Arrow Financial Corporation — Q2 2023 Form 10-Q
Business context and reporting period. Arrow is a bank holding company operating Glens Falls National Bank and Trust Company and Saratoga National Bank in northeastern New York, with banking, wealth-management and insurance activities. This unaudited filing covers the quarter and six months ended June 30, 2023; financial amounts below are in millions unless stated otherwise.
Financial results and condition
| Metric | Q2 2023 | Q2 2022 | Change |
|---|---|---|---|
| Interest and dividend income | $40.0 | $30.6 | +30.8% |
| Net interest income | $25.8 | $29.0 | -11.2% |
| Net interest margin | 2.61% | 3.02% | -41 bps |
| Provision for credit losses | $0.95 | $0.91 | +$0.04 |
| Noninterest income | $6.9 | $7.7 | -10.8% |
| Noninterest expense | $24.1 | $20.3 | +18.4% |
| Net income / diluted EPS | $6.0 / $0.36 | $12.0 / $0.72 | Net income -49.5% |
| Return on average assets / equity | 0.59% / 6.64% | 1.20% / 13.44% | Lower year over year |
| Efficiency ratio | 72.72% | 55.01% | Higher expenses relative to income |
- First half: Net income was $14.6 million versus $24.5 million in H1 2022 (-40.5%); diluted EPS was $0.88 versus $1.48. Net interest income fell 5.3% to $53.9 million, while net interest margin declined to 2.79% from 2.96%. Noninterest income decreased 14.6% to $13.6 million; noninterest expense rose 18.0% to $46.4 million.
- Balance sheet at June 30: Total assets were $4.10 billion, loans $3.07 billion, deposits $3.50 billion, borrowings $171.8 million and stockholders’ equity $361.4 million. Since year-end 2022, loans grew $86.7 million (2.9%), deposits increased $3.9 million, and borrowings increased $117.0 million.
- Funding and liquidity: Cash and cash equivalents were $173.6 million, up from $64.7 million at year-end. The company borrowed $150 million through the Federal Reserve Bank Term Funding Program (BTFP), primarily replacing FHLB advances; these advances mature in under 12 months and carried a 4.83% weighted-average rate. Reported unused capacity was approximately $529 million at FHLBNY and $708 million at the Federal Reserve, plus $52 million in correspondent-bank lines. Management reported a 17.9% basic liquidity ratio including FHLBNY collateralized borrowing capacity.
- Cash flow, six months: Operating cash flow was $25.7 million; investing cash outflow was $28.5 million; financing cash inflow was $111.7 million. Cash and cash equivalents increased $108.9 million to $173.6 million, with financing cash flow reflecting $250 million of BTFP advances and $133 million of other borrowing paydowns.
- Credit and capital: The allowance for loan losses was $31.2 million, or 1.02% of loans. Nonperforming loans were $6.5 million (0.21% of loans) and nonperforming assets $7.1 million (0.17% of assets). The allowance-to-nonperforming-loan ratio was 477%. Arrow’s CET1, Tier 1 risk-based, total risk-based and leverage ratios were 13.27%, 13.96%, 15.08% and 9.92%, respectively; Arrow and its banks were reported well-capitalized.
Material changes and management commentary
- Higher funding costs drove the earnings decline: Q2 interest expense increased $12.7 million year over year, substantially faster than the $9.4 million increase in interest and dividend income. Deposit costs rose to 1.35% from 0.14% in Q2 2022; the cost of interest-bearing liabilities increased 173 bps, while earning-asset yield increased 88 bps.
- Loans reached a record $3.1 billion, up 7.9% from June 2022. Deposits were down 1.2% year over year; noninterest-bearing deposits were 21.7% of period-end deposits versus 23.3% a year earlier. Time deposits rose to $368.8 million from $169.5 million a year earlier, which management attributed to deposit campaigns and a competitive rate environment.
- Q2 noninterest expense included a $2.8 million increase in other operating expense, primarily legal and professional fees associated with delayed filings. Management reported approximately $2.0 million of additional legal and professional fees in Q2 related to the delayed 2022 Form 10-K and Q1 2023 Form 10-Q.
- Available-for-sale securities had $62.6 million of gross unrealized losses at June 30, primarily attributed by management to interest-rate changes rather than credit quality. The company said it did not intend, and was not more likely than not required, to sell securities before recovery of amortized cost; it recorded no securities credit-loss allowance.
- No specific earnings or balance-sheet guidance was provided. Management noted that loan demand may be affected by inflation and higher rates, and that the cost of interest-bearing liabilities had been rising faster than asset yields in the near term.
Risks, contingencies and unusual items
- Controls: Management concluded internal control over financial reporting was not effective because of two unremediated material weaknesses: monitoring of internal audit and related audit committee oversight, and risk assessment of the core banking-system conversion. Management described remediation efforts; the weaknesses had not yet been considered remediated. The filing states they had not resulted in a material misstatement of the reported financial statements.
- Litigation: A June 2023 putative shareholder class action alleges materially false or misleading statements in company filings and asserts Exchange Act claims. Arrow denies wrongdoing, intends to defend the case, and reported it had not been served as of the filing date. Management did not quantify potential exposure.
- Other risks: The filing identifies interest-rate and deposit-pricing pressure, potential liquidity and credit deterioration, regional economic and tourism exposure, securities valuation risk, technology and cybersecurity risks, and execution risks from the core-system conversion and executive-management transition.
- Commitments: At June 30, commitments to extend credit were $463.2 million and standby letters of credit were $4.1 million; these are not necessarily expected to be fully funded. The company also disclosed approximately $1.3 million of residential real-estate loan modifications involving short-term interest forbearance in H1, with forgone interest under $10,000 per month.
- The auditor performed a review of interim financial information, not an audit, and reported no material modifications were needed for GAAP conformity.
Important facts for investors to verify
- Whether deposit mix, time-deposit growth and funding costs stabilize, and how that affects net interest margin and earnings.
- Whether the $150 million of short-term BTFP funding is renewed, repaid or replaced, and the availability and collateral terms of stated contingent borrowing capacity.
- Trends in past-due and nonperforming loans, consumer auto credit performance, commercial real-estate exposure and the adequacy of the allowance.
- Progress and independent validation of remediation for the disclosed material weaknesses and the implications of the shareholder lawsuit and related legal costs.
- The duration and potential effect of securities unrealized losses, and whether future liquidity needs could require securities sales before recovery of amortized cost.