivalent basis)                                              3.93 %                                  3.72 %                                  3.58 %

Net interest margin (tax
equivalent basis)                                              4.02 %                                  3.79 %                                  3.64 %

Ratio of average interest -
earning assets to average
interest-bearing liabilities                                 134.04 %      
                         132.29 %                                130.83 %






(1) Interest income on loans includes fee income of $1,027,000, $984,000 and $984,000 for the years ended December 31, 2019, 2018, and 2017, respectively.
(2) Average loan balances include loans held for sale and nonperforming loans.
(3) Interest income on loans includes net accretion on acquired loans of $44,000, $149,000 and $124,000 for the years ended December 31, 2019, 2018 and 2017,

respectively.

(4) Includes taxable debt securities and FHLB stock.
(5) Includes interest-bearing deposits with banks, money market funds, federal funds sold and interest-bearing time deposits.
(6) Stockholders’ equity attributable to First Capital, Inc.




                                       48


Rate/Volume Analysis.The following table sets forth the effects of changing
rates and volumes on net interest income and interest expense computed on a
tax-equivalent basis. Information is provided with respect to (i) effects on
interest income attributable to changes in volume (changes in volume multiplied
by prior rate); (ii) effects attributable to changes in rate (changes in rate
multiplied by prior volume); and (iii) effects attributable to changes in rate
and volume (change in rate multiplied by changes in volume). Tax exempt income
on loans and investment securities has been adjusted to a tax-equivalent basis
using the federal marginal tax rate of 21% for 2019 and 2018 and 34% for 2017.



                                          2019 Compared to 2018                          2018 Compared to 2017
                                       Increase (Decrease) Due to                      Increase (Decrease) Due to

                                                        Rate/                                          Rate/
                                Rate       Volume      Volume        Net        Rate      Volume      Volume        Net

                                                                     (In thousands)
Interest-earning assets:
Loans:
Taxable                       $   586$ 2,297$    59$ 2,942$  875$ 1,145$    48$ 2,068
Tax-exempt                          5         (20 )        (1 )       (16 )      (19 )        74         (12 )        43
Total loans                       591       2,277          58       2,926        856       1,219          36       2,111

Investment securities:
Taxable                           200        (292 )       (15 )      (107 )      109        (164 )        (5 )       (60 )
Tax-exempt                        119         186          12         317       (359 )        29          (5 )      (335 )
Total investment securities       319        (106 )        (3 )       210       (250 )      (135 )       (10 )      (395 )

Other interest-earning
assets                            145         (41 )        (8 )        96        259          76          53         388
Total net change in income
on interest- earning assets     1,055       2,130          47       3,232        865       1,160          79       2,104

Interest-bearing
liabilities:
Interest-bearing deposits         317          43          10         370        191          21           4         216
Borrowed funds                    (21 )       (21 )        21         (21 )        3           0           0           3
Total net change in expense
on interest- bearing
liabilities                       296          22          31         349        194          21           4         219

Net change in net interest
income (tax equivalent
basis)                        $   759$ 2,108$    16$ 2,883$  671$ 1,139$    75$ 1,885




                                       49


Comparison of Financial Condition at December 31, 2019 and 2018

Total assets increased from $794.2 million at December 31, 2018 to $827.5
million
at December 31, 2019 primarily due to increases in net loans receivable
and cash and cash equivalents, partially offset by a decrease in securities
available for sale.




Net loans increased from $434.3 million at December 31, 2018 to $466.5 million
at December 31, 2019. The primary contributing factor to the increase in net
loans was an increase of $14.1 million in commercial real estate loans. The Bank
also increased commercial business loans, other consumer loans and construction
loans by $9.0 million, $7.8 million and $7.2 million, respectively, during 2019.
Residential mortgage loans decreased $4.5 million during 2019 as the Bank
continued to sell the majority of newly originated residential mortgage loans in
the secondary market. The Bank originated $70.8 million in new residential
mortgages for sale in the secondary market during 2019 compared to $54.3 million
in 2018. These loans were originated and funded by the Bank for sale in the
secondary market. Of the total originations for 2019, $13.7 million paid off
existing loans in the Bank's portfolio. Originating mortgage loans for sale in
the secondary market allows the Bank to better manage its interest rate risk,
while offering a full line of mortgage products to prospective customers.



Securities available for sale, at fair value, consisting primarily of U.S.
agency mortgage-backed securities and collateralized mortgage obligations, U.S.
agency notes and bonds, and municipal obligations, decreased from $261.8 million
at December 31, 2018 to $254.6 million at December 31, 2019. Purchases of
securities available for sale totaled $69.3 million in 2019. These purchases
were more than offset by maturities of $30.6 million, principal repayments of
$29.7 million and sales of $21.7 million in 2019. The Bank invests excess cash
in securities that provide safety, liquidity and yield. Accordingly, we purchase
mortgage-backed securities to provide cash flow for loan demand and deposit
changes, we purchase federal agency notes for short-term yield and low risk, and
municipals are purchased to improve our tax equivalent yield focusing on longer
term profitability.


Cash and cash equivalents increased from $41.1 million at December 31, 2018 to
$51.4 million at December 31, 2019. The increase is due primarily to excess
funds generated from deposits.

Foreclosed real estate decreased from $3.1 million at December 31, 2018 to
$170,000 at December 31, 2019, consisting of just one residential property.

Total deposits increased $20.5 million to $722.2 million at December 31, 2019.
During 2019, interest-bearing demand deposit accounts, savings accounts and
noninterest-bearing demand deposit accounts increased $13.8 million, $3.9
million
and $2.8 million, respectively.

There were no outstanding borrowings at December 31, 2019 or 2018.




Total stockholders' equity attributable to the Company increased $13.0 million
from $85.8 million at December 31, 2018 to $98.8 million at December 31, 2019.
This increase is primarily the result of retained net income of $7.1 million and
a net unrealized gain on available for sale securities of $5.6 million due to
changes in the yield curve and long-term rate forecasts. As of December 31,
2019, the Company had repurchased 99,117 shares of the 240,467 shares authorized
by the Board of Directors under the current stock repurchase program which was
announced in August 2008 and 427,651 shares since the original repurchase
program began in 2001.



                                       50


Off-Balance-Sheet Arrangements

The Company is a party to financial instruments with off-balance-sheet risk
including commitments to extend credit under existing lines of credit and
commitments to originate loans. These instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the consolidated financial statements.



Off-balance-sheet financial instruments whose contract amounts represent credit
and interest rate risk are summarized as follows:



                                                              At December 31,
                                                          2019               2018
                                                              (In thousands)
 Commitments to originate new loans                 $       14,246     $   

5,876

 Undisbursed portion of construction loans                  23,081         

26,675

Unfunded commitments to extend credit under

 existing commercial and personal lines of credit           83,725         
   80,582
 Standby letters of credit                                     473              1,295



The Company does not have any special purpose entities, derivative financial
instruments or other forms of off-balance-sheet financing arrangements.




Commitments to originate new loans or to extend credit are agreements to lend to
a customer as long as there is no violation of any condition established in the
contract. Most equity line commitments are for a term of five to 10 years and
commercial lines of credit are generally renewable on an annual basis.
Commitments generally have fixed expiration dates or other termination clauses
and may require payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. The Company evaluates each customer's
creditworthiness on a case-by-case basis. The amounts of collateral obtained, if
deemed necessary by the Company upon extension of credit, are based on
management's credit evaluation of the borrower.



Contractual Obligations


The following table summarizes information regarding the Company’s contractual
obligations as of December 31, 2019:




                                                                Payments due by period
                                                                                                         More than
                                   Total        Less than 1 Year     1 - 3 Years      3 - 5 Years         5 Years
                                                                    (In thousands)
Deposits                        $  722,177$        687,182$     23,864$     11,131     $          0
Operating lease obligations              5                    5                0                0                0
Total contractual obligations   $  722,182$        687,187$     23,864$     11,131     $          0






                                       51


Liquidity and Capital Resources




Liquidity refers to the ability of a financial institution to generate
sufficient cash flow to fund current loan demand, meet deposit withdrawals and
pay operating expenses. The Bank's primary sources of funds are new deposits,
proceeds from loan repayments and prepayments and proceeds from the maturity of
securities. The Bank may also borrow from the FHLB. While loan repayments and
maturities of securities are predictable sources of funds, deposit flows and
mortgage prepayments are greatly influenced by market interest rates, general
economic conditions and competition. At December 31, 2019, the Bank had cash and
interest-bearing deposits with banks (including interest-bearing time deposits)
of $57.9 million and securities available for sale with a fair value of $254.6
million. If the Bank requires funds beyond its ability to generate them
internally, it has additional borrowing capacity with the FHLB, collateral
eligible for repurchase agreements and unsecured federal funds purchased lines
of credit with other financial institutions.



The Bank must maintain an adequate level of liquidity to ensure the availability
of sufficient funds to support loan growth and deposit withdrawals, to satisfy
financial commitments and to take advantage of investment opportunities. At
December 31, 2019, the Bank had total commitments to extend credit of $121.5
million. See Note 16 in the accompanying Notes to Consolidated Financial
Statements. At December 31, 2019, the Bank had certificates of deposit scheduled
to mature within one year of $33.9 million. Historically, the Bank has been able
to retain a significant amount of its deposits as they mature.



The Company is a separate legal entity from the Bank and must provide for its
own liquidity. In addition to its operating expenses, the Company requires funds
to pay any dividends to its shareholders and to repurchase any shares of its
common stock. The Company's primary source of income is dividends received from
the Bank and the Captive. The amount of dividends the Bank may declare and pay
to the Company in any calendar year, without the receipt of prior approval from
the banking regulators, cannot exceed net income for that year to date plus
retained net income (as defined) for the preceding two calendar years. At
December 31, 2019, the Company (on an unconsolidated basis) had liquid assets of
$3.8 million.



The Bank is required to maintain specific amounts of capital pursuant to
regulations. As of December 31, 2019 the Bank was in compliance with all
regulatory capital requirements which were effective as of such date with Tier 1
capital to average assets, Tier 1 capital to risk-weighted assets, common equity
Tier 1 capital to risk-weighted assets and total risk-based capital to
risk-weighted assets ratios of 10.0%, 14.0%, 14.0% and 14.9%, respectively. See
Note 18 in the accompanying Notes to Consolidated Financial Statements.



Effect of Inflation and Changing Prices

The consolidated financial statements and related financial data presented in
this report have been prepared in accordance with U.S. GAAP, which generally
require the measurement of financial position and operating results in terms of
historical dollars, without considering the changes in relative purchasing power
of money over time due to inflation. The primary impact of inflation is
reflected in increased operating costs. Unlike most industrial companies,
virtually all the assets and liabilities of the financial institution are
monetary in nature. As a result, interest rates generally have a more
significant impact on the financial institution's performance than do general
levels of inflation. Interest rates do not necessarily move in the same
direction or to the same extent as the prices of goods and services.



Market Risk Analysis



Qualitative Aspects of Market Risk. Market risk is the risk that the estimated
fair value of our assets and liabilities will decline as a result of changes in
interest rates or financial market volatility, or that our net income will be
significantly reduced by interest rate changes.



                                       52



The Company's principal financial objective is to achieve long-term
profitability while reducing its exposure to fluctuating market interest rates
by operating within acceptable limits established for interest rate risk and
maintaining adequate levels of funding and liquidity. The Company has sought to
reduce the exposure of its earnings to changes in market interest rates by
attempting to manage the mismatch between asset and liability maturities and
interest rates. In order to reduce the exposure to interest rate fluctuations,
the Company has developed strategies to manage its liquidity, shorten its
effective maturities of certain interest-earning assets and decrease the
interest rate sensitivity of its asset base. Management has sought to decrease
the average maturity of its assets by emphasizing the origination of short-term
commercial and consumer loans, all of which are retained by the Company for its
portfolio. The Company relies on retail deposits as its primary source of funds.
Management believes the use of retail deposits, compared to brokered deposits,
reduces the effects of interest rate fluctuations because they generally
represent a more stable source of funds.



Quantitative Aspects of Market Risk. The Company does not maintain a trading
account for any class of financial instrument nor does the Company engage in
hedging activities or purchase high-risk derivative instruments. Furthermore,
the Company is not subject to foreign currency exchange rate risk or commodity
price risk.


Potential cash flows, sales, or replacement value of many of our assets and
liabilities, especially those that earn or pay interest, are sensitive to
changes in the general level of interest rates. This interest rate risk arises
primarily from our normal business activities of gathering deposits, extending
loans and investing in investment securities. Many factors affect the Company's
exposure to changes in interest rates, such as general economic and financial
conditions, customer preferences, historical pricing relationships, and
re-pricing characteristics of financial instruments. The Company's earnings can
also be affected by the monetary and fiscal policies of the U.S. Government and
its agencies, particularly the FRB.



An element in the Company's ongoing process is to measure and monitor interest
rate risk using a Net Interest Income at Risk simulation to model the interest
rate sensitivity of the balance sheet and to quantify the impact of changing
interest rates on the Company. The model quantifies the effects of various
possible interest rate scenarios on projected net interest income over a
one-year horizon. The model assumes a semi-static balance sheet and measures the
impact on net interest income relative to a base case scenario of hypothetical
changes in interest rates over twelve months and provides no effect given to any
steps that management might take to counter the effect of the interest rate
movements. The scenarios include prepayment assumptions, changes in the level of
interest rates, the shape of the yield curve, and spreads between market
interest rates in order to capture the impact from re-pricing, yield curve,
option, and basis risks.



Results of the Company's simulation modeling, which assumes an immediate and
sustained parallel shift in market interest rates, project that the Company's
net interest income could change as follows over a one-year horizon, relative to
our base case scenario, based on December 31, 2019 and 2018 financial
information.



                                 At December 31, 2019         At December 31, 2018
          Immediate Change         One Year Horizon             One Year Horizon
          in the Level            Dollar        Percent      Dollar         Percent
          of Interest Rates       Change        Change       Change          Change
                                     (Dollars in thousands)
          300bp               $     3,438        11.59 %   $    790             2.91 %
          200bp                     2.392         8.07          318             1.17
          100bp                     1,289         4.35          176             0.65
          Static                        -            -            -                -
          (100)bp                  (1,562 )      (5.27 )        876             3.23
          (200)bp                  (2,853 )      (9.62 )        139             0.51




                                       53



At December 31, 2019, the Company's simulated exposure to an increase in
interest rates shows that an immediate and sustained increase in rates of 1.00%,
2.00% or 3.00% would increase the Company's net interest income over a one year
horizon compared to a flat interest rate scenario. Alternatively, at December
31, 2019, an immediate and sustained decrease in rates of 1.00% or 2.00% would
decrease the Company's net interest income over a one year horizon compared to a
flat interest rate scenario. At December 31, 2018, all scenarios described would
have resulted in an increase of the Company's net interest income over a one
year horizon compared to a flat interest rate scenario. During the year ended
December 31, 2019, the Company updated the discount rates and betas used in its
interest rate risk model for loans and deposits to better reflect the market,
and also updated the deposit decay rates based on a third-party study of
customer accounts.



The Company also has longer term interest rate risk exposure, which may not be
appropriately measured by Net Interest Income at Risk modeling. Therefore, the
Company also uses an Economic Value of Equity ("EVE") interest rate sensitivity
analysis in order to evaluate the impact of its interest rate risk on earnings
and capital. This is measured by computing the changes in net EVE for its cash
flows from assets, liabilities and off-balance sheet items in the event of a
range of assumed changes in market interest rates. EVE modeling involves
discounting present values of all cash flows for on and off balance sheet items
under different interest rate scenarios and provides no effect given to any
steps that management might take to counter the effect of the interest rate
movements. The discounted present value of all cash flows represents the
Company's EVE and is equal to the market value of assets minus the market value
of liabilities, with adjustments made for off-balance sheet items. The amount of
base case EVE and its sensitivity to shifts in interest rates provide a measure
of the longer term re-pricing and option risk in the balance sheet.



Results of the Company's simulation modeling, which assumes an immediate and
sustained parallel shift in market interest rates, project that the Company's
EVE could change as follows, relative to the Company's base case scenario, based
on December 31, 2019 and 2018 financial information.



                                                         At December 31, 2019
Immediate Change                 Economic Value of Equity                    Economic Value of Equity as a
in the Level              Dollar          Dollar          Percent         Percent of Present Value of Assets
of Interest Rates         Amount          Change          Change            EVE Ratio                Change
                                                        (Dollars in thousands)
300bp                  $   203,781$    56,973           38.81 %              25.40 %                773 bp
200bp                      187,704          40,896           27.86                23.10                  543 bp
100bp                      168,710          21,902           14.92                20.52                  285 bp
Static                     146,808               -               -                17.67                    - bp
(100)bp                    123,104         (23,704 )        (16.15 )              14.64                 (303 )bp
(200)bp                    101,568         (45,240 )        (30.82 )              11.89                 (578 )bp




                                                 At December 31, 2018
Immediate Change          Economic Value of Equity              Economic Value of Equity as a
in the Level          Dollar        Dollar      Percent       Percent of Present Value of Assets
of Interest Rates     Amount        Change      Change          EVE Ratio               Change
                                                (Dollars in thousands)
300bp               $ 106,468$  3,885        3.79 %              14.67 %               142 bp
200bp                 106,176        3,593        3.50                14.31                 106 bp
100bp                 104,978        2,395        2.33                13.85                  60 bp
Static                102,583            -           -                13.25                   - bp
(100)bp               102,230         (353 )     (0.34 )              12.95                 (30 )bp
(200)bp                93,763       (8,820 )     (8.60 )              11.63                (162 )bp




                                       54
The previous tables indicate that at December 31, 2019 and 2018 the Company
would expect an increase in its EVE in the event of a sudden and sustained 100,
200 or 300 basis point increase in prevailing interest rates and a decrease in
its EVE in the event of a sudden and sustained 100 or 200 basis point decrease
in prevailing interest rates. As previously mentioned in this report, during the
year ended December 31, 2019, the Company updated the discount rates and betas
used in its interest rate risk model for loans and deposits to better reflect
the market, and also updated the deposit decay rates based on a third-party
study of customer accounts.



The models are driven by expected behavior in various interest rate scenarios
and many factors besides market interest rates affect the Company's net interest
income and EVE. For this reason, the Company models many different combinations
of interest rates and balance sheet assumptions to understand its overall
sensitivity to market interest rate changes. Therefore, as with any method of
measuring interest rate risk, certain shortcomings are inherent in the method of
analysis presented in the foregoing tables and it is recognized that the model
outputs are not guarantees of actual results. For example, although certain
assets and liabilities may have similar maturities or periods to repricing, they
may react in different degrees to changes in market interest rates. Also, the
interest rates on certain types of assets and liabilities may fluctuate in
advance of changes in market interest rates, while interest rates on other types
may lag behind changes in market rates. Additionally, certain assets, such as
adjustable-rate mortgage loans, have features that restrict changes in interest
rates on a short-term basis and over the life of the asset. Further, in the
event of a change in interest rates, expected rates of prepayments on loans and
early withdrawals from certificates of deposit could deviate significantly from
those assumed in the modeling scenarios.



Impact of Recent Accounting Pronouncements

For a discussion of the impact of recent accounting pronouncements, see Note 1
of the accompanying Notes to Consolidated Financial Statements.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





The information required by this item is incorporated herein by reference to the
section captioned "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations - Market Risk Analysis" in this Annual
Report on Form 10-K.

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