Bay Banks of Virginia (BAYK) 10-Q 2016 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2016

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER: 0-22955

BAY BANKS OF VIRGINIA, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

VIRGINIA	54-1838100
(STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)	(I.R.S. EMPLOYER IDENTIFICATION NO.)

100 SOUTH MAIN STREET, KILMARNOCK, VA 22482

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

(804) 435-1171

(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    ☒  yes    ☐  no

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    ☒  yes    ☐  no

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer	☐	Accelerated filer	☐
Non-accelerated filer	☐	Smaller reporting company	☒

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ☐  yes    ☒  no

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

4,774,856 shares of common stock on November 1, 2016

FORM 10-Q

For the interim period ending September 30, 2016

INDEX

PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2016 (UNAUDITED) AND DECEMBER 31, 2015	3
CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015 (UNAUDITED)	4
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015 (UNAUDITED)	5
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 (UNAUDITED)	5
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015 (UNAUDITED)	6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)	7
ITEM  2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	26
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	38
ITEM 4. CONTROLS AND PROCEDURES	38
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS	38
ITEM 1A. RISK FACTORS	39
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	39
ITEM 3. DEFAULTS UPON SENIOR SECURITIES	39
ITEM 4. MINE SAFETY DISCLOSURES	39
ITEM 5. OTHER INFORMATION	39
ITEM 6. EXHIBITS	39

2

PART I – FINANCIAL INFORMATION

ITEM  1. FINANCIAL STATEMENTS

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED BALANCE SHEETS

	September 30, 2016			December 31, 2015 (1)
(Dollars in thousands)	(unaudited)
ASSETS
Cash and due from banks	$	5,280		$	4,969
Interest-bearing deposits		6,343			15,330
Certificates of deposit		4,464			5,735
Federal funds sold		460			271
Securities available-for-sale, at fair value		52,563			54,090
Restricted securities		2,209			2,731
Loans receivable, net of allowance for loan losses of $3,741 and $4,223		364,822			343,323
Loans held for sale		481			270
Premises and equipment, net		11,021			11,646
Accrued interest receivable		1,241			1,318
Other real estate owned, net		2,764			1,870
Bank owned life insurance		9,792			7,595
Goodwill		2,808			2,808
Mortgage servicing rights		590			658
Other assets		3,436			3,682
Total assets	$	468,274		$	456,296
LIABILITIES
Noninterest-bearing deposits	$	74,615		$	65,842
Savings and interest-bearing demand deposits		175,448			166,628
Time deposits		127,912			127,388
Total deposits		377,975			359,858
Securities sold under repurchase agreements		12,984			7,161
Federal Home Loan Bank advances		25,000			40,000
Subordinated debt, net of issuance costs		6,856			6,844
Other liabilities		3,511			2,864
Total liabilities		426,326			416,727
SHAREHOLDERS’ EQUITY
Common stock ($5 par value; authorized - 10,000,000 shares; outstanding - 4,774,856 and 4,774,856 shares, respectively)		23,874			23,874
Additional paid-in capital		2,828			2,812
Retained earnings		15,623			13,659
Accumulated other comprehensive loss, net		(377	)		(776	)
Total shareholders’ equity		41,948			39,569
Total liabilities and shareholders’ equity	$	468,274		$	456,296

(1) Derived from Audited December 31, 2015 Financial Statements

See Notes to Consolidated Financial Statements.

3

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

	For the three months ended						For the nine months ended
(Dollars in thousands except per share amounts)	September 30, 2016			September 30, 2015			September 30, 2016			September 30, 2015
INTEREST INCOME
Loans, including fees	$	4,153		$	3,810		$	12,140		$	11,200
Securities:
Taxable		233			144			651			402
Tax-exempt		123			102			394			276
Federal funds sold		1			—			2			—
Interest-bearing deposit accounts		25			9			52			30
Certificates of deposit		20			15			62			32
Total interest income		4,555			4,080			13,301			11,940
INTEREST EXPENSE
Deposits		648			643			1,934			1,729
Federal funds purchased		1			—			2			—
Securities sold under repurchase agreements		4			4			10			8
Subordinated debt		118			119			354			161
FHLB advances		118			87			360			259
Total interest expense		889			853			2,660			2,157
Net interest income		3,666			3,227			10,641			9,783
Provision for loan losses		259			84			407			354
Net interest income after provision for loan losses		3,407			3,143			10,234			9,429
NON-INTEREST INCOME
Income from fiduciary activities		253			197			696			589
Service charges and fees on deposit accounts		212			237			667			686
VISA-related fees		48			44			153			153
Non-deposit product income		83			77			263			324
Other service charges and fees		152			144			449			414
Secondary market lending income		165			171			465			409
Increase in cash surrender value of life insurance		73			62			197			187
Net gains on sale of securities available for sale		180			2			290			4
Other real estate losses		(6	)		(167	)		(94	)		(247	)
Net gains (losses) on the disposal of fixed assets		—			1			—			(6	)
Other income		178			5			194			62
Total non-interest income		1,338			773			3,280			2,575
NON-INTEREST EXPENSES
Salaries and employee benefits		1,881			1,959			5,751			5,847
Occupancy expense		445			465			1,344			1,342
Software maintenance		152			175			494			465
Bank franchise tax		82			61			203			159
VISA expense		20			19			81			83
Telephone expense		30			35			96			101
FDIC assessments		96			71			280			200
Foreclosure property expense		11			15			40			36
Consulting expense		87			71			216			236
Other expense		761			714			2,376			2,377
Total non-interest expenses		3,565			3,585			10,881			10,846
Net income before income taxes		1,180			331			2,633			1,158
Income tax expense		326			50			669			202
Net income	$	854		$	281		$	1,964		$	956
Basic Earnings Per Share
Average basic shares outstanding		4,774,856			4,780,649			4,774,856			4,797,405
Earnings per share, basic	$	0.18		$	0.06		$	0.41		$	0.20
Diluted Earnings Per Share
Average diluted shares outstanding		4,797,521			4,796,008			4,793,147			4,811,129
Earnings per share, diluted	$	0.18		$	0.06		$	0.41		$	0.20

See Notes to Consolidated Financial Statements.

4

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)

	For the three months ended						For the nine months ended
	September 30,						September 30,
(Dollars in thousands)	2016			2015			2016			2015
Net income	$	854		$	281		$	1,964		$	956
Other comprehensive income:
Unrealized gains (losses) on securities:
Unrealized holding gains arising during the period		—			403			895			140
Deferred tax expense		—			(136	)		(305	)		(47	)
Reclassification of net securities gains recognized in net income		(180	)		(2	)		(290	)		(4	)
Deferred tax expense		62			—			99			1
Unrealized gains (losses) adjustment, net of tax		(118	)		265			399			90
Total other comprehensive (loss) income		(118	)		265			399			90
Comprehensive income	$	736		$	546		$	2,363		$	1,046

See Notes to Consolidated Financial Statements.

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(unaudited)

(Dollars in thousands, except share data or amounts)	Shares of Common Stock		Common Stock		Additional Paid-in Capital		Retained Earnings		Accumulated Other Comprehensive Loss			Total Shareholders’ Equity
Nine Months ended September 30, 2016
Balance at beginning of period		4,774,856	$	23,874	$	2,812	$	13,659	$	(776	)	$	39,569
Net income		—		—		—		1,964		—			1,964
Other comprehensive income		—		—		—		—		399			399
Stock-based compensation expense		—		—		16		—		—			16
Balance at end of period		4,774,856	$	23,874	$	2,828	$	15,623	$	(377	)	$	41,948

See Notes to Consolidated Financial Statements.

5

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	For the Nine Months Ended September 30,
(Dollars in thousands)	2016			2015
Cash Flows From Operating Activities
Net income	$	1,964		$	956
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		791			727
Net amortization and accretion of securities		320			280
Amortization of subordinated debt issuance costs		12			5
Provision for loan losses		407			354
Stock compensation expense		16			17
Deferred tax benefit		(6	)		(12	)
Gain on securities available-for-sale		(290	)		(4	)
Increase in OREO valuation allowance		53			159
Loss on sale of other real estate		41			88
Loss on the disposal of fixed assets		—			6
Decrease (increase) in mortgage servicing rights		68			(46	)
Loan originations for sale		(14,232	)		(11,857	)
Loan sales		14,378			10,887
Gain on sold loans		(357	)		(212	)
Gain on sale of VISA loan portfolio		(150	)		—
Increase in cash surrender value of life insurance		(197	)		(187	)
Decrease (increase) in accrued income and other assets		123			(296	)
Increase in other liabilities		643			555
Net cash provided by operating activities		3,584			1,420
Cash Flows From Investing Activities
Proceeds from maturities and principal paydowns of available-for-sale securities		2,907			1,069
Proceeds from sales and calls of available-for-sale securities		14,582			4,819
Maturities of certificates of deposit		1,240			1,240
Purchases of available-for-sale securities and certificates of deposit		(15,356	)		(18,561	)
Purchase of life insurance		(2,000	)		—
Sales of restricted securities		522			169
Increase in federal funds sold		(189	)		(347	)
Proceeds from the sale of VISA loan portfolio		1,301			—
Loan (originations) and principal collections, net		(24,283	)		(35,050	)
Proceeds from sale of other real estate		244			520
Purchases of premises and equipment		(168	)		(1,111	)
Net cash used in investing activities		(21,200	)		(47,252	)
Cash Flows From Financing Activities
Net increase in demand, savings, and other interest-bearing deposits		17,593			35,073
Net increase (decrease) in time deposits		524			(3,274	)
Repurchase of common stock		—			(243	)
Net increase in securities sold under repurchase agreements		5,823			4,479
Issuance of subordinated debt, net		—			6,834
Decrease in Federal Home Loan Bank advances		(15,000	)		(5,000	)
Net cash provided by financing activities		8,940			37,869
Net decrease in cash and due from banks		(8,676	)		(7,963	)
Cash and cash equivalents (including interest-earning deposits) at beginning of period		20,299			20,965
Cash and cash equivalents (including interest-earning deposits) at end of period	$	11,623		$	13,002
Supplemental Schedule of Cash Flow Information
Cash paid for:
Interest	$	2,549		$	2,102
Income taxes		70			590
Non-cash investing and financing:
Unrealized gain (loss) on investment securities		605			136
Change in fair value of pension and post-retirement obligation		—			—
Loans transferred to other real estate owned		1,348			437
Loans originated to facilitate sale of OREO		116			118
Changes in deferred taxes resulting from OCI transactions		206			90
Transfer of loans to held for sale		1,173			—

See Notes to Consolidated Financial Statements.

6

Notes to Consolidated Financial Statements (Unaudited)

Note 1: General

Bay Banks of Virginia, Inc. (the “Company”) owns 100% of the Bank of Lancaster (the “Bank”), 100% of Bay Trust Company, Inc. (the “Trust Company”) and 100% of Steptoes Holdings, LLC (“Steptoes Holdings”). The consolidated financial statements include the accounts of the Bank, the Trust Company, Steptoes Holdings and Bay Banks of Virginia, Inc.

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”) and to the general practices within the banking industry. In management’s opinion, all adjustments, consisting only of normal recurring adjustments necessary for a fair presentation of the consolidated financial statements, have been included. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year or for any other interim periods. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

Certain amounts presented in the consolidated financial statements of prior periods have been reclassified to conform to current year presentations. The reclassifications had no effect on net income, net income per share or shareholders’ equity as previously reported.

Note 2: Significant Accounting Policies

Certificates of Deposit

Prior to January 1, 2016, the Company included its investments in certificates of deposit on the consolidated balance sheets in securities available-for sale, at fair value. Effective January 1, 2016, the Company is presenting certificates of deposit separately on the consolidated balance sheets and removing them from the available-for-sale category. As of December 31, 2015, the unrealized gain related to the certificates of deposit included in securities available-for-sale was $31 thousand and the tax effected unrealized gain included in accumulated other comprehensive income was $20 thousand. The unrealized gain and related impact were reversed the first quarter of 2016.

Loans

The Company grants mortgage loans on real estate, commercial and industrial loans and consumer and other loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans on real estate. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in the Company’s market areas.

Loans are reported at their recorded investment, which is the outstanding principal balance net of any unearned income, such as deferred fees and costs, and charge-offs. Interest on loans is recognized over the term of the loan and is calculated using the interest method on principal amounts outstanding. Loan origination fees and certain direct origination costs are deferred and recognized as an adjustment of the related loan yield over the contractual term of the loan, adjusted for early pay-offs, where applicable.

The accrual of interest is generally discontinued at the time a loan 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. Payments received for loans no longer accruing interest are applied to the unpaid principal balance. Loans greater than 90 days past due may remain on accrual status if the credit is well-secured and in process of collection. Personal loans are typically charged off no later than 180 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are charged off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual and past due policies are materially the same for all types of loans.

All interest accrued but not collected for loans that are placed on non-accrual or charged off are reversed against interest income. Any subsequent interest received on these loans is accounted for on the cash basis or cost recovery method until qualifying for return to accrual. Generally, a loan is returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, or it becomes well secured and in the process of collection.

Allowance for loan losses (“ALL”)

The ALL reflects management’s judgment of probable loan losses inherent in the portfolio at the balance sheet date. Management uses a disciplined process and methodology to establish the ALL each quarter. To determine the total ALL, the Company estimates the reserves needed for each homogenous segment of the portfolio, plus any loans analyzed individually for impairment. Depending on the nature of each segment, considerations include historical loss experience, adverse situations that may affect a borrower’s ability to repay, credit scores, past due history, estimated value of any underlying collateral, prevailing local and national economic conditions, and internal policies and procedures including credit risk management and underwriting. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as conditions change.

7

Management employs a risk rating system to evaluate and consistently categorize loan portfolio credit risk. Loans assigned risk rating grades include all commercial loans not secured by real estate, commercial mortgages, residential mortgages greater than $1 million, smaller residential mortgages which are impaired, loans to real estate developers and contractors, consumer loans greater than $250 thousand with chronic delinquency, and troubled debt restructures (“TDRs”). The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled. Risk grades are evaluated as new information becomes available for each borrowing relationship or at least quarterly. All other loans not specifically assigned a risk rating grade are monitored as a discrete pool of loans generally based on delinquency status. Risk rating categories are as follows:

Pass – Borrower is strong or sound and collateral securing the loan, if any, is adequate.

Watch – Borrower exhibits some signs of financial stress but is generally believed to be a satisfactory customer and collateral, if any, may be in excess of 90% of the loan balance.

Special Mention – Adverse trends in the borrower’s financial position are evident and warrant management’s close attention. Any collateral may not be fully adequate to secure the loan balance.

Substandard – A loan in this category has a well-defined weakness in the primary repayment source that jeopardizes the timely collection of the debt. There is a distinct possibility that a loss may result if the weakness is not corrected.

Doubtful – Default has already occurred and it is likely that foreclosure or repossession procedures have begun or will begin in the near future. Weaknesses make collection or liquidation in full, based on currently existing information, highly questionable and improbable.

Loss – Uncollectible and of such little value that continuance as a bankable asset is not warranted.

The ALL consists of specific, general, and unallocated components. The specific component is determined by identifying impaired loans (as described below) then evaluating each one to calculate the amount of impairment. Impaired loans measured for impairment generally include: (1) non-accruing Special mention, Substandard and Doubtful loans in excess of $250,000; (2) Substandard and Doubtful loans in excess of $500,000; (3) Special Mention loans in excess of $500,000 if any of the loans in the relationship are more than 30 days past due or if the borrower has filed for bankruptcy; and (4) all TDRs. A specific allowance arises when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component collectively evaluates smaller commercial loans, residential mortgages and consumer loans, grouped into segments and classes. Historical loss experience is calculated and applied to each segment or class, then adjusted for qualitative factors. Qualitative factors include changes in local and national economic indicators, such as unemployment rates, interest rates, gross domestic product growth and real estate market trends; the level of past due and nonaccrual loans; risk ratings on individual loans; strength of credit policies and procedures; loan officer experience; borrower credit scores; and other intrinsic risks related to the types and geographic locations of loans. These qualitative adjustments reflect management’s judgment of risks inherent in the segments. An unallocated component is maintained if needed to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. Changes in the allowance for loan losses and the related provision expense can materially affect net income.

The specific component of the ALL calculation accounts for the loan loss reserve necessary on 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 the 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, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not considered 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. Accrual of interest may or may not be discontinued for any given impaired loan. Impairment is measured 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 value of the collateral if the loan is collateral dependent. Because large groups of smaller balance homogeneous loans are collectively evaluated for impairment, the Company does not generally separately identify smaller balance individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a troubled debt restructuring agreement.

The general component of the ALL calculation collectively evaluates groups of loans in segments or classes, as noted above. The segments are: (1) Mortgage loans on real estate; (2) Commercial and industrial loans; and (3) Consumer and other loans. The segment for Mortgage loans on real estate is disaggregated into the following classes: (1) Construction, land and land development; (2) Farmland; (3) Residential first mortgages; (4) Residential revolving and junior mortgages; (5) Commercial mortgages (non-owner-occupied); and (6) Commercial mortgages (owner-occupied). Loans in segment 1 are secured by real estate. Loans in segments 2 and 3 are secured by other types of collateral or are unsecured. A given segment or class may not reflect the purpose of a loan. For example, a business owner may provide his residence as collateral for a loan to his company, in which case the loan would be grouped in a residential mortgage class. Historical loss factors are calculated for the prior 20 quarters by segment and class, and then applied to the current balances in each segment and class. Finally, qualitative factors are applied to each segment and class.

Construction and development loans carry risks that the project will not be finished according to schedule or according to budget and the value of the collateral, at any point in time, may be less than the principal amount of the loan. These loans also bear the risk that the

8

general contractor may face financial pressure unrelated to the project. Loans secured by land, farmland and residential mortgages carry the risk of continued credit-worthiness of the borrower and changes in value of the underlying real estate collateral. Commercial mortgages and commercial and industrial loans carry risks associated with the profitable operation of a business and its related cash flows. Additionally, commercial and industrial loans carry risks associated with the value of collateral other than real estate which may depreciate over time. Consumer loans carry risks associated with the continuing credit-worthiness of the borrower and are more likely than real estate loans to be adversely affected by divorce, unemployment, personal illness or bankruptcy of an individual. Consumer loans secured by automobiles carry risks associated with rapidly depreciating collateral. Consumer loans have historically included credit cards, which are unsecured. The credit card portfolio was sold to an unaffiliated third party in the third quarter of 2016.

The summation of the specific, general and unallocated components results in the total estimated ALL. Management may also include an unallocated component to cover uncertainties in the level of probable losses. This estimate is inherently subjective and actual losses could be greater or less than the estimates.

Additions to the ALL are made by charges to earnings through the provision for loan losses. Charge-offs result from credit exposures deemed to be uncollectible and the ALL is reduced by these. Recoveries of previously charged off amounts are credited back to the ALL. Charge-off policies are materially the same for all types of loans.

Mortgage servicing rights (“MSRs”)

MSRs are included on the consolidated balance sheet and recorded at fair value on an ongoing basis. Changes in the fair value of the MSRs are recorded in the results of operations. A fair value analysis of MSRs is performed on a quarterly basis.

Note 3: Amendments to the Accounting Standards Codification

In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-13,Financial Instruments – Credit Losses (Topic 326)which is new guidance for the accounting for credit losses on instruments within its scope. It introduces a new model for current expected credit losses (“CECL”) which will apply to financial assets subject to credit losses and measured at amortized cost and certain off-balance sheet credit exposures. This will include loans, held-to-maturity debt securities, loan commitments, financial guarantees, net investments in leases, reinsurance and trade receivables. The CECL model requires an entity to estimate the credit losses expected over the life of an exposure (or pool of exposures). The estimate of expected credit losses should consider historical information, current information and reasonable and supportable forecasts, including estimates of prepayments. In addition, ASU 2016-13 replaces the current available-for-sale debt securities other-than-temporary impairment model with an estimate of expected credit losses only when the fair value falls below the amortized cost of the asset. Credit losses on available-for-sale debt securities will be limited to the difference between the security’s amortized cost basis and its fair value. The available-for-sale debt security model will also require the use of an allowance to record estimated credit losses and subsequent recoveries. The ASU also addresses purchased financial assets with credit deterioration. Disclosure requirements are expanded regarding an entity’s assumptions, models and methods for estimating the ALL. The ASU is effective for interim and annual reporting periods beginning after December 15, 2019. The Company is evaluating the impact that ASU 2016-13 will have on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09,“Compensation – Stock Compensation (Topic 718): Improvements to Employee Shares-Based Payment Accounting.” The amendments in this ASU simplify several aspects of the accounting for share-based payment award transactions including: a) income tax consequences; b) classification of awards as either equity or liabilities; and c) classification on the statement of cash flows. The amendments are effective for public companies for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The Company is evaluating the impact that ASU 2016-09 will have on its consolidated financial statements.

In January 2016, the FASB issued ASU 2016-01,Financial Instruments – Overall (Subtopic 825-10) which requires equity investments, other than those accounted for using the equity method, to be measured at fair value through earnings. There will no longer be an available-for-sale classification measured (changes in fair value reported in other comprehensive income) for equity securities with readily determinable fair values. The cost method is also eliminated for equity instruments without a readily determinable fair value. For these investments, companies can elect to record the investment at cost, less impairment, plus or minus subsequent adjustments for observable price changes. This election only applies to equity investments that do not qualify for the net asset value practical expedient. Public companies will be required to use the exit price when measuring the fair value of financial instruments measured at amortized cost for disclosure purposes. In addition, the ASU requires financial assets and financial liabilities to be presented separately in the notes to the financial statements, grouped by measurement category and form of financial asset. The classification and measurement guidance is effective for periods beginning after December 15, 2017. The Company is evaluating the impact that ASU 2016-01 will have on its consolidated financial statements.

In February 2015, the FASB issued ASU 2015-02,Consolidation (Topic 810): Amendments to the Consolidation Analysis. The amendments modify the evaluation reporting organizations must perform to determine if certain legal entities should be consolidated as VIEs. Specifically, the amendments: (1) modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (“VIEs”) or voting interest entities; (2) eliminate the presumption that a general partner should consolidate a limited partnership; (3) affect the consolidation analysis of reporting entities that are involved with VIEs, particularly those that have fee arrangements and related party relationships; and (4) provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. ASU 2015-02 is effective for interim and annual reporting periods beginning after December 15, 2015. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

9

In January 2015, the FASB issued ASU 2015-01,Income Statement – Extraordinary and Unusual Items. ASU 2015-01 eliminates the concept of extraordinary items. However, the presentation and disclosure requirements for items that are either unusual in nature or infrequent in occurrence remain and will be expanded to include items that are both unusual in nature and infrequent in occurrence. ASU 2015-01 is effective for periods beginning after December 15, 2015. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09,Revenue from Contracts with Customers (Topic 606). The amendments in this ASU modify the guidance companies use to recognize revenue from contracts with customers for transfers of goods or services and transfers of nonfinancial assets, unless those contracts are within the scope of other standards. The ASU requires that entities apply a specific method to recognize revenue reflecting the consideration expected from customers in exchange for the transfer of goods and services. The guidance also requires new qualitative and quantitative disclosures, including information about contract balances and performance obligations. Entities are also required to disclose significant judgments and changes in judgments for determining the satisfaction of performance obligations. Most revenue associated with financial instruments, including interest and loan origination fees, is outside the scope of the guidance. In August 2015, the FASB issued ASU 2014-09 changing the effective date for ASU 2014-09 to annual reporting periods beginning after December 15, 2017 from December 15, 2016. The Company is evaluating the impact that ASU 2014-09 will have on its consolidated financial statements.

Note 4: Securities

The aggregate amortized costs and fair values of the available-for-sale securities portfolio are as follows:

(Dollars in thousands)
Available-for-sale securities September 30, 2016	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Corporate bonds	$	6,945	$	58	$	—		$	7,003
U.S. Government agencies		25,461		272		(56	)		25,677
State and municipal obligations		19,363		541		(21	)		19,883
	$	51,769	$	871	$	(77	)	$	52,563
Available-for-sale securities December 31, 2015	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Corporate bonds	$	3,950	$	—	$	(5	)	$	3,945
U.S. Government agencies		21,375		69		(156	)		21,288
State and municipal obligations		28,599		313		(55	)		28,857
	$	53,924	$	382	$	(216	)	$	54,090

Gross realized gains and gross realized losses on sales and calls of securities were as follows:

	For the three months ended September 30,					For the nine months ended September 30,
(Dollars in thousands)	2016		2015			2016			2015
Gross realized gains	$	180	$	3		$	300		$	27
Gross realized losses		—		(1	)		(10	)		(23	)
Net realized gains (losses)	$	180	$	2		$	290		$	4
Aggregate proceeds	$	4,984	$	1,995		$	14,582		$	4,819

Average yields (taxable equivalent) on securities were 3.10% and 2.43% for the three months ended September 30, 2016 and 2015, respectively, and 3.07% and 2.45% for the nine months ended September 30, 2016 and 2015, respectively.

Securities with a market value of $15.5 million and $8.6 million were pledged as collateral for repurchase agreements and for other purposes as required by law as of September 30, 2016 and December 31, 2015, respectively. As of September 30, 2016 and December 31, 2015, all the securities pledged to repurchase agreements were state and municipal obligations. All the repurchase agreements had remaining contractual maturities that were overnight and continuous. Securities sold under repurchase agreements were $13.0 million and $7.2 million as of September 30, 2016 and December 31, 2015, respectively, and included in liabilities on the consolidated balance sheets.

10

The securities pledged to each agreement are reviewed daily and can be changed at the option of the Bank with minimal risk of loss due to fair value.

Securities in an unrealized loss position at September 30, 2016 and December 31, 2015, by duration of the unrealized loss, are shown below. The unrealized loss positions were directly related to interest rate movements as there is minimal credit risk exposure in these investments. All agency securities, and states and municipal securities are investment grade or better and their losses are considered temporary. Management does not intend to sell the securities and does not expect to be required to sell the securities. Furthermore, all amortized cost bases are expected to be recovered. Bonds with unrealized loss positions at September 30, 2016 included 12 federal agencies and six municipals. Bonds with unrealized loss positions at December 31, 2015 included 24 federal agencies, one corporate bond and 17 municipals. The tables are shown below.

(Dollars in thousands)	Less than 12 months					12 months or more					Total
September 30, 2016	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
U.S. Government agencies	$	5,573	$	(43	)	$	1,385	$	(13	)	$	6,958	$	(56	)
States and municipal obligations		2,064		(21	)		—		—			2,064		(21	)
Total temporarily impaired securities	$	7,637	$	(64	)	$	1,385	$	(13	)	$	9,022	$	(77	)
	Less than 12 months					12 months or more					Total
December 31, 2015	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Corporate bonds	$	495	$	(5	)	$	—	$	—		$	495	$	(5	)
U.S. Government agencies		13,871		(141	)		1,619		(15	)		15,490		(156	)
States and municipal obligations		2,566		(17	)		3,281		(38	)		5,847		(55	)
Total temporarily impaired securities	$	16,932	$	(163	)	$	4,900	$	(53	)	$	21,832	$	(216	)

The Company’s investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock totaled $1.5 million and $2.0 million at September 30, 2016 and December 31, 2015, respectively. The Company also had an investment in Federal Reserve Bank of Richmond (“FRB”) stock which totaled $565 thousand and $505 thousand at September 30, 2016 and December 31, 2015, respectively. The investments in both FHLB and FRB stock are required investments related to the Bank’s membership with the FHLB and FRB. These securities do not have a readily determinable fair value as their ownership is restricted, and they lack an active market for trading. Additionally, per charter provisions related to the FHLB and FRB stock, all repurchase transactions of such stock must occur at par. Accordingly, these securities are carried at cost, and are periodically evaluated for impairment. The Company’s determination as to whether its investment in FHLB and FRB stock is impaired is based on management’s assessment of the ultimate recoverability of its par value rather than recognizing temporary declines in its value. The determination of whether the decline affects the ultimate recoverability of the investments is influenced by available information regarding various factors. These factors include, among others, the significance of the decline in net assets of the issuing banks as compared to the capital stock amount reported by these banks, and the length of time a decline has persisted; commitments by such banks to make payments required by law or regulation and the level of such payments in relation to the operating performance of the issuing bank; and the overall liquidity position of the issuing bank. Based on its most recent analysis of publicly available information regarding the financial condition of the issuing banks, management concluded that no impairment existed in the carrying value of FHLB and FRB stock.

Note 5: Loans

The following is a summary of the balances of loans:

(Dollars in thousands)	September 30, 2016			December 31, 2015
Mortgage loans on real estate:
Construction, Land and Land Development	$	41,530		$	42,129
Farmland		1,051			1,030
Commercial Mortgages (Non-Owner Occupied)		29,131			29,086
Commercial Mortgages (Owner Occupied)		45,504			43,956
Residential First Mortgages		185,373			164,405
Residential Revolving and Junior Mortgages		25,389			26,497
Commercial and Industrial loans		36,596			35,104
Consumer Loans		3,615			5,015
Total loans		368,189			347,222
Net unamortized deferred loan costs		374			324
Allowance for loan losses		(3,741	)		(4,223	)
Loans, net	$	364,822		$	343,323

11

The recorded investment in past due and non-accruing loans is shown in the following table. A loan past due by more than 90 days is generally placed on nonaccrual unless it is both well secured and in the process of collection.

(Dollars in thousands) Loans Past Due and Nonaccruals	30-89 Days		90 Days or More Past Due and				Total Past Due and				Total
September 30, 2016	Past Due		Still Accruing		Nonaccruals		Nonaccruals		Current		Loans
Construction, Land and Land Development	$	62	$	67	$	627	$	756	$	40,774	$	41,530
Farmland		—		—		—		—		1,051		1,051
Commercial Mortgages (Non-Owner Occupied)		—		—		—		—		29,131		29,131
Commercial Mortgages (Owner Occupied)		294		100		1,650		2,044		43,460		45,504
Residential First Mortgages		860		—		2,276		3,136		182,237		185,373
Residential Revolving and Junior Mortgages		12		—		213		225		25,164		25,389
Commercial and Industrial		19		11		92		122		36,474		36,596
Consumer Loans		—		—		—		—		3,615		3,615
Total	$	1,247	$	178	$	4,858	$	6,283	$	361,906	$	368,189
Loans Past Due and Nonaccruals	30-89 Days		90 Days or More Past Due and				Total Past Due and				Total
December 31, 2015	Past Due		Still Accruing		Nonaccruals		Nonaccruals		Current		Loans
Construction, Land and Land Development	$	93	$	—	$	672	$	765	$	41,364	$	42,129
Farmland		—		—		—		—		1,030		1,030
Commercial Mortgages (Non-Owner Occupied)		264		—		—		264		28,822		29,086
Commercial Mortgages (Owner Occupied)		133		—		2,350		2,483		41,473		43,956
Residential First Mortgages		1,304		—		2,841		4,145		160,260		164,405
Residential Revolving and Junior Mortgages		70		—		277		347		26,150		26,497
Commercial and Industrial		10		—		285		295		34,809		35,104
Consumer Loans		32		11		8		51		4,964		5,015
Total	$	1,906	$	11	$	6,433	$	8,350	$	338,872	$	347,222

In July 2016, the Bank sold its VISA loan portfolio to an unaffiliated third party, recognizing a gain of $150 thousand on sale.

Note 6: Allowance for Loan Losses

Loans Evaluated for Impairment

Loan receivables evaluated for impairment individually and collectively by segment as of September 30, 2016 and December 31, 2015 are as follows:

(Dollars in thousands)	Mortgage Loans		Commercial and		Consumer
As of September 30, 2016	on Real Estate		Industrial		Loans		Total
Individually evaluated for impairment	$	10,426	$	93	$	—	$	10,519
Collectively evaluated for impairment		317,552		36,503		3,615		357,670
Total Gross Loans	$	327,978	$	36,596	$	3,615	$	368,189
	Mortgage		Commercial
	Loans		and		Consumer
As of December 31, 2015	on Real Estate		Industrial		Loans		Total
Individually evaluated for impairment	$	10,542	$	284	$	—	$	10,826
Collectively evaluated for impairment		296,561		34,820		5,015		336,396
Total Gross Loans	$	307,103	$	35,104	$	5,015	$	347,222

12

Allowance for Loan Losses

The allowance for loan losses disaggregated based on loan receivables evaluated for impairment individually and collectively by segment as of September 30, 2016 and December 31, 2015 are as follows:

	Mortgage		Commercial
(Dollars in thousands)	Loans		and		Consumer
As of September 30, 2016	on Real Estate		Industrial		Loans		Total
Individually evaluated for impairment	$	751	$	92	$	—	$	843
Collectively evaluated for impairment		2,457		388		53		2,898
Total allowance for loan losses	$	3,208	$	480	$	53	$	3,741
	Mortgage Loans		Commercial and		Consumer
As of December 31, 2015	on Real Estate		Industrial		Loans		Total
Individually evaluated for impairment	$	1,256	$	278	$	—	$	1,534
Collectively evaluated for impairment		2,246		321		122		2,689
Total allowance for loan losses	$	3,502	$	599	$	122	$	4,223

A disaggregation and an analysis of the change in the allowance for loan losses by segment is shown below.

	Mortgage			Commercial
	Loans on			and			Consumer
(Dollars in thousands)	Real Estate			Industrial			Loans			Total
For the Three Months Ended
September 30, 2016
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	2,995		$	435		$	117		$	3,547
Reclassification of allowanace related to sold loans		—			—			(27	)		(27	)
(Charge-offs)		(46	)		—			(10	)		(56	)
Recoveries		15			—			3			18
Provision		244			45			(30	)		259
Ending Balance	$	3,208		$	480		$	53		$	3,741
	Mortgage			Commercial
	Loans on			and			Consumer
	Real Estate			Industrial			Loans			Total
For the Three Months Ended
September 30, 2015
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	2,889		$	420		$	130		$	3,439
(Charge-offs)		(12	)		(132	)		(17	)		(161	)
Recoveries		6			—			6			12
Provision		(69	)		145			8			84
Ending Balance	$	2,814		$	433		$	127		$	3,374

13

	Mortgage			Commercial
	Loans on			and			Consumer
(Dollars in thousands)	Real Estate			Industrial			Loans			Total
For the Nine Months Ended
September 30, 2016
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	3,502		$	599		$	122		$	4,223
Reclassification of allowance related to sold loans		—			—			(27	)		(27	)
(Charge-offs)		(702	)		(158	)		(41	)		(901	)
Recoveries		25			5			9			39
Provision		383			34			(10	)		407
Ending Balance	$	3,208		$	480		$	53		$	3,741
	Mortgage			Commercial
	Loans on			and			Consumer
	Real Estate			Industrial			Loans			Total
For the Nine Months Ended
September 30, 2015
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	2,778		$	323		$	104		$	3,205
(Charge-offs)		(13	)		(132	)		(103	)		(248	)
Recoveries		16			—			47			63
Provision		33			242			79			354
Ending Balance	$	2,814		$	433		$	127		$	3,374

Internal Risk Rating Grades

Internal risk rating grades are generally assigned to commercial loans not secured by real estate, commercial mortgages, residential mortgages greater than $1 million, smaller residential mortgages which are impaired, loans to real estate developers and contractors, consumer loans greater than $250,000 with chronic delinquency, and TDRs, as shown in the following table. The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled. Risk grades (refer to Note 2) are evaluated as new information becomes available for each borrowing relationship or at least quarterly.

	Construction,				Commercial		Commercial
	Land and				Mortgages		Mortgages		Commercial
(Dollars in thousands)	Land				(Non-Owner		(Owner		and
As of September 30, 2016	Development		Farmland		Occupied)		Occupied)		Industrial		Total
Grade:
Pass	$	34,042	$	1,051	$	24,398	$	36,044	$	35,026	$	130,561
Watch		5,466		—		4,212		5,433		1,193		16,304
Special mention		182		—		273		1,467		126		2,048
Substandard		1,840		—		248		2,560		251		4,899
Doubtful		—		—		—		—		—		—
Total	$	41,530	$	1,051	$	29,131	$	45,504	$	36,596	$	153,812
	Construction,				Commercial		Commercial
	Land and				Mortgages		Mortgages		Commercial
	Land				(Non-Owner		(Owner		and
As of December 31, 2015	Development		Farmland		Occupied)		Occupied)		Industrial		Total
Grade:
Pass	$	34,692	$	1,030	$	24,258	$	33,023	$	29,383	$	122,386
Watch		5,337		—		4,564		4,968		5,202		20,071
Special mention		1,119		—		—		2,687		148		3,954
Substandard		981		—		264		3,278		371		4,894
Doubtful		—		—		—		—		—		—
Total	$	42,129	$	1,030	$	29,086	$	43,956	$	35,104	$	151,305

Loans not assigned internal risk rating grades are comprised of smaller residential mortgages and smaller consumer loans. Payment activity of these loans is reviewed monthly by management. However, some of these loans are graded when the borrower’s total exposure to the Bank exceeds the limits noted above. Loans are considered to be nonperforming when they are delinquent by 90 days or more or non-accruing and credit risk is primarily evaluated by delinquency status, as shown in the table below.

14

(Dollars in thousands)			Residential
	Residential		Revolving
As of September 30, 2016	First		and Junior		Consumer
PAYMENT ACTIVITY STATUS	Mortgages (1)		Mortgages (2)		Loans (3)		Total
Performing	$	183,097	$	25,176	$	3,615	$	211,888
Nonperforming		2,276		213		—		2,489
Total	$	185,373	$	25,389	$	3,615	$	214,377
			Residential
	Residential		Revolving
As of December 31, 2015	First		and Junior		Consumer
PAYMENT ACTIVITY STATUS	Mortgages (4)		Mortgages (5)		Loans (6)		Total
Performing	$	161,564	$	26,220	$	4,996	$	192,780
Nonperforming		2,841		277		19		3,137
Total	$	164,405	$	26,497	$	5,015	$	195,917

(1) Residential First Mortgages which have been assigned a risk rating grade of Substandard totaled $3.3 million as of September 30, 2016.

(2) Residential Revolving and Junior Mortgages which have been assigned a risk rating grade of Substandard totaled $265 thousand as of September 30, 2016.

(3) No Consumer Loans had been assigned a risk rating grade of Substandard as of September 30, 2016.

(4) Residential First Mortgages which have been assigned a risk rating grade of Substandard totaled $3.9 million as of December 31, 2015.

(5) Residential Revolving and Junior Mortgages which have been assigned a risk rating grade of Substandard totaled $372 thousand as of December 31, 2015.

(6) No Consumer Loans had been assigned a risk rating grade of Substandard as of December 31, 2015.

Impaired Loans

The following tables show the Company’s recorded investment and the customers’ unpaid principal balances for impaired loans, with the associated allowance amount, if applicable, as of September 30, 2016 and December 31, 2015, along with the average recorded investment and interest income recognized for the three and nine months ended September 30, 2016 and 2015, respectively.

(Dollars in thousands) IMPAIRED LOANS	At September 30, 2016						At December 31, 2015
	Recorded		Customers’ Unpaid		Related		Recorded		Customers’ Unpaid		Related
	Investment		Principal Balance		Allowance		Investment		Principal Balance		Allowance
With no related allowance:
Construction, land and land development	$	1,532	$	1,540	$	—	$	445	$	451	$	—
Residential First Mortgages		2,520		2,552		—		3,130		3,166		—
Residential Revolving and Junior Mortgages (1)		951		951		—		233		233		—
Commercial Mortgages (Non-owner occupied)		248		248		—		264		264		—
Commercial Mortgages (Owner occupied)		2,050		2,356		—		1,352		1,390		—
Commercial and Industrial		—		—		—		—		—		—
		7,301		7,647		—		5,424		5,504		—
With an allowance recorded:
Construction, land and land development		248		287		150		262		290		120
Residential First Mortgages		1,961		1,961		366		2,507		2,507		308
Residential Revolving and Junior Mortgages (1)		232		235		148		258		259		150
Commercial Mortgages (Non-owner occupied)		—		—		—		—		—		—
Commercial Mortgages (Owner occupied)		684		692		87		2,091		2,348		678
Commercial and Industrial		93		101		92		284		285		278
		3,218		3,276		843		5,402		5,689		1,534
Total Impaired Loans:
Construction, land and land development		1,780		1,827		150		707		741		120
Residential First Mortgages		4,481		4,513		366		5,637		5,673		308
Residential Revolving and Junior Mortgages (1)		1,183		1,186		148		491		492		150
Commercial Mortgages (Non-owner occupied)		248		248		—		264		264		—
Commercial Mortgages (Owner occupied)		2,734		3,048		87		3,443		3,738		678
Commercial and Industrial		93		101		92		284		285		278
	$	10,519	$	10,923	$	843	$	10,826	$	11,193	$	1,534

(1) Junior mortgages include equity lines.

15

	For the three months ended								For the nine months ended
	September 30, 2016				September 30, 2015				September 30, 2016				September 30, 2015
	Average		Interest		Average		Interest		Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income		Recorded		Income		Recorded		Income
(Dollars in thousands)	Investment		Recognized		Investment		Recognized		Investment		Recognized		Investment		Recognized
With no related allowance:
Construction, land and land development	$	1,533	$	14	$	448	$	—	$	1,262	$	41	$	449	$	—
Residential First Mortgages		2,618		4		2,061		18		2,432		9		1,813		53
Residential Revolving and Junior Mortgages (1)		951		9		50		1		739		30		50		2
Commercial Mortgages (Non-owner occupied)		248		4		264		4		252		11		264		12
Commercial Mortgages (Owner occupied)		2,104		9		1,354		8		1,982		26		1,036		20
Commercial and Industrial		—		—		—		—		—		—		—		—
Consumer (2)		—		—		3		—		—		—		4		—
		7,454		40		4,180		31		6,667		117		3,616		87
With an allowance recorded:
Construction, land and land development		250		1		268		1		255		3		272		4
Residential First Mortgages		1,965		24		1,741		21		1,956		66		1,748		64
Residential Revolving and Junior Mortgages (1)		234		—		209		2		209		4		191		6
Commercial Mortgages (Non-owner occupied)		—		—		—		—		—		—		—		—
Commercial Mortgages (Owner occupied)		686		5		1,152		6		691		17		1,156		21
Commercial and Industrial		92		—		120		—		105		1		91		—
Consumer (2)		—		—		—		—		—		—		—		—
		3,227		30		3,490		30		3,216		91		3,458		95
Total
Construction, land and land development		1,783		15		716		1		1,517		44		721		4
Residential First Mortgages		4,583		28		3,802		39		4,388		75		3,561		117
Residential Revolving and Junior Mortgages (1)		1,185		9		259		3		948		34		241		8
Commercial Mortgages (Non-owner occupied)		248		4		264		4		252		11		264		12
Commercial Mortgages (Owner occupied)		2,790		14		2,506		14		2,673		43		2,192		41
Commercial and Industrial		92		—		120		—		105		1		91		—
Consumer (2)		—		—		3		—		—		—		4		—
	$	10,681	$	70	$	7,670	$	61	$	9,883	$	208	$	7,074	$	182

(1) Junior mortgages include equity lines.

(2) Includes credit cards.

Smaller non-accruing loans and non-accruing loans that are not graded because they are included in homogenous pools generally do not meet the criteria for impairment testing, and are therefore excluded from impaired loan disclosures. At September 30, 2016 and December 31, 2015, non-accruing loans excluded from impaired loan disclosure totaled $77 thousand and $95 thousand, respectively. If interest on these non-accruing loans had been accrued, such income would have approximated $1 thousand during both the three months ended September 30, 2016 and 2015 and $3 thousand and $9 thousand during the nine months ended September 30, 2016 and 2015, respectively.

Loan Modifications

Loans modified as TDRs are considered impaired and are individually evaluated for the amount of impairment in the ALL. The following table presents, by segments of loans, information related to loans modified as TDRs during the three and nine months ended September 30, 2016 and 2015.

16

	For the three months ended						For the three months ended
	September 30, 2016						September 30, 2015
(Dollars in thousands) TROUBLED DEBT RESTRUCTURINGS	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Residential first mortgages (1)		—	$	—	$	—		1	$	213	$	211

(1) Modification was an extension of loan terms.

	For the nine months ended						For the nine months ended
	September 30, 2016						September 30, 2015
(Dollars in thousands) TROUBLED DEBT RESTRUCTURINGS	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Residential first mortgages (2) (1)		1	$	244	$	244		1	$	213	$	211
Commercial mortgage (Owner occupied) (2)		—		—		—		1		105		124

(1) Modification was an extension of loan terms.

(2) Modification was a capitalization of interest.

	For the three months ended				For the three months ended
(Dollars in thousands)	September 30, 2016				September 30, 2015
TROUBLED DEBT RESTRUCTURINGS THAT SUBSEQUENTLY DEFAULTED	Number of Loans		Recorded Investment		Number of Loans		Recorded Investment
Commercial and industrial		—	$	—		—	$	—
	For the nine months ended				For the nine months ended
(Dollars in thousands)	September 30, 2016				September 30, 2015
TROUBLED DEBT RESTRUCTURINGS THAT SUBSEQUENTLY DEFAULTED	Number of Loans		Recorded Investment		Number of Loans		Recorded Investment
Commercial mortgage (Owner occupied)		—	$	—		1	$	124

Other Real Estate Owned

The table below details the properties included in other real estate owned (“OREO”) as of September 30, 2016 and December 31, 2015. There were three collateralized consumer residential mortgage loans with an aggregate balance of $601 thousand from two borrowers in the process of foreclosure as of September 30, 2016.

	As of September 30, 2016				As of December 31, 2015
	No. of		Carrying		No. of		Carrying
(Dollars in thousands)	Properties		Value		Properties		Value
Residential		3	$	1,172		3	$	540
Land lots		6		536		7		413
Convenience stores		1		59		2		191
Restaurant		1		55		1		55
Commerical properties		3		942		3		671
Total		14	$	2,764		16	$	1,870

Included in other assets as of September 30, 2016, was one residential property purchased in 2013 from a related party with a value of $708 thousand and a former branch, which was closed April 30, 2015, with a value of $403 thousand. Both properties are being marketed for sale.

17

Note 7: Earnings per share

The following table shows the weighted average number of shares used in computing earnings per share and the effect on the weighted average number of shares of dilutive potential common stock.

	For the three months ended								For the nine months ended
	September 30, 2016				September 30, 2015				September 30, 2016				September 30, 2015
	Average		Per share		Average		Per share		Average		Per share		Average		Per share
	Shares		Amount		Shares		Amount		Shares		Amount		Shares		Amount
Basic earnings per share		4,774,856	$	0.18		4,780,649	$	0.06		4,774,856	$	0.41		4,797,405	$	0.20
Effect of dilutive securities:
Stock options		22,665				15,359				18,291				13,724
Diluted earnings per share		4,797,521	$	0.18		4,796,008	$	0.06		4,793,147	$	0.41		4,811,129	$	0.20

For the three months ended September 30, 2016 and 2015, options on 33,451 and 60,973 shares, respectively, were not included in computing diluted earnings per share because their effects were anti-dilutive. For the nine months ended September 30, 2016 and 2015, options on 47,041 and 68,473 shares, respectively, were not included in computing diluted earnings per share because their effects were anti-dilutive.

Note 8: Stock-Based Compensation

On June 28, 2013, the Company registered with the Securities and Exchange Commission a stock-based compensation plan, which superseded all other plans. There are 342,000 shares available for grant under this plan at September 30, 2016.

Stock-based compensation expense related to stock awards for both the three month periods ended September 30, 2016 and 2015 was zero. For the nine months ended September 30, 2016 and 2015, stock-based compensation expense related to stock awards was $16 thousand and $17 thousand, respectively. Compensation expense for stock options is the estimated fair value of options on the date granted using the Black-Scholes Model amortized on a straight-line basis over the vesting period of the award. There was no unrecognized compensation expense related to stock options as of September 30, 2016.

Options for a total of 7,500 shares were granted and vested during the nine months ended September 30, 2016. The aggregate fair value of options granted during the nine months ended September 30, 2016 was $16 thousand. Options for a total of 7,500 shares were granted and vested during the nine months ended September 30, 2015. The aggregate fair value of options granted during the nine months ended September 30, 2015 was $17 thousand.

The variables used in these calculations of the fair value of the options are as follows:

	For the nine months ended September 30,
	2016	2015
Risk free interest rate (5 year Treasury)	1.49%	1.52%
Expected dividend yield	0.0%	0.0%
Expected term (years)	5	5
Expected volatility	40.1%	47.1%

Stock option activity for the nine months ended September 30, 2016 is summarized below:

						Weighted Average Remaining Contractual Life (in years)
				Weighted Average				Aggregate
				Exercise				Intrinsic
	Shares			Price				Value (1)
Options outstanding, January 1, 2016		211,185		$	6.57		6.0
Granted		7,500			5.76
Forfeited		(13,787	)		5.90
Exercised		—			—
Expired		(8,598	)		12.84
Options outstanding and exercisable, September 30, 2016		196,300		$	6.20		5.7	$	126,134

(1) The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on September 30, 2016. This amount changes based on changes in the market value of the Company’s common stock.

18

Note 9: Employee Benefit Plans

The Company has a non-contributory, defined benefit pension plan for full-time employees who were over 21 years of age and vested in the plan as of December 31, 2012, when the plan was frozen. Each participant’s account balance grows based on monthly interest credits. The Company funds pension costs in accordance with the funding provisions of the Employee Retirement Income Security Act.

The Company sponsors a post-retirement benefit plan covering current and future retirees who acquire age 55 and 10 years of service or age 65 and 5 years of service. The post-retirement benefit plan provides coverage toward a retiree’s eligible medical and life insurance benefits expenses. The plan is unfunded and funded as benefits are due.

Components of Net Periodic (Benefit) Cost

(Dollars in thousands)	Pension Benefits						Post-Retirement Benefits
Nine months ended September 30,	2016			2015			2016		2015
Service cost	$	—		$	—		$	17	$	17
Interest cost		101			99			21		23
Expected return on plan assets		(142	)		(148	)		—		—
Settlement loss		21			—			—		—
Recognized net actuarial loss		58			57			—		—
Net periodic cost	$	38		$	8		$	38	$	40

The Company expects to make no contribution to its pension plan and $2 thousand to its post-retirement benefit plan during the remainder of 2016. The Company has contributed $5 thousand towards the post-retirement plan during the first nine months of 2016.

Note 10: Long Term Debt

FHLB Debt

As of September 30, 2016, the Bank had $25.0 million of outstanding FHLB debt, consisting of four advances. As of December 31, 2015, seven advances totaling $40.0 million were outstanding. Three advances for $5.0 million each that matured in February 2016, April 2016 and September 2016 were repaid. The fixed rate advance that matured in October 2016 was replaced with a three month 0.49% fixed rate advance for $5.0 million.

The five advances are shown in the following table.

					Current			Maturity
Description	Balance		Originated		Interest Rate			Date
Adjustable Rate Hybrid	$	10,000,000		4/12/2013		3.04910	%		4/13/2020
Fixed Rate Credit		5,000,000		10/20/2015		0.52000	%		10/20/2016
Fixed Rate Credit		5,000,000		12/21/2015		0.99000	%		6/15/2017
Fixed Rate Credit		5,000,000		12/22/2015		1.08000	%		9/15/2017
	$	25,000,000

Advances on the FHLB lines are secured by a blanket lien on qualified 1 to 4 family residential real estate loans. Immediate available credit, as of September 30, 2016, was $84.7 million against a total line of credit of $115.7 million.

As of September 30, 2016 and December 31, 2015, the Company had $25.0 million and $40.0 million, respectively, in FHLB debt outstanding with a weighted average interest rate of 1.74% and 1.17%, respectively.

Subordinated Debt

On May 28, 2015, the issued an aggregate of $7,000,000 of subordinated notes (the “Notes”). The Notes have a maturity date of May 28, 2025. The Notes bear interest, payable on the 1st of March and September of each year, commencing September 1, 2015, at a fixed interest rate of 6.50% per year. The Notes are not convertible into common stock or preferred stock, and are not callable by the holders. The Company has the right to redeem the Notes, in whole or in part, without premium or penalty, at any interest payment date on or after May 28, 2020 and prior to the maturity date, but in all cases in a principal amount with integral multiples of $1,000, plus interest accrued and unpaid through the date of redemption. If an event of default occurs, such as the bankruptcy of the Company, the holder of a Note may declare the principal amount of the Note to be due and immediately payable. The Notes are unsecured, subordinated obligations of the Company and will rank junior in right of payment to the Company’s existing and future senior indebtedness. The Notes qualify as Tier 2 capital for regulatory reporting.

19

(Dollars in thousands)	Balance as of
	September 30, 2016
6.5% Subordinated Debt	$	7,000
Less: Issuance costs		(144	)
	$	6,856

Note 11: Fair Value Measurements

The Company uses fair value to record certain assets and liabilities and to determine fair value disclosures. Authoritative accounting guidance clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

Authoritative accounting guidance specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:

Level 1 –	Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 2 –	Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
Level 3 –	Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Securities available-for-sale: Securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

Defined benefit plan assets: Defined benefit plan assets are recorded at fair value on an annual basis at year end.

Mortgage servicing rights: MSRs are recorded at fair value on a recurring basis, with changes in fair value recorded in the results of operations. A model is used to determine fair value, which establishes pools of performing loans, calculates cash flows for each pool and applies a discount rate to each pool. Loans are segregated into 14 pools based on each loan’s term and seasoning (age). All loans have fixed interest rates. Cash flows are then estimated by utilizing assumed service costs and prepayment speeds. Service costs were assumed to be $6.00 per loan as of both September 30, 2016 and December 31, 2015. Prepayment speeds are determined primarily based on the average interest rate of the loans in each pool. The prepayment scale used is the Public Securities Association (“PSA”) model, where “100% PSA” means prepayments are zero in the first month, then increase by 0.2% of the loan balance each month until reaching 6.0% in month 30. Thereafter, the 100% PSA model assumes an annual prepayment of 6.0% of the remaining loan balance. The average PSA speed assumption in the fair value model is 217% and 163% as of September 30, 2016 and December 31, 2015, respectively. A discount rate of 10% was then applied to each pool as of September 30, 2016 and 11.0% as of December 31, 2015. This discount rate is intended to represent the estimated market yield for the highest quality grade of comparable servicing. MSRs are classified as Level 3.

20

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015:

(Dollars in thousands)			Fair Value Measurements at September 30, 2016 Using
Description	Balance		Level 1		Level 2		Level 3
Securities available-for-sale:
Corporate bonds	$	7,003	$	—	$	1,500	$	5,503
U. S. Government agencies		25,677		1,597		24,080		—
State and municipal obligations		19,883		—		19,883		—
Total securities available-for-sale:	$	52,563	$	1,597	$	45,463	$	5,503
Mortgage servicing rights	$	590	$	—	$	—	$	590
Defined benefit plan assets:
Cash and cash equivalents	$	3	$	3	$	—	$	—
Mutual funds - fixed income		1,071		1,071		—		—
Mutual funds - equity		1,615		1,615		—		—
Total defined benefit plan assets	$	2,689	$	2,689	$	—	$	—
			Fair Value Measurements at December 31, 2015 Using
Description	Balance		Level 1		Level 2		Level 3
Securities available-for-sale:
Corporate bonds	$	3,945	$	—	$	—	$	3,945
U. S. Government agencies		21,288		1,216		20,072		—
State and municipal obligations		28,857		—		28,857		—
Total securities available-for-sale:	$	54,090	$	1,216	$	48,929	$	3,945
Mortgage servicing rights	$	658	$	—	$	—	$	658
Defined benefit plan assets:
Cash and cash equivalents	$	3	$	3	$	—	$	—
Mutual funds - fixed income		1,119		1,119		—		—
Mutual funds - equity		1,684		1,684		—		—
Total defined benefit plan assets	$	2,806	$	2,806	$	—	$	—

The reconciliation of items using Level 3 inputs is as follows:

				Corporate
(Dollars in thousands)	MSRs			Bonds
Balance, January 1, 2016	$	658		$	3,945
Purchases		—			3,000
Impairments		—			—
Fair value adjustments		(68	)		58
Sales		—			—
Balance, September 30, 2016	$	590		$	7,003

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. Any given loan may have multiple types of collateral. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral value is significantly adjusted due to differences in the comparable properties, or is

21

discounted by the Company because of marketability, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the ALL are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Other Real Estate Owned: OREO is measured at fair value less estimated costs to sell, based on an appraisal conducted by an independent, licensed appraiser outside of the Company. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. OREO is measured at fair value on a nonrecurring basis. The initial fair value of OREO is based on an appraisal done at the time of foreclosure. Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest income on the Consolidated Statements of Income.

The following table summarizes the Company’s assets that were measured at fair value on a nonrecurring basis at the end of the respective period.

			Fair Value Measurements at September 30, 2016 Using
(Dollars in thousands)	Balance as of
Description	September 30, 2016		Level 1		Level 2		Level 3
Impaired Loans, net	$	2,375	$	—	$	—	$	2,375
Other real estate owned, net		2,764		—		—		2,764
			Fair Value Measurements at December 31, 2015 Using
	Balance as of
Description	December 31, 2015		Level 1		Level 2		Level 3
Impaired Loans, net	$	3,868	$	—	$	—	$	3,868
Other real estate owned, net		1,870		—		—		1,870

The following table displays quantitative information about Level 3 Fair Value Measurements as of September 30, 2016:

(Dollars in thousands)	Balance as of September 30, 2016		Valuation Technique	Unobservable Input		Range (Weighted Average)
Impaired Loans, net	$	2,375	Discounted appraised value		Selling Cost		10% - 20% (14%)
					Lack of Marketability		50% (50%)
Other real estate owned, net		2,764	Discounted appraised value		Selling Cost		3% - 13% (5%)
					Lack of Marketability		10% - 20% (11%)

The following table displays quantitative information about Level 3 Fair Value Measurements as of December 31, 2015:

(Dollars in thousands)	Balance as of December 31, 2015		Valuation Technique	Unobservable Input	Range (Weighted Average)
Impaired Loans, net	$	3,868	Discounted appraised value	Selling Cost		10% - 25% (13%)
				Lack of Marketability		50% - 60% (51%)
Other real estate owned, net		1,870	Discounted appraised value	Selling Cost		3% - 13% (4%)
				Lack of Marketability		10% - 20% (12%)

22

The estimated fair values of financial instruments are shown in the following table. The carrying amounts in the table are included in the balance sheet under the applicable captions.

					Fair Value Measurements at September 30, 2016 Using
(Dollars in thousands)	Balance as of		Fair Value as of
Description	September 30, 2016		September 30, 2016		Level 1		Level 2		Level 3
Financial Assets:
Cash and due from banks	$	5,280	$	5,280	$	5,280	$	—	$	—
Interest-bearing deposits		6,343		6,343		6,343		—		—
Certificates of deposit		4,464		4,464		—		4,464		—
Federal funds sold		460		460		460		—		—
Securities available-for-sale		52,563		52,563		1,597		45,463		5,503
Restricted securities		2,209		2,209		—		—		2,209
Loans, net		364,822		371,247		—		—		371,247
Loans held for sale		481		481		—		—		481
Accrued interest receivable		1,241		1,241		—		1,241		—
Mortgage servicing rights		590		590		—		—		590
Financial Liabilities:
Non-interest-bearing liabilities	$	74,615	$	74,615	$	74,615	$	—	$	—
Savings and other interest-bearing deposits		175,448		175,448		—		175,448		—
Time deposits		127,912		129,175		—		—		129,175
Securities sold under repurchase agreements		12,984		12,984		—		12,984		—
FHLB advances		25,000		25,755		—		25,755		—
Subordinated debt		6,856		7,000		—		—		7,000
Accrued interest payable		207		207		—		207		—
					Fair Value Measurements at December 31, 2015 Using
(Dollars in thousands)	Balance as of		Fair Value as of
Description	December 31, 2015		December 31, 2015		Level 1		Level 2		Level 3
Financial Assets:
Cash and due from banks	$	4,969	$	4,969	$	4,969	$	—	$	—
Interest-bearing deposits		15,330		15,330		15,330		—		—
Certificates of deposit		5,735		5,735		—		5,487		248
Federal funds sold		271		271		271		—		—
Securities available-for-sale		54,090		54,090		1,216		48,929		3,945
Restricted securities		2,731		2,731		—		—		2,731
Loans, net		343,323		347,500		—		—		347,500
Loans held for sale		270		270		—		—		270
Accrued interest receivable		1,318		1,318		—		1,318		—
Mortgage servicing rights		658		658		—		—		658
Financial Liabilities:
Non-interest-bearing liabilities	$	65,842	$	65,842	$	65,842	$	—	$	—
Savings and other interest-bearing deposits		166,628		166,628		—		166,628		—
Time deposits		127,388		127,433		—		—		127,433
Securities sold under repurchase agreements		7,161		7,161		—		7,161		—
FHLB advances		40,000		40,855		—		40,855		—
Subordinated debt		6,844		7,000		—		—		7,000
Accrued interest payable		318		318		—		318		—

The carrying amounts of cash and due from banks, interest-bearing deposits, federal funds sold or purchased, accrued interest receivable, loans held for sale and non-interest-bearing deposits, are payable on demand, or are of such short duration that carrying value approximates market value.

Securities available-for-sale are carried at quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

The carrying value of restricted securities approximates fair value based on the redemption provisions of the issuer.

23

MSRs are carried at fair value. As described above, a valuation model is used to determine fair value. This model utilizes a discounted cash flow analysis with servicing costs and prepayment assumptions based on comparable instruments and a discount rate.

The fair value of performing loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar remaining maturities. This calculation ignores loan fees and certain factors affecting the interest rates charged on various loans such as the borrower’s creditworthiness and compensating balances and dissimilar types of real estate held as collateral. The fair value of impaired loans is measured as described within the Impaired Loans section of this note. The fair value of loans does not consider the lack of liquidity and uncertainty in the market that would affect the valuation.

Time deposits are presented at estimated fair value by discounting the future cash flows using interest rates offered for deposits of similar remaining maturities.

The fair value of the Company’s subordinated debt is estimated by utilizing observable market prices for comparable securities. Qualitative factors like asset quality, market factors and liquidity are also considered.

The fair value of the FHLB advances is estimated by discounting the future cash flows using the current interest rates offered for similar advances.

The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counter parties at the reporting date. At September 30, 2016 and December 31, 2015, the fair value of loan commitments and standby letters of credit was immaterial and therefore, they are not included in the table above.

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair value of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.

Note 12: Changes in Accumulated Other Comprehensive Income (Loss)

The balances in accumulated other comprehensive income (loss) are shown in the following tables:

	For the Three Months Ended September 30, 2016
	Net Unrealized			Pension and			Accumulated Other
	Gains (Losses)			Post-retirement			Comprehensive
(Dollars in thousands)	on Securities			Benefit Plans			Income (Loss)
Balance July 1, 2016	$	624		$	(883	)	$	(259	)
Change in net unrealized holding gains on securities, before reclassification		—			—			—
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $62		(118	)		—			(118	)
Balance September 30, 2016	$	506		$	(883	)	$	(377	)
	For the Three Months Ended September 30, 2015
	Net Unrealized Gains (Losses)			Pension and Post-retirement			Accumulated Other Comprehensive
(Dollars in thousands)	on Securities			Benefit Plans			Income (Loss)
Balance July 1, 2015	$	(130	)	$	(966	)	$	(1,096	)
Change in net unrealized holding gains on securities, before reclassification, net of tax expense of $136		267			—			267
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $0		(2	)		—			(2	)
Balance September 30, 2015	$	135		$	(966	)	$	(831	)

24

	For the Nine Months Ended September 30 , 2016
	Net Unrealized Gains (Losses)			Pension and Post-retirement			Accumulated Other Comprehensive
(Dollars in thousands)	on Securities			Benefit Plans			Income (Loss)
Balance January 1, 2016	$	107		$	(883	)	$	(776	)
Change in net unrealized holding gains on securities, before reclassification, net of tax expense of $305		590			—			590
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $99		(191	)		—			(191	)
Balance September 30, 2016	$	506		$	(883	)	$	(377	)
	For the Nine Months Ended September 30, 2015
	Net Unrealized Gains (Losses)			Pension and Post-retirement			Accumulated Other Comprehensive
(Dollars in thousands)	on Securities			Benefit Plans			Income (Loss)
Balance January 1, 2015	$	45		$	(966	)	$	(921	)
Change in net unrealized holding losses on securities, before reclassification, net of tax expense of $47		93			—			93
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $1		(3	)		—			(3	)
Balance September 30, 2015	$	135		$	(966	)	$	(831	)

Reclassification for previously unrealized gains (losses) and impairments on securities are reported in the Consolidated Statements of Income as follows. No unrealized gains (losses) on pension and post-employment related costs were reclassified to the Consolidated Statements of Income in the three and nine months ended September 30, 2016 and 2015.

Accumulated Other Comprehensive Income (Loss)

Reclassification for the Three Months Ended

Holding Losses on Securities

(Dollars in thousands)	September 30, 2016			September 30, 2015
Net gains on sale of securities available-for-securities	$	180		$	2
Tax expense		(62	)		—
Impact on net income	$	118		$	2

Accumulated Other Comprehensive Income (Loss)

Reclassification for the Nine Months Ended

Holding Losses on Securities

(Dollars in thousands)	September 30, 2016			September 30, 2015
Net gains on sale of securities available-for-securities	$	290		$	4
Tax expense		(99	)		(1	)
Impact on net income	$	191		$	3

Note 13: Subsequent Event

On November 2, 2016, the Company signed a definitive merger agreement with Virginia BanCorp Inc. (“Virginia BanCorp”). Upon completion of the merger, the Company will be the surviving corporation and shareholders of Virginia BanCorp will receive 1.178 shares of the Company’s common stock for each share of Virginia BanCorp common stock they own. After the merger is completed, the Company’s shareholders will own approximately 51% of the stock of the Company and Virginia BanCorp’s shareholders will own approximately 49%. The merger is expected to be completed early in the second quarter of 2017, subject to approval of both companies’ shareholders, regulatory approvals, and other customary closing conditions. As of September 30, 2016, Virginia BanCorp, Inc. total assets were approximately $325.1 million and total stockholders’ equity was $35.7 million.

25

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the results of operations and the financial condition of Bay Banks of Virginia, Inc. This discussion should be read in conjunction with the above consolidated financial statements and the notes thereto.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements concerning the Company’s expectations, plans, objectives, future financial performance and other statements that are not historical facts. These statements may constitute “forward-looking statements” as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements. These forward-looking statements include statements about the benefits of the proposed merger between the Company and Virginia BanCorp, the Company’s and Virginia BanCorp’s plans, obligations, expectations and intentions and other statements that are not historical facts. Words such as “anticipates,” “believes,” “intends,” “should,” “expects,” “will,” and variations of similar expressions are intended to identify forward-looking statements. Factors that could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, the ability to obtain required regulatory and shareholder approvals and meet other closing conditions to the transaction; the ability to complete the merger as expected and within the expected timeframe; disruptions to customer and employee relationships and business operations caused by the merger; the ability to implement integration plans associated with the transaction, which integration may be more difficult, time-consuming or costly than expected; the ability to achieve the cost savings and synergies contemplated by the merger within the expected timeframe, or at all, changes in interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, expansion activities, demand for financial services in the Company’s market area, accounting principles, policies and guidelines and the other factors detailed in Bay Banks’s publicly filed documents, including its Annual Report on Form 10-K for the year ended December 31, 2015. These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements, which speak only as of the date they are made.

EXECUTIVE SUMMARY

On November 2, 2016, the Company signed a definitive merger agreement with Virginia BanCorp Inc. (“Virginia BanCorp”). Upon completion of the merger, the Company will be the surviving corporation and shareholders of Virginia BanCorp will receive 1.178 shares of the Company’s common stock for each share of Virginia BanCorp common stock they own. After the merger is completed, the Company’s shareholders will own approximately 51% of the stock of the Company and Virginia BanCorp’s shareholders will own approximately 49%. The merger is expected to be completed early in the second quarter of 2017, subject to approval of both companies’ shareholders, regulatory approvals, and other customary closing conditions. As of September 30, 2016, Virginia BanCorp, Inc. total assets were approximately $325.1 million and total stockholders’ equity was $35.7 million.

Earnings for the nine months ended September 30, 2016 and 2015 were $2.0 million and $956 thousand, respectively. This is an improvement of $1.0 million, or 105.4%, year over year. Improvements in net interest income and non-interest income all contributed to the increase. Net interest income grew by $858 thousand, non-interest income grew by $705 thousand and provision for loan losses increased by $53 thousand. Return on average assets improved to 0.57% from 0.31% for the same comparable period, and return on average equity improved to 6.44% from 3.23%.

The in-house loan portfolio grew by $21.0 million, or 6.0%, during the first nine months of 2016. Loans originated and sold to Fannie Mae generated growth of $4.8 million in that servicing portfolio since December 31, 2015. The portfolio of loans serviced for Fannie Mae totaled $76.4 million as of September 30, 2016 compared to $71.6 million as of December 31, 2015 and $70.6 million as of September 30, 2015. In the third quarter of 2016, the Company sold its credit card loan portfolio to an unaffiliated third party. This sale is providing improved customer service for cardholders and reducing the Company’s exposure to credit card fraud and security breaches. The Company realized a gain of approximately $150 thousand on the sale of the credit card loan portfolio.

The net interest margin declined to 3.39% for the first nine months of 2016 compared to 3.49% for the same period in 2015 as new loans are originated at rates lower than existing loans. Expansion into Richmond has generated $60.2 million of loans in that market as of September 30, 2016. Loans in the Richmond market grew $17.8 million in the nine months ended September 30, 2016.

Growth in loans requires growth in deposits or other borrowings in order to fund those loans, and retail deposits have grown $16.5 million in the nine months ended September 30, 2016. This deposit growth has allowed the Company to reduce borrowings from the FHLB by $15.0 million during that same time frame.

Loans past due or non-accruing have declined by $2.1 million to $6.3 million in the nine months ended September 30, 2016. Asset quality remains good with non-performing assets down to 1.7% of total assets at September 30, 2016 compared to 1.8% at December 31, 2015.

Finally, the Company’s core capital levels and regulatory ratios remain well above what is considered “well capitalized” by the Company’s regulators.

For more information, visit the Company’s website at www.baybanks.com. Information contained on the Company’s website is not a part of this report.

EARNINGS SUMMATION

For the three months ended September 30, 2016 and 2015, net income was $854 thousand and $281 thousand, respectively, an increase of $573 thousand or 203.9%. Diluted earnings per average share for the three months ended September30, 2016 and 2015 were $0.18 and $0.06, respectively. The primary factors in the increase were $439 thousand in net interest income related to loan growth, a $180 thousand gain from sales of investments, a $150 thousand gain from the sale of the VISA credit card portfolio and a $56 thousand increase in fees related to fiduciary activities. These increases were partially offset by an increase in the provision for loan losses of $175 thousand. Annualized return on average assets was 0.72% for the third quarter of 2016 compared to 0.26% for the third quarter of 2015. Annualized return on average equity was 8.16% and 2.82% for the three months ended September 30, 2016 and 2015, respectively.

26

For the nine months ended September 30, 2016 and 2015, net income was $2.0 million and $956 thousand, respectively, an increase of $1.0 million or 105.4%. Diluted earnings per average share for the nine months ended September 30, 2016 and 2015 were $0.41 and $0.20, respectively. The primary factors in the increase were $858 thousand in net interest income related to higher loan balances and improved yields on investments securities, a $286 thousand increase in gains realized on the sales of securities and a $150 thousand gain recognized on the sale of the VISA credit card portfolio. These increases were partially offset by higher interest expense of $503 thousand related to additional money market accounts, the issuance of subordinated debt in May 2015, and an increase of $53 thousand in the provision for loan losses. Annualized return on average assets was 0.57% for the first nine months of 2016 compared to 0.31% for the first nine months of 2015. Annualized return on average equity was 6.44% and 3.23% for the nine months ended September 30, 2016 and 2015, respectively.

The table below details certain financial and statistical information for the Company relating to income and returns.

Return on Equity & Assets

	Nine Months			Twelve Months			Twelve Months
	Ended			Ended			Ended
	September 30,			December 31,			December 31,
(Dollars in thousands, except per share amounts)	2016			2015			2014
Net Income	$	1,964		$	366		$	1,830
Average Total Assets		459,974			416,872			343,838
Return on Average Assets		0.57	%		0.09	%		0.53	%
Average Equity	$	40,737		$	39,740		$	38,418
Return on Average Equity		6.44	%		0.92	%		4.76	%
Cash Dividends declared per share	$	—		$	—		$	—
Average Shares Outstanding		4,774,856			4,791,722			4,818,377
Average Diluted Shares Outstanding		4,793,147			4,805,318			4,829,581
Net Income per Share	$	0.41		$	0.08		$	0.38
Net Income per Diluted Share		0.41			0.08			0.38
Cash Dividend Payout Ratio		0.0	%		0.0	%		0.0	%
Average Equity to Average Assets Ratio		8.86	%		9.53	%		11.17	%

RESULTS OF OPERATIONS

The principal source of earnings for the Company is net interest income. Net interest income is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of assets which earn interest. Changes in the volume and mix of assets which earn interest and liabilities that bear interest, the associated yields and rates, and the volume of non-performing assets have an effect on net interest income, the net interest margin, and net income.

27

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2016 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 2015

NET INTEREST INCOME

Net Interest Income Analysis	Average Balances, Income and Expense, Yields and Rates
(Fully taxable equivalent basis)
(Dollars in thousands)	Three months ended 9/30/2016							Three months ended 9/30/2015
	Average Balance		Income/ Expense		Yield/ Cost			Average Balance		Income/ Expense		Yield/Cost
INTEREST EARNING ASSETS:
Taxable investments	$	33,149	$	233		2.81	%	$	29,746	$	144		1.94	%
Tax-exempt investments (1)		20,987		186		3.55	%		19,428		155		3.19	%
Total investments		54,136		419		3.10	%		49,174		299		2.43	%
Gross loans (2)		358,087		4,153		4.63	%		325,166		3,810		4.69	%
Interest-bearing deposits		19,217		25		0.52	%		17,769		9		0.20	%
Certificates of deposits		5,083		20		1.57	%		3,645		15		1.65	%
Federal funds sold		1,679		1		0.31	%		1,469		—		0.07	%
Total Interest Earning Assets	$	438,202	$	4,618		4.22	%	$	397,223	$	4,133		4.16	%
INTEREST-BEARING LIABILITIES:
Savings deposits	$	43,588	$	24		0.22	%	$	41,835	$	19		0.18	%
NOW deposits		43,122		21		0.20	%		40,772		15		0.15	%
Time deposits => $100,000		62,055		218		1.39	%		56,042		215		1.52	%
Time deposits < $100,000		65,563		224		1.36	%		57,134		207		1.44	%
Time deposits - Wholesale		237		1		0.60	%		6,387		6		0.39	%
Money market deposit accounts		89,727		160		0.71	%		75,676		181		0.95	%
Total Deposits		304,292		648		0.84	%		277,846		643		0.92	%
Federal funds purchased		154		1		0.87	%		327		—		0.67	%
Securities sold under repurchase agreements		9,545		4		0.17	%		9,728		4		0.18	%
Subordinated debt		6,854		118		6.84	%		6,840		119		6.96	%
FHLB advances		29,334		118		1.60	%		30,000		87		1.15	%
Total Interest-Bearing Liabilities	$	350,179	$	889		1.01	%	$	324,741	$	853		1.04	%
Net interest income and net interest margin			$	3,729		3.40	%			$	3,280		3.30	%
Non-interest-bearing deposits	$	76,810		—		0.00	%	$	60,658		—		0.00	%
Total Cost of funds						0.83	%						0.89	%
Net interest rate spread						3.38	%						3.28	%

Notes:

(1) Income and yield assumes a federal tax rate of 34%.

(2) Includes loan fees and nonaccrual loans.

Interest income for the three months ended September 30, 2016, on a tax-equivalent basis, was $4.6 million, an increase of $485 thousand from the third quarter of 2015, due mainly to increases in loan balances, additional investment securities and higher yields on investments. Interest expense for the three months ended September 30, 2016 was $889 thousand, an increase of $36 thousand from the third quarter of 2015, due primarily to increases in deposits, which supported loan growth. Net interest income for the three months ended September 30, 2016, on a tax-equivalent basis, was $3.7 million, an increase of $449 thousand from the third quarter of 2015.

The annualized net interest margin was 3.40% and 3.30% for the three months ended September 30, 2016 and 2015, respectively. This increase is due primarily to higher investment yields of 3.10% in the third quarter of 2016 compared to 2.43% in the third quarter of 2015, plus reduced costs of money market accounts and time deposits. The net interest margin increase was partially offset by reductions in loan yields, to 4.63% for the third quarter of 2016 from 4.69% for the third quarter of 2015, as market rates remain historically low and new loans are made at rates lower than existing loans. The cost of funds declined to 0.83% for the third quarter of 2016 from 0.89% for the third quarter of 2015, a result of higher non-interest bearing deposit balances and lower costs of time deposits.

The net interest spread, which is the difference between the annualized yield on earning assets and the total cost of funds, increased to 3.38% for the three months ended September 30, 2016, compared to 3.28% for the three months ended September 30, 2015.

NON-INTEREST INCOME

Non-interest income for the third quarter of 2016 increased by $565 thousand, or 73.1%, compared to the third quarter of 2015. Contributing to this increase was a $178 thousand increase in gains on the sale of investments, a $150 thousand gain recognized on the sale of the VISA credit card portfolio, a $56 thousand increase in fiduciary fees from the Trust Company and a reduction of $161 thousand in losses from OREO.

28

NON-INTEREST EXPENSE

For both the three months ended September 30, 2016 and 2015, non-interest expenses totaled $3.6 million. Salaries and employee benefits declined $78 thousand quarter over quarter as the result of the staff reductions in December 2015 and August 2016.

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 2015

NET INTEREST INCOME

Net Interest Income Analysis	Average Balances, Income and Expense, Yields and Rates
(Fully taxable equivalent basis)
(Dollars in thousands)	Nine months ended 9/30/2016							Nine months ended 9/30/2015
	Average Balance		Income/ Expense		Yield/ Cost			Average Balance		Income/ Expense		Yield/ Cost
INTEREST EARNING ASSETS:
Taxable investments	$	31,181	$	651		2.78	%	$	27,343	$	402		1.96	%
Tax-exempt investments (1)		23,024		597		3.46	%		17,450		418		3.20	%��
Total investments		54,205		1,248		3.07	%		44,793		820		2.45	%
Gross loans (2)		351,805		12,140		4.60	%		312,301		11,200		4.78	%
Interest-bearing deposits		14,715		52		0.47	%		18,607		30		0.21	%
Certificates of deposits		5,343		62		1.57	%		2,701		32		1.58	%
Federal funds sold		1,027		2		0.31	%		920		—		0.06	%
Total Interest Earning Assets	$	427,095	$	13,504		4.22	%	$	379,322	$	12,082		4.25	%
INTEREST-BEARING LIABILITIES:
Savings deposits	$	42,826	$	66		0.21	%	$	43,058	$	57		0.18	%
NOW deposits		40,781		52		0.17	%		41,570		47		0.15	%
Time deposits => $100,000		62,201		670		1.44	%		55,910		637		1.52	%
Time deposits < $100,000		64,076		654		1.36	%		56,789		608		1.43	%
Time deposits - Wholesale		2,552		10		0.50	%		7,347		21		0.39	%
Money market deposit accounts		86,059		482		0.75	%		57,501		359		0.83	%
Total Deposits		298,495		1,934		0.87	%		262,175		1,729		0.88	%
Federal funds purchased		254		2		1.06	%		109		—		0.68	%
Securities sold under repurchase agreements		7,361		10		0.18	%		7,736		8		0.14	%
Subordinated debt		6,850		354		6.90	%		3,114		161		6.91	%
FHLB advances		32,754		360		1.47	%		33,241		259		1.04	%
Total Interest-Bearing Liabilities	$	345,714	$	2,660		1.03	%	$	306,375	$	2,157		0.94	%
Net interest income and net interest margin			$	10,844		3.39	%			$	9,925		3.49	%
Non-interest-bearing deposits	$	70,096		—		0.00	%	$	61,030		—		0.00	%
Total Cost of funds						0.85	%						0.78	%
Net interest rate spread						3.36	%						3.47	%

Notes:

(1) Income and yield assumes a federal tax rate of 34%.

(2) Includes loan fees and nonaccrual loans.

Interest income for the nine months ended September 30, 2016, on a tax-equivalent basis, was $13.5 million, an increase of $1.4 million from the first nine months of 2015, due mainly to increases in loan balances. Interest expense for the nine months ended September 30, 2016 was $2.7 million, an increase of $503 thousand from the first nine months of 2015, due primarily to subordinated debt that was issued in May 2015, higher costs of FHLB advances and increases in money market deposits in Richmond, which supported loan growth. Net interest income for the first nine months of 2016, on a tax-equivalent basis, was $10.8 million, an increase of $919 thousand from the same period of 2015.

The annualized net interest margin was 3.39% and 3.49% for the nine months ended September 30, 2016 and 2015, respectively. As shown in the volume and rate analysis table, the change is due to the following factors: (1) reductions in loan yields, to 4.60% for the first nine months of 2016 from 4.78% for the first nine months of 2015, as market rates remain historically low and new loans are made at rates lower than existing loans, which resulted in rate-related reductions in interest income of $478 thousand; and (2) the cost of funds increased to 0.85% for the first nine months of 2016 from 0.78% for the first nine months of 2015, which was due to the higher cost of FHLB advances and resulted in rate-related increases in interest expense of $105 thousand.

The net interest spread, which is the difference between the annualized yield on earning assets and the total cost of funds, increased to 3.75% for the nine months ended September 30, 2016, compared to 3.47% for the nine months ended September 30, 2015.

29

The following table details the volume and rate changes to net interest income.

Volume and Rate Analysis of Changes in Net Interest Income

	Nine Months Ended
	September 30,									Years Ended December 31,									Years Ended December 31,
	2016 vs. 2015									2015 vs. 2014									2014 vs. 2013
(Dollars in Thousands)	Increase (Decrease)									Increase (Decrease)									Increase (Decrease)
	Due to Changes in:									Due to Changes in:									Due to Changes in:
	Volume (1)			Rate (1)			Total			Volume (1)			Rate (1)			Total			Volume (1)			Rate (1)			Total
Earning Assets:
Taxable investments	$	56		$	193		$	249		$	184		$	21		$	205		$	(68	)	$	(2	)	$	(70	)
Tax-exempt investments (2)		135			44			179			12			16			28			59			15			74
Gross loans		1,418			(478	)		940			2,590			(740	)		1,850			1,403			(668	)		735
Certificates of deposit		31			(1	)		30			17			13			30			—			4			4
Interest-bearing deposits		(7	)		29			22			17			(1	)		16			(33	)		(1	)		(34	)
Federal funds sold		—			2			2			1			—			1			(1	)		—			(1	)
Total interest earning assets	$	1,633		$	(211	)	$	1,422		$	2,821		$	(691	)	$	2,130		$	1,360		$	(652	)	$	708
Interest-Bearing Liabilities:
NOW checking	$	(1	)	$	6		$	5		$	(2	)	$	—		$	(2	)	$	1		$	(14	)	$	(13	)
Savings deposits		—			9			9			(1	)		9			8			(5	)		(15	)		(20	)
Money market accounts		179			(55	)		124			221			209			430			10			(23	)		(13	)
Time deposits < $100,000		78			(32	)		46			89			(60	)		29			(87	)		(176	)		(263	)
Time deposits => $100,000		72			(39	)		33			182			(122	)		60			(21	)		(205	)		(226	)
Time deposits - Wholesale		(14	)		2			(12	)		17			1			18			9			—			9
Federal funds purchased		1			1			2			5			—			5			1			—			1
Securities sold under repurchase agreements		—			2			2			—			3			3			(1	)		(6	)		(7	)
Subordinated notes		194			(1	)		193			279			—			279			—			—			—
FHLB advances		(4	)		105			101			131			(124	)		7			165			(270	)		(105	)
Total interest-bearing liabilities	$	505		$	(2	)	$	503		$	921		$	(84	)	$	837		$	72		$	(709	)	$	(637	)
Change in net interest income	$	1,134		$	(215	)	$	919		$	1,900		$	(607	)	$	1,293		$	1,288		$	57		$	1,345

Notes:

(1) Changes caused by the combination of rate and volume are allocated based on the percentage caused by each.

(2) Income and yields are reported on a tax-equivalent basis, assuming a federal tax rate of 34%.

INTEREST SENSITIVITY

The Company employs a variety of measurement techniques to identify and manage its exposure to changing interest rates and subsequent changes in liquidity. The Company utilizes simulation models that estimate the effect of interest rate changes on net interest income and the economic value of equity. The Bank uses an asset-liability management consultant to assist with the management of interest rate risk, liquidity risk and balance sheet strategy. The Bank’s Asset Liability Committee (the “ALCO”) is responsible for monitoring interest rate risk and is composed of appointed members from management and the Board of Directors. Through the use of simulations, the ALCO reviews the overall magnitude of interest rate risk and then formulates policy with which to manage asset growth, funding sources, pricing, and off-balance sheet commitments. These decisions are based on management’s plans for growth, expectations regarding future interest rate movements, economic conditions both locally and nationally, and other business and risk factors.

The simulation models indicate that the Bank’s balance sheet is neutral to asset sensitive, which management believes is favorable in the current low interest rate environment. This means that as rates rise, interest-earning assets should reprice as fast or faster than interest-bearing liabilities, allowing interest income to rise as fast or faster than interest expense. Thus, net interest income should remain stable or grow. Moderate growth in the balance sheet is expected to assure continued growth in net interest income.

NON-INTEREST INCOME

Non-interest income for the first nine months of 2016 increased by $705 thousand, or 27.4%, compared to the first nine months of 2015. Contributing to this increase was an increase of $286 thousand in gains on the sale of investments, a $150 thousand gain recognized on the sale of the VISA credit card portfolio, an increase of $107 thousand in fiduciary fees from the Trust Company and a decrease of $153 thousand in losses related to OREO sales and write-downs.

30

NON-INTEREST EXPENSE

Non-interest expense increased $35 thousand, or 0.3% and was $10.9 million and $10.8 million for the first nine months of 2016 and 2015, respectively. The primary driver of this increase was Federal Deposit Insurance Corporation deposit insurance assessments which increased by $80 thousand as a result of a higher assessment base compared to 2015 and a $44 thousand increase in bank franchise taxes, which were partially offset by a decrease in salaries and employee benefits of $96 thousand due to staff reductions in December 2015 and August 2016.

FINANCIAL CONDITION

Average Interest-Earning Assets and Average Interest-Bearing Liabilities

Average interest-earning assets increased 12.6% to $427.1 million for the nine months ended September 30, 2016, as compared to $379.3 million for the nine months ended September 30, 2015, due mainly to higher loan balances. Average interest-earning assets as a percent of total average assets were 92.9% for the nine months ended September 30, 2016 as compared to 92.5% for the same period in 2015. The loan portfolio, with $351.8 million in average balances as of September 30, 2016, is the largest category of interest-earning assets.

Average interest-bearing liabilities increased 12.8% to $345.7 million for the nine months ended September 30, 2016, as compared to $306.4 million for the nine months ended September 30, 2015, due primarily to the growth in money market deposits in the Richmond branches. The largest category of interest-bearing liabilities is time deposits, with combined average balances of $128.8 million for the nine months ended September 30, 2016, up from $120.0 million for the similar period in 2015. Average balances of money market deposit accounts increased by $28.6 million to $86.1 million for the first nine months of 2016 compared to the same period in 2015 primarily attributable to growth in the Richmond, Virginia market.

Loans

During the nine months ended September 30, 2016, gross loans increased by $21.0 million or 6.0%, to $368.2 million from $347.2 million at year-end 2015. The largest components of this increase were increases of $21.0 million related to residential mortgages.

Types of Loans

	As of September 30,					As of December 31,					As of December 31,					As of December 31,					As of December 31,
	2016					2015					2014					2013					2012
(Dollars in thousands)	Amount		% of Total			Amount		% of Total			Amount		% of Total			Amount		% of Total			Amount		% of Total
Mortgage loans on real estate:
Construction and land loans	$	41,530		11.3	%	$	42,129		12.1	%	$	43,048		14.4	%	$	31,839		12.7	%	$	29,024		12.2	%
Secured by farmland		1,051		0.3	%		1,030		0.3	%		1,128		0.4	%		1,262		0.5	%		1,443		0.6	%
Secured by 1-4 family residential		210,762		57.2	%		190,902		55.0	%		160,667		53.9	%		138,502		55.3	%		133,437		56.0	%
Other real estate loans		74,635		20.3	%		73,042		21.0	%		53,860		18.1	%		48,803		19.5	%		47,055		19.8	%
Commercial and industrial loans (not secured by real estate)		36,596		9.9	%		35,104		10.1	%		34,002		11.4	%		23,939		9.6	%		20,525		8.6	%
Consumer and other		3,615		1.0	%		5,015		1.5	%		5,349		1.8	%		5,986		2.4	%		6,653		2.8	%
Total	$	368,189		100.0	%	$	347,222		100.0	%	$	298,054		100.0	%	$	250,331		100.0	%	$	238,137		100.0	%

Notes:

Deferred loan costs and fees not included.

Loan Maturity Schedule of Selected Loans

As of September 30, 2016

	Commercial and		Construction, Land and
(Dollars in thousands)	Industrial		Land Development
Within one year	$	11,297	$	23,403
Variable Rate
One to Five Years		1,083		186
After Five Years		183		713
Total Variable Rate		1,266		899
Fixed Rate
One to Five Years		11,064		13,286
After Five Years		12,969		3,942
Total Fixed Rate		24,033		17,228
Total Maturities	$	36,596	$	41,530

31

Asset Quality – Provision and Allowance for Loan Losses

The provision for loan losses is a charge against earnings that is necessary to maintain the allowance for loan losses at a level consistent with management’s evaluation of the loan portfolio’s inherent risk.

As shown in the following table, the provision for loan losses was $407 thousand for the nine months ended September 30, 2016, $1.6 million in 2015 and $611 thousand in 2014. The ALL was $3.7 million as of September 30, 2016, $4.2 million as of December 31, 2015 and $3.2 million as of December 31, 2014. The increase in the provision expense and ALL in 2015 was due primarily to additional impairment reserves for one commercial borrower who pleaded guilty in a federal court to “Willful Failure to Collect or Pay Over Employment Tax” and admitted to regularly and deliberately creating false financial statements for submission to financial institutions in order to encourage banks to lend new funds to his affiliated companies, or to enable the renewal of existing loans to such entities. As of September 30, 2016, management considered the allowance for loan losses to be sufficient to cover estimated potential loss exposure inherent in the loan portfolio.

Allowance for Loan Losses

	Nine Months Ended
	September 30,			Years Ended December 31,
(Dollars in thousands)	2016			2015			2014			2013			2012
Balance, beginning of period	$	4,223		$	3,205		$	2,925		$	3,094		$	3,189
Loans charged off:
Mortgage Loans on Real Estate		(702	)		(521	)		(313	)		(879	)		(1,798	)
Commercial and industrial		(158	)		(9	)		—			(17	)		(388	)
Consumer and other (including Visa program)		(41	)		(128	)		(79	)		(132	)		(189	)
Total loans charged off		(901	)		(658	)		(392	)		(1,028	)		(2,375	)
Recoveries of loans previously charged off:
Mortgage Loans on Real Estate		25			27			36			68			289
Commercial and industrial		5			—			—			1			18
Consumer and other (including Visa program)		9			52			25			14			78
Total recoveries		39			79			61			83			385
Net charge offs		(862	)		(579	)		(331	)		(945	)		(1,990	)
Reclassification of allowance related to sold loans		(27	)		—			—			—			—
Provision for loan losses		407			1,597			611			776			1,895
Balance, end of period	$	3,741		$	4,223		$	3,205		$	2,925		$	3,094
Average loans outstanding during the period	$	351,805		$	319,597		$	266,016		$	240,964		$	240,557
Ratio of net charge-offs during the period to average loans outstanding during the period		0.25	%		0.18	%		0.12	%		0.39	%		0.83	%

The ratio of the allowance for loan losses to total loans was 1.02 %, 1.22% and 1.07% as of September 30, 2016, December 31, 2015 and December 31, 2014, respectively.

Allocation of the Allowance for Loan Losses

	Nine Months Ended
	September 30,				Years Ended December 31,
(Dollars in Thousands)	2016				2015				2014				2013				2012
Mortgage Loans on Real Estate	$	3,208	0.87	%	$	3,502	1.01	%	$	2,778	0.93	%	$	2,466	0.98	%	$	2,572	1.08	%
Commercial and industrial		480	0.13	%		599	0.17	%		323	0.11	%		256	0.10	%		262	0.11	%
Consumer and other		53	0.02	%		122	0.04	%		104	0.03	%		203	0.09	%		252	0.11	%
Unallocated		—	0.00	%		—	0.00	%		—	0.00	%		—	0.00	%		8	0.00	%
Total	$	3,741	1.02	%	$	4,223	1.22	%	$	3,205	1.07	%	$	2,925	1.17	%	$	3,094	1.30	%

Non-Performing Assets

Non-performing assets, which include OREO and non-performing loans, decreased by $514 thousand to $7.8 million, or 1.7% of total assets as of September 30, 2016 compared to $8.3 million as of December 31, 2015. This decrease is primarily related to a decrease of $1.6 million in non-accruing loans partially offset by an increase of $894 thousand of OREO and $167 thousand in loans past 90 days or more and still accruing. The increase in OREO was attributable to the foreclosure of two properties related to the above-mentioned commercial borrower who perpetrated fraud against the Bank.

32

Loans charged off during the first nine months of 2016, net of recoveries, totaled $862 thousand compared to $185 thousand for the first nine months of 2015, primarily due to the aforementioned commercial borrower. This represents an increase in the annualized net charge-off ratio to 0.32% for the first nine months of 2016 compared to 0.08% for the first nine months of 2015. Nearly all of those charge-offs were anticipated and specific reserves had been provided for them in the ALL. Management believes it is maintaining an adequate level of the ALL at 1.02% of total loans at September 30, 2016 and 1.22% at December 31, 2015. The reduction is due mainly to anticipated declines in the specific components of the ALL. Historical loss factors have increased and qualitative factors are unchanged.

Non-Performing Assets

	As of
	September 30,			As of December 31,
(Dollars in Thousands)	2016			2015			2014			2013			2012
Loans past due 90 days or more and still accruing	$	178		$	11		$	14		$	18		$	126
Non-accruing loans		4,858			6,433			1,954			2,754			5,730
Total non-performing loans		5,036			6,444			1,968			2,772			5,856
Other real estate owned		2,764			1,870			2,791			3,897			3,151
Total non-performing assets	$	7,800		$	8,314		$	4,759		$	6,669		$	9,007
Allowance for loan losses	$	3,741		$	4,223		$	3,205		$	2,925		$	3,094
Allowance to non-performing loans		74.4	%		65.6	%		162.9	%		105.5	%		52.8	%
Non-performing assets to total assets		1.7	%		1.8	%		1.2	%		2.0	%		2.7	%

The Bank had $2.8 million and $1.9 million of OREO at September 30, 2016 and December 31, 2015, respectively. As of September 30, 2016, OREO consists of three residences, six lots, one former convenience store, one former restaurant and three commercial business properties. During the first nine months of 2016, four properties with a total book value of $1.3 million from three borrowers were added through foreclosure, and five properties with a total book value of $402 thousand were sold. There were $53 thousand of write-downs of OREO properties during the first nine months of 2016, compared to $159 thousand for the same period in 2015. All properties maintained as OREO are valued at the lesser of cost or fair value less estimated costs to sell and are actively marketed.

Classified assets, which include loans with risk rating grades of substandard, doubtful and loss, plus OREO, increased by $1.1 million during the first nine months of 2016 to $12.1 million, or 27.3% of Tier 1 capital plus the allowance for loan losses. Risk rating grades are assigned conservatively, causing some homogenous loans, such as residential mortgages, to fall into the pool of adversely risk rated loans and thereby evaluated for impairment, even though they may be performing as agreed and therefore not impaired.

As of September 30, 2016, loans valued at $10.5 million were considered impaired, whereas $10.8 million were considered impaired as of December 31, 2015. Between December 31, 2015 and September 30, 2016, nine additional loans were identified as impaired, two dispensed through foreclosure and charged-off, one was paid off and three were upgraded. Management has reviewed the impaired credits and the underlying collateral and the current losses have been specifically reserved.

Securities

Investment securities totaled $52.6 million, $54.1 million and $40.4 million as of September 30, 2016, December 31, 2015 and December 31, 2014, respectively.

.

33

(Dollars in thousands)
			Gross		Gross
Available-for-sale securities	Amortized		Unrealized		Unrealized			Fair
September 30, 2016	Cost		Gains		(Losses)			Value
Corporate bonds	$	6,945	$	58	$	—		$	7,003
U.S. Government agencies		25,461		272		(56	)		25,677
State and municipal obligations		19,363		541		(21	)		19,883
	$	51,769	$	871	$	(77	)	$	52,563
			Gross		Gross
Available-for-sale securities	Amortized		Unrealized		Unrealized			Fair
December 31, 2015	Cost		Gains		(Losses)			Value
Corporate bonds	$	3,950	$	—	$	(5	)	$	3,945
U.S. Government agencies		21,375		69		(156	)		21,288
State and municipal obligations		28,599		313		(55	)		28,857
	$	53,924	$	382	$	(216	)	$	54,090
			Gross		Gross
Available-for-sale securities	Amortized		Unrealized		Unrealized			Fair
December 31, 2014	Cost		Gains		(Losses)			Value
U.S. Government agencies	$	16,969	$	33	$	(37	)	$	16,965
State and municipal obligations		23,335		226		(160	)		23,401
	$	40,304	$	259	$	(197	)	$	40,366

The Company currently classifies the entire investment portfolio as available-for-sale in order that it may be considered a source of liquidity, if necessary. Securities available-for-sale are carried at fair market value, with after-tax unrealized gains or losses disclosed as a component of comprehensive income. The after-tax unrealized gains or losses are recorded as a portion of other comprehensive income in the equity of the Company, but have no impact on earnings until such time as the gain or loss is realized, typically at the time of sale. As of September 30, 2016, December 31, 2015 and December 31, 2014, the Company had accumulated other comprehensive gains net of deferred tax related to securities available-for-sale of $506 thousand, $107 thousand and $45 thousand, respectively.

The investment portfolio shows a net unrealized gain of $794 thousand on September 30, 2016, $166 thousand on December 31, 2015, and $68 thousand on December 31, 2014.

As of September 30, 2016, securities available-for-sale at fair value totaled $52.6 million as compared to $54.1 million on December 31, 2015. This represents a net decrease of $1.5 million or 2.8% for the nine months ended September 30, 2016. As of September 30, 2016, available-for-sale securities represented 11.2% of total assets and 12.2% of earning assets.

The bank owned life insurance’s cash surrender value as of September 30, 2016 was $9.8 million. During the third quarter of 2016, the Company bought an additional $2.0 million of insurance. The insurance’s purpose is to offset the cost of employee benefits.

Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in net income if (i) there is evidence of credit related impairment; (ii) the Company intends to sell the security or (iii) it is more-likely-than-not that the Company will be required to sell the security before recovery of its amortized cost basis. As a result, temporary impairment can occur with rising interest rates, since the market value of a fixed income investment will fall as interest rates rise. Conversely, market values will increase as interest rates fall.

The Company seeks to diversify its assets to minimize risk by maintaining a large portion of its investment portfolio in securities issued by states and political subdivisions. Many of these types of securities also provide tax benefits. Mortgage-backed securities and collateralized mortgage obligations held in the investment portfolio provide liquidity via cashflows, and are solely issued by agencies of the U.S. government. The Company owns no derivatives, and participates in no hedging activities.

34

Investment Maturities and Average Yields

As of September 30, 2016

	One Year or
	Less or			One to Five			Five to Ten			Over Ten
(Dollars in Thousands)	No Maturity			Years			Years			Years
U.S. Government and Agencies:
Book Value	$	2		$	15,149		$	6,659		$	3,679
Market Value		2			15,310			6,706			3,659
Weighted average yield		5.62	%		1.82	%		2.27	%		2.41	%
States and Municipal Obligations:
Book Value	$	50		$	4,810		$	13,490		$	1,013
Market Value		50			4,916			13,889			1,028
Weighted average yield		3.98	%		3.34	%		3.56	%		4.26	%
Corporate Bonds:
Book Value	$	—		$	6,945		$	—		$	—
Market Value		—			7,003			—			—
Weighted average yield		0.00	%		5.83	%		0.00	%		0.00	%
Restricted Securities:
Book Value	$	—		$	—		$	—		$	2,209
Market Value		—			—			—			2,209
Weighted average yield		0.00	%		0.00	%		0.00	%		1.30	%
Total Securities:
Book Value	$	52		$	26,904		$	20,149		$	6,901
Market Value		52			27,229			20,595			6,896
Weighted average yield		4.04	%		3.13	%		3.13	%		2.33	%

Notes:

Yields on tax-exempt securities have been computed on a tax-equivalent basis.

Deposits

As of September 30, 2016, total deposits were $378.0 million compared to $359.9 million at year-end 2015. This represents an increase in balances of $18.1 million or 5.0% during the nine months. The increase was driven by a $8.8 million increase in savings and interest bearing deposits, an increase of $524 thousand in time deposits and a $8.8 million increase in noninterest-bearing deposits.

Average Deposits and Rates

	Nine Months Ended September 30,					Twelve Months Ended December 31,
	2016					2015					2014
(Dollars in thousands)	Average Balance		Yield/ Rate			Average Balance		Yield/ Rate			Average Balance		Yield/ Rate
Non-interest bearing Demand Deposits	$	70,096		0.00	%	$	61,825		0.00	%	$	59,551		0.00	%
Interest bearing Deposits:
NOW Accounts		40,781		0.17	%		41,030		0.15	%		42,258		0.15	%
Regular Savings		42,826		0.21	%		42,716		0.18	%		43,416		0.16	%
Money Market Deposit Accounts		86,059		0.75	%		63,830		0.87	%		30,187		0.42	%
Time Deposits - Retail
CD’s $100,000 or more		62,201		1.44	%		55,713		1.51	%		44,879		1.75	%
CD’s less than $100,000		64,076		1.36	%		57,228		1.43	%		51,230		1.54	%
Time Deposits - Wholesale		2,552		0.50	%		6,900		0.40	%		2,154		0.44	%
Total Interest bearing Deposits		298,495		0.87	%		267,417		0.89	%		214,124		0.86	%
Total Average Deposits	$	368,591		0.70	%	$	329,242		0.72	%	$	273,675		0.67	%

Maturity Schedule of Time Deposits of $100,000 and over

	As of
	September 30,		As of December 31,
(In thousands)	2016		2015		2014
3 months or less	$	2,394	$	12,898	$	6,429
3-6 months		2,713		5,010		2,481
6-12 months		4,871		7,462		17,005
Over 12 months		52,148		36,362		30,775
Totals	$	62,126	$	61,732	$	56,690

35

LIQUIDITY

Liquidity represents an institution’s ability to meet present and future financial obligations (such as commitments to fund loans) through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with other banks, federal funds sold and investments and loans maturing within one year. The Company’s ability to obtain deposits and purchase funds at favorable rates are major factors for liquidity. Management believes that the Company maintains overall liquidity that is sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

At September 30, 2016, cash totaled $5.3 million, federal funds sold totaled $460 thousand, interest-bearing deposits totaled $6.3 million, securities, certificates of deposit and investments maturing in one year or less totaled $1.3 million and loans maturing in one year or less totaled $27.3 million. This results in a liquidity ratio of 8.7% as of September 30, 2016 as compared to 12.1% as of December 31, 2015. The Company determines this ratio by dividing the sum of cash and cash equivalents, investment securities maturing in one year or less, loans maturing in one year or less and federal funds sold, by total assets. The Bank has a formal liquidity management policy and contingency plan, which includes periodic evaluation of cash flow projections.

The table below presents selected information on short-term borrowings:

	As of
	September 30,			As of December 31,
	2016			2015			2014
(Dollars in Thousands)
Balance outstanding at period-end	$	12,984		$	7,161		$	6,012
Maximum balance at any month end during the year		12,984			10,491			9,164
Average balance for the period		7,361			7,612			7,538
Weighted average rate for the period		0.18	%		0.15	%		0.12	%
Weighted average rate on borrowings at period end		0.10	%		0.14	%		0.12	%

The parent company has no substantial operations of its own, so its primary sources of liquidity are fees received from the Bank, interest on investments and borrowings. The parent company’s liquid assets consisted of cash and investment securities totaling $3.6 million as of September 30, 2016. The parent company has sufficient liquidity to meet its obligations and provide a source of capital for the Bank.

FHLB advances have declined by $15.0 million since December 31, 2015, to $25.0 million as of September 30, 2016. This reduction was funded from deposit growth.

On May 28, 2015, the Company issued an aggregate of $7,000,000 of subordinated notes (the “Notes”). The Notes have a maturity date of May 28, 2025. The Notes bear interest, payable on the 1st of March and September of each year, commencing September 1, 2015, at a fixed interest rate of 6.50% per year. The Notes are not convertible into common stock or preferred stock, and are not callable by the holders. The Company has the right to redeem the Notes, in whole or in part, without premium or penalty, at any interest payment date on or after May 28, 2020 and prior to the maturity date, but in all cases in a principal amount with integral multiples of $1,000, plus interest accrued and unpaid through the date of redemption. If an event of default occurs, such as the bankruptcy of the Company, the holder of a Note may declare the principal amount of the Note to be due and immediately payable. The Notes are unsecured, subordinated obligations of the Company and will rank junior in right of payment to the Company’s existing and future senior indebtedness. The Notes qualify as Tier 2 capital for regulatory reporting.

As of September 30, 2016, securities sold under repurchase agreements increased by $5.8 million to $13.0 million from $7.2 million at December 31, 2015. This increase was the result of one new account.

In addition, the Bank has a line of credit with the FHLB worth $115.7 million, with $84.7 million available, plus federal funds lines of credit with correspondent banks totaling $21.5 million.

The following table presents the Company’s contractual obligations and scheduled payment amounts, excluding interest, due at various intervals over the next five years and beyond as of September 30, 2016:

	Payments Due by Period
			Less than
(Dollars in thousands)	Total		1 year		1-3 years		3-5 years		Over 5 years
FHLB advances	$	25,000	$	15,000	$	—	$	10,000	$	—
Subordinated debt		7,000		—		—		—		7,000
Securities sold under repurchase agreements		12,984		12,984		—		—		—
Operating leases		266		127		132		7		—
Total	$	45,250	$	28,111	$	132	$	10,007	$	7,000

As of September 30, 2016, the Company was not aware of any other known trends, events or uncertainties that have or are reasonably likely to have a material impact on liquidity.

36

CAPITAL RESOURCES

Capital resources represent funds, earned or obtained, over which a financial institution can exercise greater long-term control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition and quality of the Company’s resources, and consistency 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 to absorb potential losses, yet allows management to effectively leverage its capital to maximize return to shareholders. The Company’s capital, also known as shareholders’ equity, is comprised mainly of outstanding common stock and retained earnings. Capital can be increased with securities offerings or through earnings.

Several factors impact shareholders’ equity, including net income and regulatory capital requirements. The Company’s capital resources are also impacted by net unrealized gains or losses on securities. The available-for-sale securities portfolio is marked to market monthly and unrealized gains or losses, net of taxes, are recognized as accumulated other comprehensive income (loss) on the balance sheets and statement of changes in shareholders’ equity. Another factor affecting accumulated other comprehensive income (loss) is changes in the market value of the Company’s pension and post-retirement benefit plans and changes in the plan obligations. The Company’s shareholders’ equity before accumulated other comprehensive loss was $42.3 million on September 30, 2016 compared to $40.3 million on December 31, 2015. Accumulated other comprehensive loss decreased by $399 thousand between December 31, 2015 and September 30, 2016, primarily as a result of increases in unrealized net gains in the investment portfolio.

Book value per share, before accumulated other comprehensive loss, on September 30, 2016, compared to December 31, 2015, increased to $8.86 from $8.45. Book value per share, including accumulated other comprehensive loss, increased to $8.79 on September 30, 2016 from $8.29 on December 31, 2015. No cash dividends were paid for the nine month period ended September 30, 2016, nor for the comparable period ended September 30, 2015.

One source of funds available to the Company is the payment of dividends by the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval from the Bank’s regulators.

The Bank is subject to minimum regulatory capital ratios as defined by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). As of September 30, 2016, the Bank’s capital ratios continue to be well in excess of regulatory minimums.

In July 2013, the Federal Reserve issued final rules that made the changes to its capital rules to align them with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. Effective January 1, 2015, the final rules require the Bank to comply with the following minimum capital ratios: (i) a new Common Equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from the prior requirement of 4.0%); (iii) a total capital ratio of 8.0% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4.0% of total assets (unchanged from the prior requirement). The following additional capital requirements related to the capital conservation buffer are being phased in over a four year period beginning January 1, 2016. When fully phased in on January 1, 2019, the rules will require the Bank to maintain (i) a minimum ratio of Common Equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% Common Equity Tier 1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of Common Equity Tier 1 to risk-weighted assets of at least 7.0% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation), and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets. The capital conservation buffer requirement is being phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of Common Equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. As of September 30, 2016, the Bank maintained Common Equity Tier 1 capital of $41.5 million, Tier 1 capital of $41.5 million, risk weighted assets of $331.8 million, and total risk-based capital of $45.2 million. As of September 30, 2016, all ratios were in excess of the fully phased-in requirements, with the Common Equity Tier 1 ratio at 12.50% of risk-weighted assets, the Tier 1 capital ratio at 12.50% of risk-weighted assets, the total capital ratio at 13.63% of risk-weighted assets, and the Tier 1 leverage ratio at 8.91% of total assets.

OFF BALANCE SHEET COMMITMENTS

In the normal course of business, the Company offers various financial products to its customers to meet their credit and liquidity needs. These instruments may involve elements of liquidity, credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby-letters of credit is represented by the contractual amount of these instruments. Subject to its normal credit standards and risk monitoring procedures, the Company makes contractual commitments to extend credit. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Conditional commitments are issued by the Company in the form of performance stand-by letters of credit, which guarantee the performance of a customer to a third-party. The credit risk of issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

37

Off Balance Sheet Arrangements

	September 30, 2016		December 31, 2015		December 31, 2014
(Dollars in thousands)
Total loan commitments outstanding	$	38,173	$	42,713	$	36,443
Standby-by letters of credit		382		473		355
Low income housing tax credit funds		998		499		—

The Company maintains liquidity and credit facilities with non-affiliated banks in excess of the total loan commitments and stand-by letters of credit. As these commitments are earning assets only upon takedown of the instrument by the customer, thereby increasing loan balances, management expects the revenue of the Company to be enhanced as these credit facilities are utilized.

There have been no material changes to the off balance sheet items disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operation” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

CONTRACTUAL OBLIGATIONS

There have been no other 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 fiscal year ended December 31, 2015.

RECENT ACCOUNTING PRONOUNCEMENTS

Refer to Note 3, Amendments to the Accounting Standards Codification, in the Notes to the Consolidated Financial Statements contained in Item 1 of this report, for information related to the adoption of new amendments to the Accounting Standards Codification.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not required.

ITEM 4. CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

As of the end of the period to which this report relates, the Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-14 of the Securities Exchange Act of 1934. In designing and evaluating its disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that objectives of the disclosure controls and procedures are met. The design of any disclosure controls and procedures is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential conditions. Based upon their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic Securities and Exchange Commission filings as of September 30, 2016.

CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING

There was no change to the Company’s internal control over financial reporting during the three months ended September 30, 2016 that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In the ordinary course of its operations, the Company is a party to various legal proceedings. Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on the business, financial condition, or results of operations of the Company.

38

ITEM 1A. RISK FACTORS

Not required.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On December 17, 2014, the Company announced a share repurchase program pursuant to which it is authorized to repurchase up to 240,892 shares of its common stock. The share repurchase program was authorized to last through December 31, 2015. On November 12, 2015, the Board of Directors extended the share repurchase program until December 31, 2016. A total of 43,000 shares have been repurchased as of September 30, 2016. No share repurchases have been made during 2016.

ITEM 3. DEFAULT UPON SENIOR SECURITIES

None to report.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM  5. OTHER INFORMATION

None to report.

ITEM 6. EXHIBITS

2.1	Agreement and Plan of Merger, dated November 2, 2016, by and between Bay Banks of Virginia, Inc. and Virginia BanCorp Inc. (attached as Exhibit 2.1 to the Current Report on Form 8-K filed November 8, 2016 and incorporated herein by reference).
10.1	Employment Agreement, dated November 2, 2016, between Bay Banks of Virginia, Inc., Bank of Lancaster and Randal R. Greene (attached as Exhibit 10.1 to the Current Report on Form 8-K filed November 8, 2016 and incorporated herein by reference).
10.2	Employment Agreement, dated November 2, 2016, between Bay Banks of Virginia, Inc., Bank of Lancaster and Deborah M. Evans (attached as Exhibit 10.2 to the Current Report on Form 8-K filed November 8, 2016 and incorporated herein by reference).
10.3	Employment Agreement, dated November 2, 2016, between Bay Banks of Virginia, Inc., Bank of Lancaster and Douglas F. Jenkins, Jr. (attached as Exhibit 10.3 to the Current Report on Form 8-K filed November 8, 2016 and incorporated herein by reference).
31.1	Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101	The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2016, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets as of September 30, 2016 and December 31, 2015, (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2016 and 2015, (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015, (iv) Consolidated Statements of Changes in Shareholders’ Equity for the nine months ended September 30, 2016, (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015, and (vi) Notes to Consolidated Financial Statements.

39

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Bay Banks of Virginia, Inc.
(Registrant)
November 14, 2016	By:	/s/ Randal R. Greene
		Randal R. Greene
		President and Chief Executive Officer
		(Principal Executive Officer)
	By:	/s/ Deborah M. Evans
		Deborah M. Evans
		Treasurer and Chief Financial Officer
		(Principal Financial and Accounting Officer)

40